July 2, 2007 | posted by Michael Baxter in IABN |

It’s not difficult to reason why? Once again, there are two dollars to the pound. Sterling exchange rate has entered the kind of territory previously seen in 1992, the year of the infamous Black Wednesday - the last time we saw a sterling crisis. But, why is the pound so strong? Answer: it’s the rate of interest.

In the US, the current official cost of borrowing is 5.25 per cent, but it’s expected to fall. In the UK rates are 5.75 per cent and expected to hit 6 per cent during the course of this year. As a result, money has been flooding into the UK, pushing the pound up.

You can understand why the rate of interest keeps the pound high in the short-run. But, we are also seeing something of a balance of payments crisis, meaning that in the long-term, the pound should be a lot weaker. And yet, sterling remains strong at a time when our exporters struggle to compete.

The thing that clinches it for the UK is this. While our balance of payments is bad, in the US it is even worse.

In the first quarter of 2007 the UK balance of payments deficit was the equivalent of 3.6 per cent of GDP. That’s enormous, and would normally cause the warning bells to ring across the economic landscape. But, instead, attention has focused on the US, where the deficit is even larger - around 6 per cent of GDP. Hence the pound remains strong against the dollar.

Indeed, after comparing the relationship between the dollar and the pound relative to the rate of interest, and after factorising in expected changes in UK and US rates, Capital Economics has calculated that the pound dollar rate could even hit $2.10.

Furthermore, the UK balance of payments deficit actually improved in the last quarter. According to the Office of National Statistics, in the first quarter of 2007, the UK balance of payments current account deficit was £12.2 billion, compared to £14.5 billion in the last quarter of 2006 (although the deficit was lower in the previous two quarters).

But the danger is this. The UK’s balance of payment deficit would have been much worse, if it wasn’t for something a tad odd. The difference between the UK assets held abroad and liabilities in the form of British assets in the UK owned by overseas investors, is minus £302.9 billion. Not only is this a massive deficit, it’s getting worse fast. Back in the second quarter of 2006 it stood at £221.2 billion; enormous, but just two thirds of the current shortfall.

And yet despite this massive deficit, investment income has been a positive contributor to our balance of payments. For example in the second quarter of 2006, our balance of trade of goods and services was a truly terrifying £15.9 billion, but our investment income was £7.9 billion, taking our overall current account deficit to a more manageable £10.7 billion.

In contrast, during the quarter just gone, our investment income had been whittled down to £3.4 billion, less than half the level enjoyed nine months earlier.

So the big question is this: why is our net income from investments positive when the net value of investments is negative? The answer: because most of the investments held in the UK are in the form of low risk debt. On the other hand, the UK’s investments are more risky. In recent years, with the global economy performing so well, with stock markets enjoying a bull run across the world, and with the rate of interest so low, the UK’s approach has worked. We have enjoyed a handsome return on our risky investments.

The snag is this. Moving forward, with the rate of interest in the UK now a lot higher, debt repayments flowing from the UK to abroad are likely to rise. At the same time, any kind of slow-down in the global economy, and let’s face it, it’s got to see a slowdown in growth sooner or later, could see our investment income fall rapidly.

Should our net income go negative - and it seems inevitable this will happen sooner or later, then providing our balance of trade on goods and services does not suddenly improve, the UK’s balance of payments deficit on current account could rocket, perhaps hitting 5 per cent of GDP or more.

Furthermore, it is widely expected that the US will see its balance of trade improve, so it is quite possible then the UK will soon have the highest deficit as a proportion of GDP of all the world’s major economies.

It seems unlikely that, in this environment, the pound will remain so high.