January 5, 2009 | posted by Michael Baxter in Sterling | comments (2) |

The collapse in sterling was one of the stories of 2008. We could be days away from parity with the euro.

Incredibly, Goldman Sachs reckons sterling will return to 1.25 euros to the pound within a few months. And beyond that could hit 1.75 euros. If they are right, then all those people who are smirking because they are paid in euros, could soon end up with egg on their face.

But is Goldman Sachs right?

Unlike some economists, it has been argued here that the fall the pound is a good thing. For the UK to correct its underlying problems – namely that as a country we spend more than we produce – for something that manifests itself in the form of balance of payments deficits, we need a cheaper pound.

The pound was propped up for years by the flow of money into the UK. This has stopped. In part, the recent falls in sterling allow for future cuts in interest rates. If the Bank of England cuts rates by, say, half a per cent when its MPC next meets, it seems likely the pound will be unaffected. If the rate cut is less than that, or if the bank stays its hand altogether, then the pound may rise. If rates are cut by 1 per cent, and talk about zero rates grows, then sterling will probably fall further.

The main export markets for the UK are also in serious economic trouble. So can we really export our way out of trouble?

There have been three major examples of falls in sterling in the past. In 1931, exodus from the gold standard was a good thing, and the UK grew when the world was in depression. In 1967, the devaluation of the pound led to inflation, and things just got worse. The ejection from ERM in 1992 is now widely seen as a good thing, the move that provided the impetus for recovery.

Just like in 1931, the fall in the pound can create a boom even in a time of global economic hardship. Although our export markets are in recession too, these economies have not stopped altogether. They are just spending a couple of per cent less than a year ago. The pound, on the other hand, is more than 25 per cent cheaper.

The UK has certain advantages over its Eurozone rivals. Business is more flexible and the labour market is less rigid. The UK can adjust more quickly than our European cousins.

It is possible that the cheap pound will help create a UK renaissance, which could lead to rises in sterling in the future. But this is surely unlikely to happen for some time.

On the other hand, the UK is not the only Western European economy with problems. France and Spain suffer from massive balance of payments deficits too, but because they share their currency with Germany – with its massive balance of payments surplus – they are not seeing their currency fall in value, yet.

For these reasons, the UK recovery may prove to be more rapid than in, say, France.

It does seem that in the longer term, the UK will be more susceptible to inflation than the Eurozone. The ECB has kept much tighter reins on monetary policy. Inflation can lead to currency weakness.

So, if you imagine a pair of scales. On the right hand side are the prospects for a fall in sterling, on the left the prospects for a rise. On the right we have the prospects for rates falling all the way to zero, and in the longer term the danger that the UK will be more exposed to inflation than the Eurozone.

On the left side, we have greater flexibility in the UK economy and the possibility that the Eurozone’s economic problems are just as serious as the UK’s, but are just lagging behind. If this is right, then today’s falls in the pound will be tomorrow’s fall in the euro.

December 2, 2008 | posted by Michael Baxter in Sterling | comments (0) |

It was the biggest fall in sterling against the dollar since 1992.

Sterling plummeted again yesterday, falling five cents against the dollar and three cents against the euro.

At the time of writing, there are 1.4799 dollars to the pound and just 1.176 euros to the pound.

The pound is falling as the economic woe grows. With yesterday’s Purchasing Managers Index from the Chartered Institute of Purchasing Supply falling to the lowest level ever recorded, and with news on job losses mounting – HSBC and Aston Martin are the latest – expectations are growing for a big cut in the UK rate of interest.

The view expressed here a couple of months ago that rates would hit zero, seems to be gaining traction – with more and more economists warning this is a real possibility.

Yet it is not time to panic.

At current levels the pound–dollar ratio was even lower in 2002 and 1993.

If you believe the fundamental problem with the UK is that it was spending more money than it was earning, then it seems that an overvalued pound was a part of that problem. (For heaven’s sake, at one point in 2007, the UK actually enjoyed a higher GDP per capita than the US, measured at exchange rates.)

The UK needs a cheaper pound before the economy can be restructured – and we can export more.

Sure, it is not easy relying on exports at the time of a worldwide economic slowdown, but bear in mind the pound is now more than 25 per cent down on its dollar price seen a few months ago.

As for the euro, the pound has been steadily falling for years. At one point earlier this decade there were more than 1.7 euros to the pound; 12 months ago, there were 1.4 euros to the pound.

Sure, global demand is falling, but it has not fallen out of sight. An economy that suddenly finds it can sell its products abroad for 25 per cent less, measured in dollars, than it could a few months ago, will surely benefit.

It will help when our main trading partners in the Eurozone recover, which is why the French and Germany economies may recover before the UK does.

Just bear in mind, the global economy was in dire straights in 1931, the year the UK left the gold standard and allowed the pound to sink – yet economic recovery in the UK did follow.

But the danger lies in the possibility of even steeper falls in sterling. Should sterling collapse by another 25 per cent against the dollar and the euro – then we will be in trouble. If that happened, the UK government may not be able to fund its spending, and the Bank of England may have to up interest rates.

If the UK is going to export its way out of trouble, then entrepreneurial Britain needs invigorating. We need to innovate ourselves out of trouble, not spend our way forward. That is why Alistair Darling missed a trick when he announced a £16bn cut in VAT, which we will barely notice, and only much more modest plans to lend to business.

It is business that needs money – not old mature business that is past its sale by date, but new dynamic business with bold ideas.

October 23, 2008 | posted by Michael Baxter in Sterling | comments (1) |

So the pound crashed yesterday and it was all Gordon Brown’s and Mervyn King’s fault. On Radio 4 yesterday, John Redwood, the MP who once stood against John Major, and later proved he had no idea what a sense of humour was when he was interviewed by Clive Anderson, lambasted the government. By saying Britain was probably in recession, argued Redwood, Mervyn King was responsible for the crash in sterling. He went on to say, and here we paraphrase, Gordon Brown was to blame for it was he who appointed the idiotic King.

On BBC2’s Newsnight yesterday evening, the programme’s economics editors argued that the fall in sterling will not help British exporters, for the simple reason that global demand is collapsing.

It was hailed as a disaster: Great Britain PLC – RIP.

It is just that this analysis happens to be wrong. Yesterday’s development with sterling was perhaps the single best piece of news since the ejection of sterling from the ERM in 1992. It marks the beginning of the British recovery. King deserves eulogy for his honest assessment, and this is why:

It has become popular to compare today’s economic crisis with 1929 and then the 1930’s depression. But it gets forgotten that the UK experience was different. While the US boomed in the 1920s, Britain struggled. The problem seems to have been, at least partially, that when the British chancellor of that era, a certain Winston Churchill, agreed to take the nation into the gold standard, the rate of exchange was too high. The pound was tied to 4.86 dollars, British business wasn’t competitive, wages were forced down, and in 1926 we saw the General Strike.

Britain was still suffering from the after effects of World War I, when overseas assets were sold off, leaving the UK cupboard pretty bare.

And yet, here is the curiosity of that era. When that particular economic depression, or as economists refer to it, the British slump, descended on Britain, the economy escaped relatively lightly, at least in comparison to its main economic rivals.

But the pivotal moment appears to have been in 1931, when Britain left the gold standard. The pound was devalued, and despite the massive contraction in global demand at that time, a slow recovery was begun.

That is why economists normally say the UK slump ran from 1929 to 1933. It was nasty, but nothing like the decade-long depression experienced in the US.

The ejection of the pound in 1992 is also held up as a key moment in Britain’s economic history. Indeed, the devaluation that followed provided the foundations for 63 quarters of economic growth – a period which appears to have come to an end.

Not all devaluations work. In 1967, the Harold Wilson government devalued the pound, and Britain’s pipe-smoking premier famously said this will not “affect the pound in your pocket.” On this occasion, the pound in our pockets and purses was affected, since the devaluation led to inflation. Clearly there is a danger today’s falling pound will lead to inflation, but in today’s environment of shrinking demand, that seems highly unlikely.

For the last decade or so, Britain has suffered from an ailment that economists call the Dutch Disease. This is so named after the Dutch economy was supposed to have suffered from high oil exports pushing up the value of the guilder such that other businesses were no longer competitive. In the case of the UK, the root cause of the Anglo–Dutch disease was the City, and money flowing into the UK.

In recent years, the world has been upside down. Japan has enjoyed big surpluses on its current account, and the yen has been weak. In the UK and US, deficits have been enormous and the respective currencies strong. This was largely down to the flow of hot money around the world. This phenomenon was also behind the current financial crisis – with mad bankers, failing regulators, and the false view house prices always go up, little more than symptoms of deeper forces at work.

It is conventional wisdom that the UK’s manufacturing base has been so decimated that any fall in sterling will not lead to an export recovery. But that argument misses the point.

Indeed, right now, we should be thankful for this lack of manufacturing base. Across the world, manufacturing is in recession. In China, toy factories are closing faster than you can say Santa Claus.

But Britain’s specialty is the knowledge economy – that and services.

So, as the pound falls, all companies which export services and knowledge will find demand will rise – and because these industries are more scalable than manufacturing, they will be able to meet rising demand.

Thanks to the high value of the pound, Britain’s exporters are super efficient. This contrasts with Japan, where the forthcoming challenge will be quite different.

Brits holidaying abroad are about to become an endangered species. But the indigenous holiday industry is set to boom.

But the falling pound is only half the story. The recovery is set to come from another quarter, too. Read on for that.

But it does seem the media have become so used to reporting doom, that they can‘t see good news when it smacks them in the face. John Redwood may think Mervyn King is an idiot; all we would say to that is this: it takes one to know one, John.

August 15, 2008 | posted by Michael Baxter in Sterling | comments (0) |

The pound closed in on its lowest value against the dollar in almost two years yesterday; meanwhile, in the US, inflation hit a 17-year high. The two are connected, and their connection throws light on what may well happen next as Stage 2 in the credit crunch unfolds.

Economists once coined the phrase Dutch Disease to describe what happens when an economy’s currency is driven so high by one particular sector – in the case of Holland it was oil – that the rest of the economy is rendered uncompetitive. Well, in the UK too, oil drove up the price of the pound. Such was the jump in sterling and the resulting loss of competitiveness for UK manufacturing that some have argued North Sea oil was a mixed blessing for the UK.

The pound surely stopped being a petro currency two or three years ago now, yet it stayed high. It stayed high despite surging consumer spending, and the resulting massive deficit in the UK’s current account. Many have argued, including this publication, that sterling is due a sharp correction.

For the last few years, though, it seems that the pound ceased being a petro currency and became a kind of bankers’ currency instead. Money surged into the UK, and was lent to British banks and business at low interest rates. The UK was considered low risk, so money lent to the UK carried a low premium.

The UK, on the other hand, enjoyed much higher returns on assets its citizens held abroad.

But during the credit crunch, this changed. Post credit crunch, presumably it will change some more. Less money is flowing into the UK, and much of the money that is coming in is being invested via sovereign wealth funds into buying assets on the cheap. The result will be a much greater flow of dividends leaving the UK in future years.

It seems then there are good reasons to think the pound has been due a correction, and that once corrected the change will stay in place for the foreseeable future.

It may be this correction is what we are witnessing, right now.

The pound has of course been falling against the euro for some time, but until recently actually rose against the dollar. Now even this has gone into sharp reverse.

It seems likely that the main reason why the pound initially gained against the dollar, even though the two economies have similar structural problems, is that the US economic cycle is 18 months to 2 years ahead of the UK. Maybe we are now simply seeing the UK experience the kind of falls the US suffered from earlier in 2007.

It is both good and bad news. It is bad news for Brits travelling abroad, and it is bad news for inflation. As the pound falls, foreign goods become more expensive, pushing up prices yet again. This will in turn make it much harder for the Bank of England to lower interest rates.

On the other hand, our exporters should experience a healthy boost as a result. It won’t happen straight away, for as long as the Eurozone is contracting, it is difficult to see how the UK can enjoy export-led expansion. But if the Eurozone recovers, as was predicted in the article above, the result will then be surging exports.

The pressure a falling pound will exert on the Bank of England to up interest rates may be a good thing in the long-run too. The savings ratio in the UK is too low. It may be that this can only be corrected through higher interest rates – well, that and a shortage of credit. So a weaker pound will at least help in that respect.

But it is difficult to see how the UK economy can continue to expand if its high-spending consumers turn to thrifty savers.

That is why exports are so important. And that is why the telling point will be how rapidly the Eurozone can recover, in an environment where its two main external customers are losing steam.

As for the dollar, this has of course risen sharply in recent days, not just against the pound, but against the euro. This has largely been caused by the bad economic news from the Eurozone and Japan.

But, if the analysis above on an imminent Eurozone recovery is right, the dollar’s resurgence may be short-lived, at least against the euro – maybe not against the pound.

US inflation hit a 17-year high in July. The annual US consumer price index was 5.6 per cent higher than a year ago last month. Prices surged by 0.8 per cent in July alone. Even if you strip out food and energy, prices rose by 0.3 per cent in the month.

Then again, with oil and food falling in price, there are good reasons for thinking the index will fall soon. For that reason, it seems unlikely the Fed will tighten interest rates.

The US is simply seeing the same inflation picture that the rest of us are experiencing. The fight against inflation is in full flow. It is being fought in the form of falling real income levels, meaning the resulting fall in demand will lead to lower prices in the future.

The US has avoided recession so far, and the Eurozone experienced recession for two simple reasons. The US government gave out a huge tax credit – something that most Eurozone governments are unable to do because the EU Stability Pact does not allow them the scope to up their borrowing by the amount required to fund this credit. Secondly, the ECB has been much firmer with inflation.

There is one of two possible outcomes. Either the ECB has been foolishly tough on inflation and the Stability Pact is unnecessarily restrictive with its rules. Or rather, this tighter approach will pay dividends in the longer-term.

Right now, it seems the odds are with the latter possibility; this suggests the Eurozone will recover while the US and UK remain in the doldrums. If that is right, then presumably the dollar will fall back against the euro.

August 13, 2008 | posted by Michael Baxter in Sterling | comments (0) |

So the world re-aligns. The US and UK see the consequences of all those years of borrowing. And the rest of the world look on, and thank their lucky stars their own economies were based on producing things. But all of a sudden, it looks different. France joins Germany, Italy and Spain in the recession-fears club; Japan stutters; China changes; and we wait and see whether the recent trend seen of falling oil prices continues, and if it does continue, what this means for Russia.

And as all this happens, the dollar turns from being yesterday’s whipping boy, to the big buying opportunity.

The dollar is now at its highest price relative to the euro since February; relative to sterling it is at its highest price since November 2006. And the change really is like clockwork.

If you believe that the UK economy lags around 18 months behind the US, then the timing is about right – maybe a touch late, but the right ballpark.

In some ways the recent falls in the dollar against sterling seemed a touch odd. After all, the UK has suffered from similar problems to the US – massive current account deficit, over-indebted consumers. It is just that the US suffered first.

But what we are really seeing now, though, is something quite curious.

The dollar has fallen because the US economy needs to export its way out of trouble. This has gone into reverse, partially because the rest of the world can’t afford to let the US export its way out of trouble.

So, if the dollar continues to rise, US exports will fall, and the US economy will weaken again.

The world needs to see two things happen. It needs to see oil, food and other commodities fall in price – and it needs to see the Chinese consumer continue to spend more. If neither of these things happens, then it is difficult to see how the current economic crisis can improve any time soon.

December 20, 2007 | posted by Michael Baxter in Sterling | comments (0) |

“It ain’t the rate of interest that’s the problem,” said Airbus Jean-Claude Trichet, yesterday, “it’s the lack of credit.”

You will recall, yesterday, the President of the European Central Bank took Helicopter Ben (Bernanke’s) idea for solving a credit crisis by scattering money across the land a step further. Mr Trichet and his ECB cohorts announced an extraordinary 349 billion euro cash injection, propting us to nick-name him Airbus Jean.

You would have thought, after pumping all that money out there, the ECB would be lowering interest rates soon. But yesterday the great cash splatterer told the European parliament “the risks to price stability over the medium term are clearly on the upside.” He also said that price stability requirements and the need to get banks to start lending again are separate issues.

Naturally, banks and commentators saw red at those words. Kevin Gaynor, Head of Economics and interest-rate strategy at RBS in London told Bloomberg “It can’t have temporary support for the market stretching into six months and yet maintain the fig leaf that monetary policy is based on an unchanged view of economic risks.”

But, Mr Trichet could be right. The crisis we are seeing at the moment is not down to official interest rates, it’s down to market interest rates. Central banks want us to lend and borrow at one rate. The markets are forcing this level higher although, by the way, interbank rates do seem to falling.

Meanwhile, in the US, Federal Reserve Bank of Richmond President Jeffrey Lacker said “Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation…I am uncomfortable with the inflation picture.”

Yet, in the UK, after the Bank of England dropped a size 10 hint that interest rates are going to fall several times next year, markets started to work out the ramifications.

The pound fell. At the time of writing it stood at $1.99, the lowest level since June. We predicted yesterday that if the Bank of England really does slash interest rates next year, the pound is likely to be the casualty.

Not that this would necessarily be a bad thing. If the UK could find it is able to export its way to growth, that would be be good news indeed, although it could lead to more inflation.

But was we have said before, when both the US and UK suddenly start importing a good deal less, but export more, it is naive to believe the global economy can just carry on regardless.