Sunday, December 21, 2003
The buck stops where?
Posted by David Smith at 09:08 AM
Category: David Smith's other articles

A week ago, when the world awoke to the news of Saddam Hussein’s capture in Iraq, one event seemed likely to follow. The dollar, a beleaguered currency throughout 2003, would surely benefit from such a decisive piece of good news for George Bush.

Briefly, in Asian trading, the dollar perked up. But by the time European currency dealers were at their desks early on Monday morning, its slide had resumed. The dollar’s weakness, say analysts, is “fundamental”, based on deep-seated economic factors, most notably America’s huge current account deficit, on track to top $600 billion(350 billion) in 2004.

More important than the big plus of Saddam’s capture were comments from John Snow, the US treasury secretary, who described the dollar’s decline as “orderly” and pointed to the fact that, even after its fall, it was higher than its average over the past 25 years.

Analysts interpret that as further evidence that America has abandoned her traditional strong dollar policy, instead pursuing a strategy of “benign neglect” in which a weak currency is welcomed in Washington for the beneficial effect it could have on growth in 2004, Bush’s re-election year.

The fall has helped push up dollar prices of gold and oil. But it has been most dramatic against the euro. Just over two years ago the boot was on the other foot and Europe’s single currency, still in its infancy, seemed to be in terminal decline. Launched in January 1999 at a rate of $1.16, it had tumbled to just 83 US cents.

Since then, however, its rise - and the dollar’s fall - has been dramatic. On Friday the euro stood at $1.24, up nearly 50% from its low point.

But the effect has also been dramatic on the pound, or the “cable” rate as it is known in the foreign exchange markets. Early last year it traded in the low $1.40s against the dollar, a level comfortable for exporters and at the bottom end of the $1.40-$1.60 range typical for much of the past decade.

Now, however, the pound is at $1.77, its highest for 11 years and the return of the $2 pound - last seen in 1992 and then only fleetingly - has become a distinct possibility.

Sterling’s rise against the dollar, which has contributed to a boom in British shoppers travelling to New York, has taken it well above “fair value”.

Shop price comparisons tell part of the story. Converted at the present exchange rate a Big Mac sells for the equivalent of 1.50 in New York, compared with 1.99 in London. Levi jeans are barely more than half the price; hotel rooms typically 35%-40% cheaper; digital cameras two-thirds of the UK price, and designer clothing more than 50% below prices in Britain.

Some estimates suggest that, based on relative prices, the pound should be as low as $1.30 against the dollar. Calculations for the Treasury’s assessment of euro entry in the summer suggested an equilibrium rate of about $1.55. Everybody agrees that, at a level where it is about to break above $1.80, the pound is overvalued.

For British firms, the return of the sterling-dollar rollercoaster is an unwelcome reminder of past turbulence. The pound dropped to within a whisker of one-for-one parity with the dollar in the mid-1980s, before rising strongly in the second half of the decade. Then, as now, the pound was caught in the backwash of bigger events playing out on the world’s financial markets.

“Many companies are going to be looking into 2004 and thinking this can only get worse,” says Tony Norfield, global head of currency research at ABN-Amro, the investment bank. “Sterling is going higher and so is the euro. We don’t think the European Central Bank is anywhere near the point where it will think about intervening.”

In the boardrooms of Britain’s big companies, directors are anxiously watching the dollar slide. America, Britain’s biggest single export market, has dragged in UK exports at a rapid rate in recent years.

The strong dollar will affect sectors from food, to drink, drugs, engineering and defence. Many have tried to hedge their exposure to the dollar, but even that can be insufficient.

Zafar Khan, an analyst at SG Securities, says: “All the aerospace type companies such as Airbus, Rolls Royce and Smiths will tend to hedge their transaction exposure, but that is something which can be a progressive problem, because as the currency keeps going down, your hedging rate will deteriorate over time and that squeezes your profit margin.”

The high euro is also crippling continental companies. Companies like Volkswagen, which exports 750,000 cars a year to America, are trying to reduce the impact by shifting production overseas. The car-maker is to open a new plant in Mexico in 2005 for its Golf models enabling it to both make and sell a product in the same currency. But a company spokesman said in the intervening period the group does hedge its dollar exposure “quite aggressively”.

The concern among many chief executives is that the falling dollar will undermine a faltering European economic recovery. Even before the latest rise in the euro’s value, the prospects were for only a muted recovery for the “euroland” economies. Economists predict growth of under 2% next year, implying a continuing rise in unemployment, compared with a booming 4.5% expansion in America. The euro’s rise will reinforce such trends.

Airbus has already said it will hav to take 1.5 billion euros out of its costs to stay competitive while maintaining margins.

Smiths, the defence to medical equipment company, is one of many companies with American subsidiaries. In America it is seeing an increase in production, but it is having to pay a big penalty when these profits are translated back into sterling. Last year it cost Smiths some 20m in profit and this year it will be more.

Tomkins, another British based engineer, has suffered a similar hit. Some 70% of its operations are in the US and it is costing the profit between 15m and 20m a year against total profits of 270m.

Not all firms are adversely affected. Some British chief executives with big American manufacturing interests who see the weak dollar as a benefit, which outweighs the impact on profits. Dave McCulloch, who runs Enodis, says: “About 75% of our business is in North America, and between 20% and 25% is exported from there. Clearly, this is going to make our US products much more competitive in Europe, so transactionally it will have a benefit for us." Similarly Unilever, the food group, which has a quarter of its sales in American, is also seeing some benefits, which balance the hit it takes on profits. The vast majority of its borrowings are now in dollars.

What business hates, however, is volatility, and the dollar’s slide, say analysts, is set to continue.

“The euro is going to $1.30 but after that it gets trickier to predict,” says Jim O’Neill, head of global economic research at Goldman Sachs. “2004 should be the year when the dollar’s weakness spreads to Asia.”

This, the Asian factor, has been what has been so unusual about the dollar’s slide. Across Asia, central banks have been acting to prevent their currencies rising against the weak dollar. In China, this has meant holding the currency, the renminbi, to its peg of around 8.3 against the dollar despite US pressure to revalue. In Japan it has meant intervening to restrict the yen’s rise to about half of that for the euro. Other Asian central banks, not wanting to see their currencies become uncompetitive, have followed suit.

This has produced a twin boost for the euro and sterling. Not only has the rise that should have occured in Asian currencies been diverted to Europe but the actions of the Asian central banks have added to this effect in another way.

“What we have been seeing is diversification of currency reserves by the Asian central banks into the euro and sterling,” says Mike Gallagher, head of research at, the financial research company. The Asians, in other words, have bene buying dollars to stop their currencies from rising and then selling some of them in exchange for euros and pounds.

Now, say currency watchers, the onus is on China to break the loigjam. “We think China will recognise it is in its interest to revalue the renminbi,” says John Calverley, chief economist at American Express in London. He points out that China’s long period of deflation - falling prices - appears to be over, and that with an inflation rate of 3% and rising, it will need a stronger currency to head off a potential inflationary problem.

Others agree. “If the Chinese haven’t moved by the end of March I’d be very surprised,” says O’Neill of Goldman Sachs.

Even if Asia takes some of the pressure off, that will not remove the difficulties imposed by a weak dollar from Britain and Europe. Economists at Citigroup in New York say the dollar needs to fall another 20% over the next few years.

Analysts at Deutsche Bank suggest that even if the pound does not make it to $2, it is going to stay strong against the dollar for the next few years. Looking forward 2-3 years, they predict a dollar-sterling rate in the $1.90s.

That’s good news for bargain hunters travelling to America. For Britain’s exporters it means having to battle against the handicap of an overvalued currency. Barely had sterling come down from the heights against the euro than it has risen to them against the dollar. Sometimes you can’t win.

From The Sunday Times, December 21 2003