Sunday, December 12, 2004
Stretched pound hits trade
Posted by David Smith at 10:00 AM
Category: David Smith's other articles

The last time the pound rose above $2 was on September 2, 1992, the start of a turbulent month when it closed at $2.004. A fortnight later came “Black” Wednesday, the pound’s humiliating exit from the European exchange-rate mechanism, and sterling plunged against everything, including the dollar.

For a while last week, as the pound came within a whisker of $1.95, it looked as if we were heading for $2 before Christmas. It may still happen, although these things never run in a straight line and the dollar actually gained some ground last week.

Most currency analysts are bearish about the dollar, taking their cue from the grim economics of America’s twin deficits. The dollar, it is argued, has completed only about half the fall needed to bring the US current account deficit — more than 5% of gross domestic product — down to manageable levels.

On the other hand, there are signs of official resistance to the dollar’s slide, not least in Europe, where the euro’s transformation from basket case to the Mr Incredible of the currency markets is deemed to have gone far enough.

Gerhard Schroder, the German chancellor, fretted publicly about it last week. These two forces will battle it out in Europe and Asia in the coming months and determine how far the dollar has to go.

If the pound does go above $2 and stay there, what would be the effect? Figures last week showed that Britain had a goods trade deficit of

£5.3 billion in October, the second worst ever (the worst was £5.7 billion in January). Even including the monthly surplus on services, the overall deficit was £3.8 billion.

So far this year the goods trade deficit is £48.8 billion with two months to go, more than the

£47.4 billion deficit for the whole of last year. Nothing much is going right when it comes to Britain’s trade. The North Sea oil surplus will be lucky to reach £2 billion, half last year’s level.

The trade deficit on manufactured goods, £38.7 billion last year, is already £37.6 billion in the first 10 months of 2004. For a country that recorded the first manufacturing trade deficit in its history as recently as 1983, it is a sorry tale.

When it comes to external deficits, in fact, Britain stands shoulder to shoulder with America. Our current account deficit, forecast by the Treasury to be £30 billion next year, is small in relation to America’s $600 billion (£310 billion) of red ink. But it is growing. And Britain, like America, has trade deficits with most of the world.

Did you know that we have had a £2.4 billion trade deficit with Belgium and Luxembourg so far this year, and a £4.7 billion deficit with the Netherlands? A £10 billion-plus deficit with Germany may not be a surprise, but a £3 billion-plus gap with Italy perhaps is.

There are few bright spots in Britain’s trade position vis-à-vis the rest of the EU, where the deficit is heading for more than £25 billion this year. There are few around the rest of the world either. Britain runs big deficits with China, Japan, Hong Kong, South Korea and many other Asian countries. The deficit with China, £6.4 billion last year, is widening by about a billion a year. We even run a deficit with Canada.

One of the few surpluses is with America. Last year British exporters sold £6 billion more goods to the United States than importers bought from there. This year the surplus is heading for something similar.

In that respect, the pound’s rise against the dollar looks logical, despite the problems it is creating for exporters like Jaguar, the Ford subsidiary
Britain’s share of the US trade deficit may be small in relation to China’s $134 billion (£70 billion) but we all have our part to play in the adjustment. The higher the pound rises against the dollar, the smaller will Britain’s trade surplus be with America.

Except that, while sterling has risen sharply against the dollar, the Chinese renminbi has yet to do so. The Beijing authorities may be preparing a currency realignment, but they do not seem to want to be rushed.

The result is that as sterling has risen against the dollar, it has also been pushed higher against the renminbi, rendering UK firms even less competitive in relation to China. In markets where the main competitor’s currency is dollar-linked, exporters will find life much tougher.

But surely it is a case of swings and roundabouts. Won’t Britain benefit from sterling’s fall against the euro in recent weeks, so that the trade deficit with the EU narrows? It should, except for two things. Sterling’s fall against the euro has been quite modest, and the euro’s dollar rise threatens to undermine an already moribund economy.

Forecasters are revising down projections for growth in the euro area next year. The small benefit of a lower pound against the euro is not going to compensate for that. In the recent pre-budget report the Treasury managed to conjure up some optimistic export forecasts, but they were hard to justify.

Where does that leave us? Between a rock and a hard place. Sterling’s rise against the dollar will undermine exports in one of the few places where there is a decent trade surplus. The overall trade deficit will continue to get wider. Sooner or later that will require a significantly lower pound to correct it. The only question is when.

PS: I promised to report on the house-price debate between me (soft landing) and Roger Bootle, economic adviser to Deloitte (20% crash). In fact the debate, at the Council of Mortgage Lenders’ annual conference, did not get beyond our opening statements because the organisers ran out of time. If any promoter wants to organise a rematch, we would be up for it.

Even as far as it went, it was a fascinating tussle. The Bootle argument, in essence, is that the rising house prices of the past two or three years have been a bubble transferred from the equity market. The house price-earnings ratio is at least 30% above its long-run average, too big an overvaluation to be worked off gradually. Every big housing boom in the past has been followed by a drop in real (inflation-adjusted) house prices.

My case was that it takes a lot to produce a house-price crash. In the late 1980s and early 1990s, when interest rates and unemployment doubled, the peak-to-trough fall in house prices was 13%. In the first half of the 1930s, the depression years, official figures show a 13% to 14% house-price fall.

In today’s much more stable economic environment, should we really expect a bigger house-price crash than in those times? I argued we should not, and that the house price-earnings ratio might be of limited use. A better measure would look at the cost of housing to homeowners, a user-cost index, taking into account the new environment of low inflation and lower real interest rates.

If I’m right, people will not cut prices in the absence of economic distress; prices will be “sticky downwards” and the market will stagnate, not crash.

If Roger is right, the fact we are in an era of low inflation means that the real-price falls of previous downturns (then disguised by high inflation) will translate into actual price falls this time. There is also a question about whether there could be a hard landing for the housing market alongside a soft landing for the economy as a whole. History tells us that hasn’t happened before.

“Soft landing”, I can tell you, features prominently on the growing list of irritating business and economic jargon readers have been helpfully providing. All will be revealed soon.

From The Sunday Times, December 12 2004


Does this mean that the pound buying up dollars now would be an investment for the future, I would like to add something similar to this on my site

Posted by: Sheraz Iqbal at April 19, 2006 02:05 PM
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