Sterling's bumpy ride

Should businesses be bracing themselves for the sterling roller coaster to head down again?
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The Independent Culture
WITH STERLING falling again on the markets, ahead of Wednesday and Thursday's meeting of the Monetary Policy Committee, and the CBI and the unions demanding with one voice that it should be lowered as soon as possible if British exports are to remain competitive, the nation's currency is once again at the centre of economic debate.

As sterling's only consistent feature has been its inconsistency, should businesses now be bracing themselves for the sterling roller coaster to head down again? Not, it is clear, if the Bank of England has anything to do with it. A lower pound was cited by the Monetary Policy Committee as one of the reasons behind its June interest rate rise. Just how strong, however, is the pound? And how low might it - or might the Bank of England prefer it not to - go? The answer, as always, depends on how you ask the question.

Since August 1996, when sterling found its present set of wings, the pound has risen 25 per cent against the DM but only 5 per cent against the American dollar. Sterling has traditionally clung closer to the dollar's coat-tails than the DM's, though this is arguably now as much a symptom as a justification of Britain's "semi-detached" European status. For investors, sterling, like the dollar and the Swiss franc, offers an alternative to the euro-bloc. The "alternatives" will tend to move together, and against the euro, simply because they are precisely that, alternatives.

When concerns about EMU and Asia pushed up the dollar this year and last year, they naturally did the same to sterling; and a succession of interest rate increases from the newly independent Bank of England, ensured that the pound never trailed too far behind its transatlantic big brother.

Stability against the dollar is, however, of limited comfort to UK exporters, over half of whose sales go to the EU, and who then compete with Europeans for the 13 per cent sold to North America. The trade-weighted exchange rate is 22 per cent higher than two years ago; a considerable shift, even for an economy proud of its "flexibility". Certainly, a rising currency does not necessarily imply a loss of competitiveness. A postwar upwardly mobile DM did not - at least, not until the 1990s ! - consistently knee- cap German industry, since low unit cost inflation held the real exchange rate relatively stable.

Sadly for all concerned, the strong pound circa 1998 has been a function not of relatively low but of relatively high inflation. Adjust for inflation, and that 22 per cent rise in the nominal pound since mid-1996 turns into a 32 per cent rise in the real exchange rate. UK plc may be flexible, but it is not Houdini; and while the restructuring prompted by a sharp sustained real appreciation produces a leaner corporate base by definition (since the flabbier companies go to the wall), the accompanying job losses and the interim reduction in investment and R&D render it a less than ideal fitness programme.

Is sterling overvalued, however? Yes, if you are selling Rovers; no, on the OECD's measure of Purchasing Power Parity (which equates prices of traded goods); perhaps, on estimates of Fundamental Equilibrium Exchange Rates (which attempt also to incorporate capital flows); yes, on the Economist magazine's "Big Mac" index (based on the prices of that most standardised of consumer products).

Let us just say that the currency looks a little top-heavy. To the Rover exporter, the pound is undoubtedly and perhaps irrationally overvalued. To the currency "exporter", however, sterling's strength has been the all too rational product of UK interest rates and an expected eventual depreciation. Why? Because there are few free lunches in the financial markets. What is gained on the swings is generally lost on the roundabouts. UK interest rates are high relative to German, but what investors gain on these "swings", they expect on balance to lose on the currency "roundabout".

Forecasts for the pound, a couple of years out, cluster in a DM2.60-70 range (or the euro equivalent). If this fall is to offset the intervening interest rate return, the decline needs to start from somewhere in the DM2.90s; which is where sterling has obediently been sitting.

Interest rate expectations are, however, fickle things, and in the context of a reviving European economy and a slowing UK one, investors have roving eyes. Were the UK-German interest rate gap look ing likely to close more quickly than previously thought, sterling would slip.

At an extreme, there is no greater sell signal for a currency than rumblings of recession; and while the UK is not yet there, ever softer economic data have begun to prompt a rethink and, already, a slightly weaker Pound. The Bank of England's Inflation Report on August 12th will be a crucial determinant of where those thoughts go next.

Increasingly, however, the "strength" or "weakness" of the pound will have less to do with the UK itself, than with its neighbours. Set against EMU-land, Great Britain is as large as is the Netherlands relative to Germany. This is not very Great. Sterling's exchange rate will be a function of shifts in the euro and dollar tectonic plates; a passive and perhaps even more volatile outlook. No novelty in the latter, of course, for UK exporters; but in the more competitive post-EMU environment, a possibly greater disadvantage.

EMU-based companies, like their US counterparts, will be somewhat insulated against currency shifts by a large "domestic" base. The exchange rate will still matter to Germany et al; but it will not matter as much. It will, however, still matter enormously to the very open UK. The transformation into "Little Britain" will be economically as well as psychologically uncomfortable.

Fortunately for UK businesses, there is a near-term silver lining. After a tricky pregnancy, the euro looks set to be a bouncing baby. The expected UK-German interest rate differential is, indeed, likely to narrow; initially, as UK interest rate forecasts are adjusted, but subsequently and more importantly as European rate expectations rise on the back of EMU-land's robust economic growth.

Note that we are talking here about expectations. Actual interest rates will be much more sluggish; and the Bank of England, which cited sterling weakness as a rationale for June's rate rise, would be likely to respond to an already softening pound by pushing back still further its first interest rate cut. Continental European interest rates will move up before UK rates move down.

If sterling is heading lower, where might it be heading to? Those "fair value" estimates go as low as DM2.30; but any medium term scenario must allow for possible EMU entry, and EMU begins in Dublin. The Irish punt will join EMU at DM2.48. It is difficult to imagine Dublin welcoming in sterling at an ultra-competitive DM2.30. Realpolitik supports the DM2.60- 70 consensus (with a cautious Bank of England probably preferring the upper end of that range); though the route to that destination is unlikely to be straightforward. The characteristic approach would be for sterling to head down to and straight through that level, before bobbing back upwards.

If a volatile pound can be expensive and inconvenient for UK industry, it presents a more fundamental dilemma for a UK government keeping its options open on EMU. Stability against the euro is probably impossible without a commitment to EMU; but the key criterion for EMU membership is two years of stability.

EMU entry can be neither a spontaneous nor a unilateral decision. Well before the next elections, if it is genuinely to keep those options open, the Government will need to take exchange rates seriously. Two years' stability is an ambitious objective for a currency which counts itself lucky to sit still for two weeks.

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