Hamish McRae: Sterling is on the up, but don't get carried away by better holiday rates

Economic view

Bought your holiday currency yet? Slightly better rate, eh? We may be a long way from the days of the pound at $2.00 and €1.50 but its plight is not nearly as dire as it was last year. The pound does, on a long view, remain relatively cheap, which may not be great for foreign holidays but – the flip side – it is helpful to exporters. So what happens next?

Some perspective: the trend of the pound, the dollar and the euro over most of this decade, weighted by the trade each region does with other currency blocs, is shown on the chart. As you can see, for the early of this period, the pattern was one of a weakening dollar and a strengthening euro, with the pound an island of stability in between. Then came the plunge of sterling, starting in 2008, and a recovery of the dollar as the financial disaster encouraged a flight to what was seen as a safe haven. The euro remained relatively strong until this spring, when the Greek debt crisis struck and questions about the long-term future of the euro mounted.

You have to see this decline in the context of the previous strength: the euro is back to where it was during the 2003-06 period. While it is weaker than it was in 2008-09, it is by no means a weak currency. And you have to see the dollar in this long-term context too: it remains a lot weaker than it was in 2002. As for the pound, it has come off the bottom on the trade-weighed index but remains relatively cheap.

Some forecasts for the three currencies from Barclays Wealth are shown on the right-hand side of the graph. The dollar is expected to be flat overall, the euro to dip a bit more then recover somewhat, and sterling? That really is quite a bullish forecast, expected to climb by 10 percentage points by the end of 2011.

Translated into actual rates, Barclays' prediction is for the pound to be worth $1.70 and €1.30 at the end of 2011. This seems pretty sensible.

But this is a beauty parade where none of the contenders is terribly attractive. You can make a good argument against any of them. The dollar is weakened by the huge US current account deficit and is only supported by the Chinese piling up American assets. The euro is weakened by the lacklustre economic recovery on the Continent, not to mention the deeper fears about its long-term future. And the pound's fate depends very much on inflation coming back down into the target range, on the coalition holding together as it tightens its fiscal squeeze and on the British economy being able to keep growing despite that. Barclays' expectation of a rise in the pound is based on the view that it is undervalued, rather than that it is particularly attractive in absolute terms.

But 'twas ever thus. All currencies experience fashionable and unfashionable phases. The headline on the lead story on the front of the first edition of The Independent in October 1986 was "Conservatives try to halt sterling side". Currency values are the product of perception as much as reality. Ultimately, the value of a currency will be determined by its purchasing power – purchasing power parity exerts a gravitational force, pulling a currency back towards what is sometimes called its "fair value". But it can diverge a long way from that value and for a long time. The pound was too high at $2.00 but it peaked even higher and stuck around there – to the delight of Britons visiting the US – for several years.

So to look forward you have to try to gauge how sentiment might shift, and sentiment not so much in the developed world but in the emerging world, for that is where the savings are being generated.

There was an interesting example of the power of the East last week when China unexpectedly bought a large chunk of 10-year Spanish bonds, making a massive difference not just to the auction but to Spain's prospects for financing its deficit in the coming months. If the authorities in China have made a strategic decision to buy euro-denominated sovereign debt, that will have a big impact on the currency through the rest of this year.

It does not solve the problem of European fiscal deficits, nor does it secure the longer-term future of the currency. But it buys time for the eurozone and by so doing, may help change the perception of the euro as a currency that it bound to fail. (My own view, for the record, remains that the euro will survive this cyclical downturn thanks to the political will of the members, but not the next one – the downturn that will strike towards the end of this decade.)

Over the next 10 years, the power of the Bric currencies, in particular the Chinese yuan, will rise relative to that of the currencies of the developed world, especially the dollar. The former is not yet convertible in the sense that you cannot buy and sell it freely. Expect that status to change gradually. Over the next few years, the value will be allowed to creep upwards. Meanwhile, however, the main focus remains on the West.

That leads us to that crucial question: where are the surprises?

Let's go back to those projections in the graph, for that is a sensible baseline. As far as the dollar is concerned, there may well be a period of greater weakness ahead. Yes, in the medium term the flat outlook will probably be right. But I could see a serious wobble developing through the summer and autumn, particularly if US consumption falters (as it may already be doing) and the double dip is deeper than expected. The Chinese are not going to pull the plug on the dollar by unloading US securities, though that fear must lurk in the background. But they may be making a strategic decision to balance their investment more evenly.

That would have implications for the euro. If you believe that the sovereign debt crisis will stop at Greece, then other European debt is attractive. It is an intriguing issue: if and when Greece defaults, will that drag other countries into default too? There is no need for that to happen. So at the right price, Spanish and Italian debt is worth buying.

It also has implications for sterling. The UK has retained its AAA rating for the time being, though it, along with several other countries, has been downgraded by a Chinese rating agency. If China decides to diversify out of the dollar, some investment is likely to come in to the UK. If that happens, expect the rise in the pound against the dollar, as projected by Barclays, to take place much sooner than forecast.

All this is conjecture. It is about potential surprises, which by their very definition probably won't happen. But the big point to grasp is that the period of extreme weakness in the pound has clearly come to an end. We no longer have an unfashionable currency.

Vince Cable's proposal for a graduate tax is just plain stupid. Discuss

Sometimes you just know an economic proposal is seriously stupid. Most of the time, economics is not like that: there are respectable intellectual arguments for different policies. But with the proposed graduate tax, now at Vince Cable's request being considered by Lord Browne's committee on university funding, it is astounding how the evidence stacks up against it.

Start with the funding side. The Government would supply all revenue to the universities. They would in effect become a nationalised industry. The Government would have to decide which should get the money, and inevitably how they should spend it. Would that result in better universities or worse? And who would get the blame for shortfalls in funding?

Next, the timing. Assuming that revenue was only raised from future graduates, there would be a long time lag between money going out and tax revenue being raised. Not a bright idea for a government under huge pressure not to borrow yet more.

Now look at incentives. Graduates would be encouraged to work abroad, where they would not pay the tax. Already many of our best young are seeking to work in Asia, where opportunities are greater and taxes lower. Would-be students might be encouraged to study abroad, again to avoid the tax.

Now look at the international dimension. It would be impossible to charge foreign graduates a fee for UK universities if they had never gone to a UK university, so foreign workers in the UK, with a degree, would pay less tax than British ones. How fair is that? But it gets worse. Suppose a non-national was considering a UK university, and perhaps working here afterwards. Might he or she decide instead not to come? We earn a lot from foreign students. Neil Shephard of Oxford University has estimated that such a tax would add up to £5bn to the deficit.

The most upsetting thing is that Cable knows all this. He is an economist who worked for Shell. So why push the idea? Funny stuff, politics.