The $2 question: Weak dollar is good for visitors to US, but outlook for world economy is bleak

Click to follow
The Independent Online

Transatlantic travellers hoping to cash in on a $2 pound for the first time in 14 years should enjoy the good times while they last, because a tumbling dollar could start an economic whirlwind.

Sterling hit its highest level against the dollar since September 1992 for the second day in a row, with little sign of obstacles to the magic $2 level. At one point yesterday a pound was worth $1.9848 on the open market.

"Two dollars is a certainty," said Neil Mellor, a currency strategist at the Bank of New York office in London. He said the crucial test would be $2.002, its peak the pound reached on 9 September 1992 before its ejection from the exchange rate mechanism on Black Wednesday. "If it does, there's a possibility it would catapulted up and there's a lot of space for it to rise," he said.

Last Christmas, the pound was languishing at $1.80 so those iPods, Hugo Boss suits and Manolo Blahnik shoes will feel 10 per cent cheaper. Back in the UK shoppers might expect to see cheaper clothes and electronics goods as the prices of imports from the US and countries whose currencies are tied to the dollar, such as China, fall. Some companies too will benefit as they pay less for a host of raw materials including oil and wheat, which are priced in dollars.

But these short-term benefits - which will shared by UK - may well be outweighed by the short-term costs of strong pound - and the danger that the fall in the dollar could presage a major economic shock that would reverberate around the world.

Sterling's rally to 14-year highs against the US dollar is a significant threat to Britain's strong corporate earnings and economic growth rates, experts warn. Just as exports to the US and China are cheaper, so imports from the two industrial powerhouses will become more expensive.

"A strong exchange rate makes UK exports more expensive and UK firms could see sales into the dollar area negatively affected by the strength of the pound," said Chris Iggo, senior strategist at AXA Investment Managers.

The EEF, a manufacturing lobby group, warns that a sustained $2 pound will see a lot more companies suffering. The screw will be tightened further if the Bank of England raises interest rates again in February - its third in seven months - which support the pound and make borrowing more expensive.

But the fact is that the sharp rise in the pound - up 14 per cent against the dollar this year - is not a vote of approval for the UK economy but a damning verdict on the outlook of the world's largest economy by experts in the financial markets.

The dollar has been falling for much of this year but has taken a nosedive in the past few weeks, losing 4 per cent against the euro in the past month alone.

Experts have been warning that the US and the dollar have been living on borrowed time. Non-stop spending by US households has delivered a record trade and current account deficits. The dollar has held up because overseas investors, especially the Chinese and other Asians governments are keen to buy dollar assets.

But recent comments by the Chinese central bank about the need to move into other currencies helped trigger the start of the dollar's recent slump a week ago. Private investors have also be keen to buy into US Inc but the prospect of further falls in the dollar could encourage them to cash in their chips now, pushing the dollar down further and creating a vicious cycle.

In its most recent forecast the International Monetary Fund (IMF) warned that if that happened there would be a "disorderly unwinding" that would see a rapid fall in the dollar, volatile movements in the financial markets and a "significant hit" to the world economy. A weak dollar would put up the prices of imports, discouraging Americans from spending. It would ALSO drive up inflation and force the US Federal Reserve to raise interest rates. That could transform its stagnant housing market into a financial disaster zone. A consumer-led recession would hit those countries that have done well by selling to Americans.

According to the old adage, if the US sneezes, the rest of the world catches a cold; if the US succumbs to a cold then the rest of the world will get the flu.

Yesterday stock markets fell across the world as fears of a US slowdown stoked worries over the economic outlook.

While on Wall Street the Dow Jones index was down 40 points or 0.35 per cent, stock markets in Germany, France and Spain were all down more than 1 per cent and in London the FTSE 100 dropped 0.5 per cent

"The strong sterling will strengthen the headwinds for the UK economy as UK exporters take a direct hit and the consumer spending, the main driver of the UK economy, will come under further pressure," said Ted Scott, a UK equities fund manager at F&C.

The IMF yesterday declined to comment further. However after five years of issuing warnings over the dollar and the global imbalances, the IMF is taking action. It has launched multilateral talks to allow big players such as the US and China to talk frankly in private about the possible ways to reduce these imbalances without triggering the market reaction they dread.