Tuesday, April 17, 2007

Passing the Buck

At the time of writing, the pound was on the brink of breaking through the $2 barrier for the first time since 1981. If you are earning dollars, it's enough to make you want to bury gold in the garden. In the meantime, cue another wave of pale-faced and wonky-toothed Brits to these shores, ready to frustrate me with their dumb questions. "Where's 34th Street mate?" "Erm, it's just south of 35th Street. If you get to 33rd Street, you've gone too far."

Although dollar weakness has been similarly expressed via other currencies, it's difficult to escape the conclusion that the pound is the most overvalued major currency. After all, the same arguments that explain the weakness of the dollar (current account deficit, over-consumption, etc..) also afflict sterling, whilst the UK economy moreover finds its potential growth rate stifled by poor productivity and creaking infrastructure.

Given that currencies can only be valued in 'relative' terms and not absolute ones (a dollar is still a dollar, even when it's collapsing) then to be bearish on the greenback, you have to be bullish on something else. Hence the pound's strength is probably a beneficiary of the hunt for the world's 'least weak currency', as well as some temporary technical factors, rather than a fundamental view on the UK economy. Thus, to find answers to the curious strength of the pound, one would find more insight by visiting Shanghai than London.

To understand the global economy, it helps to remember one seemingly indisputable fact.....Americans spend, Asians save. American consumption accounts for 25% of global consumption, and it is not in anyone's interests for the US to suffer a recession. As a result, the South-East Asians (from whom the US buys its clothes, toys and electronics) and the Middle-Easterners (from whom the US buys its oil and gas) had been happy to keep the US motor running (literally) by recycling its income back into dollars, mainly US government bonds, in order to avoid their currencies appreciating (thus potentially ending the party).

It was akin to doing one's weekly shop at Tesco and then after paying, finding the supermarket manager lending you back the money you just spent to ensure you come back the following week. The Asian currencies (especially the Chinese Yuan) thus remain essentially fixed, and the US current account deficit keeps on rising.

The problem is however that the Asians ended up accumulating trillions of US-dollar denominated reserves, which they also had to worry about sterilising (ie. mopping up) to avoid a dangerous and inflationary increase in their money supply. But eventually these reserves reached levels that created a new and unexpected problem for the Asians that reminds one of the old adage: "If you owe the bank £1,000 then it's your problem. If you owe the bank £1,000,000, then it's the bank's problem." The Australian current account deficit for example is almost as large as a % of its GDP, but since the US economy is so much larger, the Aussie dollar continues to rally, almost as inexplicably as the pound.

Eventually, at some point, but who knows when, Americans will have to spend less, and the Asian currencies will have to appreciate in order to reduce the imbalances that are currently distorting the global economy. But if that probably desirable outcome occurred, then the effect on those aforementioned foreign reserves would be devastating, and therein lies the problem which would put Gordon Brown's gold selling cock-up into some perspective.

As a result, in the interests of diversification the Asians and the oil importers continue to snap up non-US assets (or at least US hard assets), and they have obviously had the UK (especially its high-end property) in its sights. In short, it seems the rationale for the appreciation of the pound can solely be found in the fact that it's not the dollar, hardly the recipe for long-term currency strength. However, now that the trend has momentum, speculators climb on board making further sterling strength a self-fulfiling prophecy, at least for now. With any luck however, someone will step in and buy Charlton.

A concept known as Purchasing Power Parity (PPP) offers one indication of the 'fair value' of a given currency. It postulates in simple terms that identical goods should be identically priced in local currency terms. In other words if a basket of goods costs £1,000 in the UK, and an identical basket of goods costs $1,500 in the US, then the equilibrium exchange rate should be £1=$1.50. If it didn't, then in theory one could profitably arbitrage the difference between the two.

The Economist newspaper (NB: it's not a magazine) created the 'Big Mac index' since the ubiquitious burger was identical across borders, as anyone whose travelled widely and found themselves unusually delighted to see the famous golden arches would know. Its most recent index was produced in Feb 2007, and suggested that the 'correct' exchange rate between the US and UK should be $1.61 because a Big Mac in the UK costs £1.99 and in the US, it costs $3.22. In theory therefore, entrepreneurial Brits should be buying up thousands of Big Macs in the US, and bringing them home to sell. In practice, the stench on the plane would be overwhelming, and the ketchup would ruin the seats.

The unusual recent strength in the pound can also be explained by a confluence of shorter-term temporary factors. The most important of these is that UK interest rates are now 0.25% higher than those in the US, and poised to continue their upward path (whilst expectations for an interest rate reduction in the US increase).

High short-term interest rates attract 'hot money' from speculators, likely to be funding their purchases in low-yielding currencies like Japanese Yen or Swiss Franc. Indeed Yen or Swiss Franc-denominated mortgages are the new hot product for desperate UK homebuyers. This combination of high interest rates and currency strength will likely lead to more comments like those of the English woman I overheard on Fifth Avenue last Christmas, "..it's so cheap, they're paying us to shop here," which I roughly translated as, "...we won't have to call Ocean Finance until at least February next year."

British holidaymakers may feel smug, but they are probably wrong to do so. If inflation is already well above the Bank of England's 2% target despite the dampening effect of the strong pound, then interest rates may have to rise to levels which the indebted UK public might find unpalatable. In my opinion the markets are probably underestimating the likelihood of a 0.5% hike by the Bank of England in May, a decision which would surely see the pound fly through the $2.10 mark. It also conversely implies that any sudden slowdown in the UK's stratsopheric house prices would not produce the hoped-for interest rate cuts, because the subsequent fall in the pound would ratchet up inflation.

Whilst people take fright at the size of its deficits, they perhaps lose sight of the unique attributes of the US economy. It has a young, productive and hard-working workforce, an abudance of space and it remains at the very forefront of most growing global industries, particularly technology and healthcare. Compared with the ageing populations of Western Europe, or the UK's crowded island, weak manufacturing base and uncomfortably high bias towards cyclical financial services, then from my perspective (marvelling at the US work ethic every single day), it begs the question, why are people so keen to bet against the US?


At 12:39 PM, Blogger Confidential Rick said...

Absolutely NY. The UK is storing up big trouble for itself with it's high interest rates (next to the EU as well as US) and the absurd reliance on the UK property market to support the economy.

At 6:57 AM, Blogger Wyn Grant said...

Very interesting analysis. What we can be sure about is that the IMF is incapable of addressing the global imbalances problem. Which leads one to ask, what is it for? In the case of the World Bank, it appears ok to give a big pay rise to your squeeze if you are running the shop. UK house prices are over valued because of the planning system which is also a major problem as far as productivity is concerned, especially in services where there is a significant gap with the US.

At 11:38 AM, Blogger tim said...

Yes, but lets not get distracted from the pressing issues of the day. 1) What are the chances of West Ham grabbing a point tonight? 2) How is your son coping with the last minute loss at Everton? My view is that the world is a cruel, harsh place and maybe its not such a bad thing that he finds this out in the first 14 weeks...


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