Sterling's Sudden Slide

Exporters are cheering, but does higher inflation loom?

For months, the pound's strength has been a hot political issue in Britain. BMW Group blamed its decision to close British auto maker Rover Group on the high pound. U.S. auto giant Ford Motors Corp. gave it as the reason for shutting down its assembly plant in Dagenham and axing 9,000 British jobs. Other beleaguered manufacturers in Britain's Northeast claim the currency is eroding British competitiveness and threatening 187,000 more jobs. "The strong pound has become a political hot potato that's driving policy," said Goldman, Sachs & Co. chief currency economist Jim O'Neill in London.

But suddenly, the pound has sunk. As of May 23, the pound had fallen around 10% against the dollar for the year, to $1.48. Even more important-- because 70% of British exports go to Europe--is sterling's 8% decline, to 61 pence against the euro. What triggered sterling's slide was the Bank of England's May 3 decision not to increase interest rates, despite rising rates in both the U.S. and the euro zone. The bank had raised rates to current levels of 6%, from 5% in September, in four quarter-point steps. "The perception that Britain's interest rates are at a peak is what caused the currency to peak," says Credit Suisse First Boston Britain economist Robert Barrie.

More good news may be on the way. Goldman's O'Neill thinks sterling will weaken further against the dollar, to $1.45. More important, he thinks an eventual sharp fall against the euro--which he figures is 25% undervalued vs. the pound--is coming. That assumes the pound remains closely linked to the dollar and that the U.S. currency finally begins to crack. The British government wants a weaker pound to give manufacturers relief and to smooth Britain's eventual adoption of the euro. Most observers figure the pound would have to fall to at least 75 pence per euro for such a move to become feasible.

The continued risk of high interest rates certainly doesn't please Old Economy players. But they may just have to lump it. Although manufacturers and the labor unions are highly vocal, they no longer dominate the economy. Since 1979, manufacturing's share of output has fallen to 20%, from 29%. Meanwhile, the services sector has grown by 20% over the past five years and now accounts for around 75% of the economy, says J.P. Morgan & Co. economist Danny Gabay. Services have been largely sheltered from sterling's appreciation since most do little exporting; the sector grew an above-average 3% in the first quarter, he adds.

Still, the Bank of England needs to keep its guard up. A sharp currency drop carries its own risks. On May 23, the central bank's governor, Eddie George, told a parliamentary committee that if sterling were to drop 25% against the euro, it could add two to three points to the inflation rate over the next 12 to 18 months. The strong pound has helped keep inflation down--it's just 1.9%--despite roaring demand in some parts of the economy. Annual house-price inflation, for instance, is running at 13%. Unemployment is at a 20-year low of 3.9%, and wage increases are now about 6% a year.

Sterling's Sudden Slide (int'l edition)

A plummeting exchange rate could also spark the economic overheating the bank has worked hard to avoid. Worse yet, such developments would undermine the credibility the bank has been building slowly since it was made independent from the Treasury in 1997.

If the bank yields to pressure from politicians to keep rates down and lower the pound, its authority could be shattered. At the same time, the bank has to be wary of raising rates too high and driving the economy into recession. That's why they are keeping their fingers crossed at the bank's Threadneedle St. headquarters.

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