Britannia Radio

Why there are fears for pound and dollar

As sterling drops to near-parity with the euro, there are huge concerns for the greenback too

BY EDWARD HELMORE

FIRST POSTED SEPTEMBER 22, 2009

On the eve of the G20 summit in Pittsburgh, economists are growing anxious over rumours that central banks are planning to tighten money supply and shut down stimulus programmes, potentially sending global stockmarkets into a new tailspin.

Prime Minister Gordon Brown yesterday denied the notion but still these and similar fears are playing havoc with currencies, especially sterling and the dollar.

Yesterday, the pound dropped to a five-month low against the euro - €1.104 - after the Bank of England issued a warning that sterling may have been fundamentally undermined by the financial crisis. It was the worst performing currency against the euro last week.

The dollar, which has been weakening for months, has rallied slightly but the greater concern remains: US government spending is at its highest since World War II, the US balance sheet is out of control, and economic and political power is shifting east.

Yet whenever a new crisis hits, investors seek refuge in the greenback. Economists are nervous that if investors conclude the dollar's problems are too great and unload, some countries could be tipped into liquidity traps that cannot be controlled because money supply cannot be relaxed further. Officials at the Bank of Canada and the Reserve Bank of New Zealand are warning of the developments.

Not only would it hurt America's economy, says Mansoor Mohi-uddin, director of foreign exchange strategy at UBS, but "extreme dollar weakness also poses a threat to the rest of the world. For most of this decade, the world economy has been able to accommodate sliding currencies as global growth has boomed. But in the credit crunch world, a super-weak dollar risks exporting deflation across the globe."

But what's the alternative? As the old joke goes "HOW'S YOUR WIFE?" "COMPARED TO WHAT?"

In Britain, sterling's slide is partly caused by concerns that futher monetary easing might be needed to stimlute growth, a move likely to discourage foreign investment. Now even the Bank of England acknowledges the financial crisis could lead "overseas investors to reassess their willingness or ability to purchase sterling assets and thereby finance the UK trade deficit".

The chance of a sterling crisis has been on the cards for months. In June, financial historian Niall Ferguson warned that the deterioration in the UK's public finances meant the probability of "a real sterling crisis" was around one in three. The probability of major tax hikes and cuts in public spending is roughly one in one, he added.

Nor is there much confidence that the UK economic stimulus measures have done much to help. Melinda Burgess, an analyst at Royal Bank of Scotland, told the FT yesterday: "The reasons to be negative on the pound are stacking up. The risk now is that the UK will be left behind in the global economic recovery... Sterling’s headwinds are getting stronger and stronger."

And if that wasn't enough to worry about, one Bank of England policymaker warned yesterday that we could be in for an oil shock. From an unprecedented $147 (£90) per barrel in July 2008, it fell to $30 by year's end, then doubled to $60 and now sits at around $70.

"We need to be looking carefully to see where the next big global shock might be coming from," says Andrew Sentance, who sits on the Bank's Monetary Policy Committee. "And the energy market is one of the prime candidates we need to keep an eye on."