Why is the British pound so strong ?

Source: The Independent
Comment: Two views on why the pound is so strong
Tuesday, 8 July 1997

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One of the deepest mysteries of the financial markets is why exchange rates move the way they do. There are two mainline views on why the pound is as strong as it is. One predicts that sterling will fall back sooner or later because its strength simply reflects the fact that the UK is at a more advanced stage of its interest rate cycle than other European economies. Demand in Britain is booming, and interest rates will probably climb for another 12 months. Although the big continental economies are starting to recover, few analysts think they will raise rates before the end of this year.

That makes sterling a decent one-way bet for currency traders, for the time being at least. But the position will flip when the UK economy starts its downturn ahead of its trading partners - perhaps by the middle of next year. British interest rates will start falling while European rates are still heading up.

Ebbing and flowing prospects for the single currency complicate this outlook. When EMU starts to look less likely, the Deutschmark gains at the expense of the pound. However, this undercurrent - the idea of sterling as a safe haven - probably has less impact on exchange rates than business cycle fundamentals.

The main alternative explanation for the super, soaraway pound is that the British economy is stronger and more competitive than it used to be. Businesses have emerged from two harrowing recessions in a lean, mean and competitive state. International investors have therefore re-evaluated Britain's economic prospects and the strong pound is an expression of their vote of confidence.

If this is the explanation, the pound will stay high and there is no relief in prospect for industry. The problem with this theory is that if true, our commerce shouldn't need any relief. If a strong exchange rate is simply a reflection of industrial strength, as the strong Deutschmark in the past mirrored the might of German industry, it is not going to bring British business to its knees.

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So although there is a genuine policy dilemma for the Bank of England, in the sense that it would be preferable not to have had a 20 per cent exchange rate appreciation in less than a year, the dilemma is not as acute as many commentators suggest. In any case, a single decline in the notoriously erratic figures for manufacturing output should not tilt the balance away from the next increase in base rates when all the other indicators suggest that industry is still holding its own, while consumers are dancing all the way down the high street.