Buck the Trend, Sterling hits 12-year highs

Following the announcement on 9 March that Britain’s trade deficit had
widened significantly in January, economists reacted saying the numbers were ”
terrible”. In December 2003, the value of imports exceeded exports by £4.2bn; a
month later the figure was £5.6bn. The culprit was seen as the US dollar and
statistics revealed that UK exports to countries other than the EU had fallen by
17.5%.

It is easy to point the finger of blame at the US, but Institute of Directors
chief economist Graeme Leach explains: “Research has shown that the strength of
the US economy outweighs the price effect inflicted by a weak dollar. Although
margins may be squeezed, pickup in GDP growth means sales are likely to
increase. Provided sterling doesn’t appreciate too much, the damage can be
limited.”

The UK has a significant trade surplus with the US to the tune of £4bn for
the first 10 months of 2003. And while the US has a massive current account
deficit to wrestle with, rebounding GDP growth and high levels of consumer
spending are on balance, which is good for UK plc with the sterling/dollar rate
very much a secondary consideration.

So the problems of the UK’s trade deficit and the possible threat to UK plc,
if there is one, lie elsewhere. Part of the answer, according to chief currency
strategist at HBOS treasury services Steve Pearson, is with the dollar-linked
economies of the Far East. On the one hand the weakening dollar cheapens the
costs of the products of countries such as India and China, enabling them to
achieve huge growth in sales and therefore further economies of scale. On the
other, Britain’s consumer credit boom is fuelling the purchase of increasing
amounts of imported goods from the Far East. If British companies have something
to fear, then it ought to be in price competition, but the restructuring of the
manufacturing sector in the UK has long since forced producers to outsource to
Far Eastern countries in any case.

Meanwhile, trade statistics are revealing. By far the largest UK export
market is the rest of the European Union, which is why, for example, the Trade
Weighted Index used by the Bank of England as one of its measures of the
strength of sterling and for determining interest rate controls is weighted 60%
in favour of Europe. And, in fact, the story of the euro-sterling exchange rate
trend is a large balancing factor, tending to offset the effect of the weak
dollar.

For many companies with a combination of exports either to the eurozone or
denominated in euro, the effect of a weakening sterling – vis-a-vis the euro –
has neutralised the effect of the weak dollar.

However, the effect of the dollar on British business goes much deeper. It is
not just a question of exports. The function of the dollar as global reserve
currency and the means for pricing key commodities, the most important of which
is oil, means that on the broad scale the UK must always consider what the
dollar is doing on the foreign exchanges.

This is nothing new. Over time there are periods when the dollar is weak, as
it is now, and our base commodities are cheaper. Then there are periods when
sterling is weaker and we have to pay more. This is the result of having a
marginal currency in a world where dollar, euro and yen are by far the most
traded currencies. But more important is the price of commodities themselves. If
the weak dollar’s effect is so influential, why are we not getting cheap oil?
Recent estimates have suggested that benchmark crude prices may hover around the
$27 a barrel mark for the rest of this year and may average $24 in 2005. This is
at the more expensive end of the spectrum, and supply and demand, political
events and the behaviour of producers are all as influential on the price the UK
is paying as the dollar rate.

The other significant dollar influence that affects the UK and its businesses
is the high level of business investment they have in the US. Britain is still
one of its highest investors, whether through portfolio investment or in
business assets. Consequently, repatriated earnings and income to portfolio
investment is always likely to be affected by dollar rates.

But, again, this is a factor that is well understood by British business.
There may be better times than others to invest in the US but over time it is a
question of swings and roundabouts. Further, there is no evidence to suggest
that UK companies are either embarking on a US buying spree while the dollar
lingers about $1.80 to the pound or that fund managers are selling, for example,
euro-denominated securities to buy dollar-denominated ones at anything above a
normal level.

In a nutshell, the special relationship that sterling has with the dollar
produces ups and downs. The fact that the pound is buffeted between the dollar
and the euro is the more recent and significant development. Whereas once
sterling was as much, if not more, traded as some eurozone legacy currencies,
and there were market checks and balances in sterling’s relationship with other
currencies, now the ongoing struggle between dollar and euro sidelines the
pound. To a large extent we are pulled one way or the other, depending on a
variety of trade, political and financial variants over which Britain and its
businesses have modest influence.

Advocates and opponents of euro membership will make capital out of either
the stability our currency would have against that of our eurozone trading
partners or the higher risks we would face versus the dollar.

There are bigger issues to consider, such the UK’s trade deficit and the US
current account deficit. There’s the outcome of the US elections, whether there
will be other developments in the Middle East or further attacks by terrorist
groups. Can the Far East central banks continue to support the dollar by
recycling their trade surpluses or buying US treasury bonds and, in the
meantime, will the US economy really recover, employing more people and
regenerating consumer buying power?

There are too many indeterminate factors to keep UK company treasurers awake
at night. Their job is to do their best to hedge the risks they can do something
about and keep their businesses on a well-funded, even keel. Coping with weaker
or stronger currencies is just part of the job which they have been doing for a
long time. Right now, we have a situation where some sectors and UK businesses
are vulnerable to weak dollar levels, while others are clearly not. We’ve looked
at the effect of the weak dollar on three UK businesses – BAE Systems, BP and
Diageo.

BAE Systems – balance vs the dollar

Defence and aerospace designer and manufacturer BAE Systems’ preliminary
numbers released on 25 February reported sales of £12.6bn with an order book
worth £46bn. It has operations in North America, where sales to 31 December 2003
were worth £2.7bn, as well as close business relationships with Airbus and the
Swedish aerospace sector among its international partners.

While BAE Systems is significantly exposed to changes in the dollar/sterling
exchange rate, it also receives large cashflows in both euro and Swedish kronor.
BAE’s North America organic sales increased by 11% during the year.

Nevertheless, the preliminary results statement gives fairly short shrift to
the weakening dollar. “… on translation, the strength of the euro more than
offset the weakening dollar, and reported sales and profit increased by £165m
and £4m, respectively …”

A spokesperson for BAE described the effect of the weak dollar as ”
completely neutral” and, on the basis of its most recent report covering the
period in which the dollar weakened considerably, the company would seem to have
achieved a virtuous balance between the currency risk exposures posed by its
principal trading currency zones.

BP – dollarised big British hitter

With a market capitalisation of more than £98bn on 9 March 2004, BP accounted
for 8.8% of the market cap of the FTSE-100 index. BP had turnover of about
$232bn for the year to 31 December 2003 and its “total replacement cost profit”
numbers show that roughly 32% derives from North America, 16% from the UK, 13%
from Europe and 39% from the rest of the world.

Crucially, not only does it operate in markets which are generally
dollar-denominated – oil and its derivatives and associated lines of business –
but it reports in US dollars. The net result is that although it may be
uncomfortable for sterling investors to receive dividends in pounds after
translation from dollars when the dollar is as weak against sterling, the
company itself has a natural hedge against dollar movements.

A spokesperson for BP says that because of the global scope of its business
and the range of its revenues from different business sectors, it has an
effective internal hedge against currency movements such as that of the dollar’s
weakness against sterling. The effect of the currently weak dollar has been
negligible.

Diageo – exposed and hurting

Premium drinks group Diageo had half-year sales of £5bn to 31 December 2003.
Roughly 30% of its sales derived from North America over the period and it is
therefore exposed to fluctuations in the sterling/dollar exchange rate. Its
interim financial statement released on 19 February contained the following in
its Financial Review section: “Exchange rate movements during the six-month
period adversely impacted profit before exceptional items and taxation by £14m,
of which £38m was in respect of the US dollar, largely offset by a £34m benefit
on the euro. This includes translation exchange only in respect of the profits
of associates. The adverse impact on group operating profit was £20m, offset by
a beneficial impact on finance charges of £6m.

“Based on current exchange rates, it is expected the full-year equivalent
adverse impact of exchange rate movements on profit before exceptional items and
taxation will be about £95m. Similarly, based on current exchange rates, the
full-year impact of adverse exchange rate movements on profit before exceptional
items and taxation for the financial year ending 30 June 2005 is estimated to be
£75m,” explains the statement.

Based on this reporting, Diageo is wrestling with its dollar exposure but
suffering some significant knocks in the process.

Remembering George Bernard Shaw’s remark: “If all the economists were
laid end to end, they’d never reach a conclusion,” we should not be surprised if
there is some variation between predictions for the dollar/sterling exchange
rate … “… We see the dollar/euro rate as $1.28-1.30 for the first six
months of this year and dollar/sterling in the range $1.88-1.90 …”

HBOS Treasury Services
Steve Pearson, chief currency strategist

The dollar/euro $1.22 at six months and $1.34 at 12 months. Dollar/sterling
$1.79 at six months and $1.91 at 12 months.

Citigroup

“We would expect about half of any euro appreciation to be reflected in an
appreciation of the pound against the US dollar. That would take the pound from
around $1.75 at the moment to $1.84. Against the euro, the pound could fall to
£1.31 or one euro buys £0.76 (though our forecast is it falls to £0.71). That
will reinforce the upward trend in UK interest rates.”

LloydsTSB International Economic Calendar 19 January 2004
Trevor Williams, Financial Markets Division

“… We are looking at dollar/euro of $1.32 at six months and $1.35 by the
end of the year, As far as dollar/sterling is concerned, we see $1.86 at six
months, $1.87 by the end of the year and a correction during next year down to
$1.80.

HSBC currency economist

Barclays forecasts dollar/euro rates of $1.34 for this year, $1.37 for 2005
and $1.29 for 2006. For dollar/sterling, the comparable rates are $1.86 for
2004, $1.84 for 2005 and $1.72 for 2006.