Buck the Trend

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.