Hamish McRae: After a decade riding high, the pound may have a long way to fall

Is the pound the new dollar? There are obvious parallels between the UK and the US economies: several years of rapid growth, financed in part by a housing bubble, but a deteriorating current account, weakening public finances and a large overhang of household debts. In the case of the US this has led to a sharp fall in the dollar, a fall that may not yet be over. Until last autumn, however, the pound remained reasonably strong, rising against the dollar and falling only slightly against the euro. Now in the past few weeks that period of strength seems to have come to an end.

Most of us have hardly noticed what has been happening, largely because we think of the external value of the pound in dollar terms. Anything below $1.50 is weak and anything approaching $2.00 is strong. Yesterday it was still just above $2.00. But if instead you look at the value of the pound against a basket of currencies, and of course against the euro, sterling is as weak as at any time for a decade.

If our economy seems to be following the pattern of the US one, though about nine months later, it is at least plausible that sterling could fall quite a lot further. While in the medium term that would help to boost demand by making exports cheaper and imports more expensive, in the short term it would be unwelcome because any further fall would put yet more pressure on inflation and hence further inhibit the ability of the Bank of England to cut interest rates.

First, the case for the prosecution. Our current account has deteriorated suddenly in the past few months. Until 2006 we were bobbing along with a deficit of around 2.5 per cent of GDP, but in the last quarter of last year this had increased to more than 5 per cent. There are two reasons for this. One was a continuing but unremarkable decline in the trade account. The other, which I find more interesting, was that through most of the past decade the trade gap was plugged both by capital inflows (of which more in a moment), by earnings from services and by investment income. The sudden deterioration of the past few months was because of a falling-off of investment income.

What seems to have happened is that the financial crisis of the second half of last year cut the earnings of the financial services industry and reversed the flow of investment income. I say "seems to have happened" because we don't yet have figures for the City's earnings last year. We won't get these till the summer, and even then they may be substantially revised in the years ahead. Put in simple language, though, the UK has been borrowing short-term to finance long-term overseas investments. We earn roughly 2 per cent a year more on our investments than we pay for our finance, so this practice has, over the years, been a good deal. But the past few months have not been a good time for this particular financial device and the weakness of sterling may be associated in some measure with this.

There is a further twist to the story. We seem also to have been importing savings from the rest of the world to support our mortgage lending. The total flow of funds collected by the mortgage lenders in their branches has been insufficient to finance the mortgages they have been issuing. The balance of funds came from the money markets, and it looks as though a fair chunk of these may have come in across the exchanges. As Northern Rock discovered, relying on the money markets to finance home loans only works if the markets are functioning smoothly, and that has not been the case. The markets remain so jittery that it was possible yesterday for a rush of rumours to unsettle the shares of HBOS, leading to that Bank of England statement of support. That has not happened since there had to be a similar statement about NatWest after the fringe bank crisis in the 1970s. (That proved the turning point in confidence, which suggests we may be close to a similar turning point now.)

At any rate our home lenders are now cutting back their flow of loans to something closer to the available flow of deposits. So the scale of the funds coming across the exchanges to finance house purchase has almost certainly fallen sharply, and one prop for the pound seems to have fallen away.

That does not mean that sterling will go into free-fall. It is still protected by relatively high interest rates. We are not, at least for the time being, likely to see the collapse in rates that has taken place in the US. But the Bank of England's latest Quarterly Bulletin does note that while until January expectations of changes in relative interest rates did help to explain movements in sterling, since then the link seems to be weaker. In other words, news that suggested sterling rates would remain high relative to those of other currencies has not supported the pound as one might have expected.

So what will happen? Currencies are about the hardest elements to predict in any of the markets, and a lot of people have made the error of expecting a sharp fall in the pound/dollar rate, only to be confounded. But I am impressed by some work by the Bank Credit Analyst group in Montreal, and have reproduced a table from their latest report here. The BCA team has constructed economic models that seek to predict house prices and retail sales. As you can see, it expects house prices to go negative on a year-on-year basis this summer. That is pretty much in line with many other predictions. It also thinks that growth in retail sales volume could drop close to zero by the end of the year. That is gloomier than the other forecasts I have seen, but if it is right then the pound could go down quite a bit more. My judgement would be that demand will fall more slowly than the BCA model predicts, and if that were right, then I suppose the decline in sterling would come later, maybe in 2009. But it is impossible to predict the timing of currency movements so don't take that seriously.

What is worth saying is that the pound is likely to remain fairly weak for some time. The big issue will be whether it drops off the plateau it has been on 1997, a period of remarkable stability. Indeed over the past decade sterling has been the most stable currency in the world, measured by its weighted index, bar none. My guess is that it won't go right down to its level in the mid-1990s, but could dip some of the way there.

Finally, an inevitable question. Does a weaker sterling have political implications? Put it this way. At the present level it is hard to read anything much into this, but were the pound to become really weak I do not think it would be something that the Prime Minister would welcome.