Hamish McRae: Be careful what you wish for - those dollar bargains could damage us all

If the US dollar dropped another 20%, Britain's biggest export market would be gravely damaged

The dollar is going down - or are other currencies coming up?

Unsurprisingly we see the twists and turns of the dollar from the perspective of the dollar/sterling rate, and we know that anything close to $2 must be a good time to shop in the US. So the fact that the pound should be back within a whisker of that level at around $1.95 has sparked the usual predictions of Britons making a pre-Christmas rush to New York to stock up with prezzies. After all, you don't see a $2 pound that often: the last time it was up there was in 1992.

Sadly it doesn't work quite like that, though I like the principle. It reminds me of the comment from a friend of my daughter about the prices in the shops in Rome: "They are amazing; provided you buy enough you can pay for your flight". With the cheapest flights at around £270 you would have to buy quite a lot of stuff even at the $2 pound to be ahead, and there is the little matter of VAT and whether to go through the red channel on your return. Even the new £290 duty-free allowance that starts in January would not help enough.

Holidays are different: I expect the surge in Brits skiing in Colorado to carry on this season because shifts in the exchange rate do have a swift impact on tourism. The lags in trade patterns are longer.

It is worth thinking about currencies from a personal point of view because our response as individuals to exchange rate changes mirrors the response of the economy as a whole. Some purchases are price sensitive, or price elastic as economists would say. Tourism has traditionally been a good example of that. The choice between the Alps and the Rockies is undoubtedly affected by the dollar/euro rate.

But a lot of purchases are pretty price inelastic. If you want to buy a BMW you are not going to be pushed towards a Cadillac because the latter has become 5 per cent cheaper. At some price you might buy a US-built car but the change in the relative prices would have to be huge and it would in any case take time for the US producers to build up the appropriate import structure. Similarly it would take a big movement in relative prices in the US to get Americans to switch back from imports to US-built cars.

That leads to a bigger point. The current account deficit of the US is around 7 per cent of GDP. The scale of the shift away from imports towards exports to correct that is so big that it would require an enormous change in exchange rates and an enormous change in the structure of the American economy. At some rate US exports would become so super-competitive that they would sweep the world. But that rate would be so low as to be very disruptive of world trade. We would be thinking of a 20 per cent fall, maybe more.

Come back again and think of it in sterling terms. A fall of 20 per cent would push the pound up to about $2.40, the last rate at which it was fixed under the Bretton Woods system (see first graph). At that rate our own exports to the US, of around £54bn, would be gravely damaged and that is our largest export market. Meanwhile US exports to us, worth £37bn, would climb. So the fall of the dollar would have a directly damaging impact on our trade, in one of the few major markets in the world where we have a surplus. Not very good news for us.

An across-the-board fall of 20 per cent would not be good news for the rest of the world economy either. The bottom left-hand graph shows how the real exchange rates, adjusted for the share of each country's or region's trade with the rest of the world, have moved over the past six years. The euro has become significantly stronger and the dollar a bit weaker, but only a bit. On the other hand the real exchange rate for the Chinese yuan has hardly moved and the rate for the Japanese yen has plunged.

Yet the biggest deficits for the US have been against China and Japan. By rights the yuan should be a lot stronger and the yen vastly stronger. What we need ideally would be for the dollar to stay more or less stable against sterling and the euro and fall sharply against the yuan and yen.

That has not happened in the case of the yuan because China has linked its currency to the dollar and only recently has begun to let it creep up. You can see the slight divergence over the last 18 months in the graph. Against the yen, the rate has been influenced by the Japanese authorities, which have sought to hold down the currency by intervening in the markets to buy dollars (as has China to maintain the dollar peg). So both China and Japan have built up huge foreign exchange reserves, mostly held in dollar securities, in effect lending the US the money to buy their goods. Were the dollar to fall sharply, that would reduce the value of their investments as expressed in their own currency.

So they are in a bind. It was a hint from China that it might diversify its reserves, which at some stage it has to do, that provoked the most recent slide of the dollar.

This leads to the next stage of the debate. The Chinese and Japanese authorities are helping prop up the dollar. But so too do private investors the world over. Is the US allowed to run this huge current account deficit because foreign investors are stupid? Or are they responding rationally to the fact that there are better investment opportunities in the US than there are in, say, Japan?

So why do people invest in the US? Is it just the higher short-term interest rates or is it something to do with better medium-term growth prospects? You get a higher running return in cash than you could in other currencies. As you can see from the top right-hand graph the steady climb of the Fed Funds rate has meant that cash invested in the US has progressively received a higher return. Actually cash will be invested for longer periods and the rising short-term rate has in effect validated the higher three-month rate. Recently however market expectations for the trend in three-month rates have dipped and are now below the Fed Funds rate. The market is expecting cuts in rates.

That is not surprising, as it is clear the US economy is slowing, with a sharp fall in house prices. You can see how consensus expectations for US growth in 2007 have fallen during the course of this year from over 3 per cent to about 2.5 per cent, while the corresponding forecasts for the eurozone have recently climbed a little.

Capital Economics, drawing attention to the US slowdown, notes that the markets think the US authorities can stimulate the economy with quite small cuts in rates. It points out that if growth disappoints and cuts in rates are sharper than expected the dollar will have further to fall.

I think that is right. This issue is whether we see a further nudge down then reasonable stability or something altogether less orderly. If the latter, then the spring might prove rather a good time for a shopping trip to the US. But if the fall gets out of hand that will be bad news for us here, and not just for our retailers. Markets have a history of overshooting.