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Bucking the trend

There are two sorts of entities in the world, at least for
the purposes of this article. On the one hand, there are stable, sensible
corporates who like nice, predictable, stable currency environments. On the
other hand, there are the ravening hordes of currency speculators who live off
adrenalin rushes and who loath stability and low volatility and probably dream
of the US dollar imploding spectacularly so that they can ride the wild swings
that would then ensue as the world’s currency markets fight to rebalance
themselves.

For finance directors of UK plcs, the ‘worry index’, whether measured in
terms of sweaty palms, lost sleep or increasingly agitated ulcers, starts to
creep up as we move out of the ‘global currency stability’ position and towards
the nightmare scenario constituted by a US dollar collapse.

Don’t panic ­ yet

Let us begin by saying quickly that the latter is not yet on the cards, so
mad panic is not in order. However, we are already quite a way outside what most
UK corporates would consider to be their comfort zone, with regards to global
currency flows. So complacency is not in order either.

Currency movements have to do with increases or decreases in risk aversive
behaviour on the part of those who command large pools of currency. This
includes Asian, European and North American central bankers. It also includes
the sovereign wealth funds that have sprung up over the past few years and it
includes private finance, which means the way European, US and Japanese
households choose to invest their surplus funds, and what fund managers do with
those funds.

As Adarsh Sinha, FX analyst at Barclays Capital, explains, the second half of
2007 has been characterised by a very substantial increase in risk aversive
sentiment. This has been sparked, in no small part, by the US sub-prime fiasco
and the resulting wobbliness in the banking system as banks try to figure out
their exposure.

However, there are also systemic issues that raise their heads when things
get wobbly. These systemic issues include the US trade imbalance/current account
deficit that now takes around 5% of US GDP to finance and the fact that
countries like Japan, China and the Gulf states are sitting on vast dollar
reserves, which are being eroded quite substantially as the dollar weakens.

Sinha points out that there have been across-the-board flows out of the
dollar and into low yielding currencies like the yen and the Swiss franc for the
past six months. Moreover, Asian central banks have been diversifying out of the
dollar for the past four years in a gradual way. He expects this process to
continue in an orderly fashion.

“We do not think there will be a sudden sharp move out of the dollar. The
Asian bankers are worried about dollar depreciation, but what is important to
them is liquidity and the depth of the market. The US market is the most liquid
and the deepest market in the world, so, for now, those characteristics are more
important. Plus, we think that whatever diversification is taking place out of
the dollar is already priced in to the current weakness of the dollar,” Sinha
says.

Past the worst

Things are rough now, but unlikely to get substantially worse. In fact, Sinha
expects the US dollar to strengthen against the pound a little in the second
half of 2008. The implications for FTSE FDs are clear, he says. If your company
is being paid in dollars, then hedge ­ even if it looks expensive. If you are
buying dollar goods and services with sterling, enjoy ­ but still hedge. We are
in volatile times and companies have no business playing the FX markets.

If you are competing against US companies for export markets, expect to
struggle for a long time to come. If you are dealing with Asian countries with
currencies that are pegged to the dollar, expect price inflation.

Ken Dickson at Standard Life points out, however, that the position for UK
exporters could improve by the middle of next year. “The theory that Asia and
the emerging economies are now decoupled from the health, or otherwise, of the
US economy is not yet really being tested. The US dollar is weak at present, but
we are in a transitional period where, in the absence of a clear decoupling
between Asia and the US, the US will get the benefit of having acted first to
cut interest rates and from having created a beneficial low interest rate
regime.”

As a result, US equities will start to look cheaper and more attractive. “You
will start to see capital flows into the dollar through 2008,” he says. “If the
position for the dollar starts to look better, then low yield currencies will
start to look unattractive. However, we do not expect any speedy return to
market normality.”

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