2006 was a traumatic period for the dollar. In fact back in November, the dollar passed a milestone, falling to $1.30 to the euro, while as of this morning sterling was sitting at $1.96. With the US economy expected to slow while the eurozone at last starts to take up the slack left by Uncle Sam, throw in the economy behind The Great Wall and it’s no surprise the dollar has suffered. Capital Economics is predicting $1.4 to the euro soon, while the Sunday Times recently headlined on the front page of the business section “Pound set to hit $2.”

You can understand why the dollar is so precarious. Uncle’s Sam’s massive current account deficit, propagated by spending US consumers, was inevitably going to have an impact, and 2006 has been full of predictions of gloom for the currency. Warren Buffett, for example, said he planned to sell many of his US assets in favour of assets from overseas in anticipation of a falling dollar. But the question some have asked is this: If the greenback is dropping on the back of a poor balance of payments, why isn’t the pound falling too?

The answer is actually quite obvious, but lying within the whys and wherefores there is a mystery.

The UK may have a poor record in its balance of payments in recent years, but it is nowhere near as bad as the US, with the UK current account deficit in the region of two percent of GDP, compared to five or even six percent of GDP in the US. The mystery relates to why the UK deficit is not a good deal worse, because if you examine the facts, you would have thought the UK would have an even higher current account shortfall.

In recent years, the UK’s current account has benefited from a positive flow of investment income. We get more money in from investments than we fork out. This has helped to greatly reduce the overall deficit. Yet, and this is the puzzle, the value of investments abroad is actually lower than the value of investments held in the UK by overseas individuals and institutions. In short, we are making more money from less.

There is only one possible explanation for this strange phenomenon. It’s thought that foreigners are typically investing in UK bonds and other low risk forms of investments, perhaps encouraged by the UK’s relatively high rate of interest. With that low risk, yield is inevitably low too.

The UK, on the other hand, typically invests in equities and other more risky assets. And since it’s been an outstanding couple of years for equity investment, the economy has enjoyed much higher returns on its more modest investment. It’s as if Great Britain plc, or so the Bank of England has said, is like a bank or venture capitalist borrowing to invest in projects that earn a higher rate of return than the cost of funding.

But as any financial advisor would tell you, greater risk may mean that from time to time, you will enjoy a better reward, but sometimes the risk backfires. The same danger exists for the UK.

For 2007, the problem is this: 22 percent of the UK’s total overseas assets are invested
in the US. If the US economy slows next year, the way most expect, then the UK is likely to see a big fall in investment income, or so says Paul Dales from Capital Economics. He said that Capital Economics estimates that a US slowdown “could reduce the UK’s annual investment income surplus by anywhere up to 1.5% of GDP.” he added “This, in turn, could leave the sterling exchange rate looking fundamentally over-valued at current levels.”

Of course there’s another implied prediction in the Capital Economics theory: that as the US economy slows, then US equities will not perform as well as they have been. In other words, it is predicting, by inference, that US equities will have a bad year next year.

For further information

Dollar loses ground against euroBBC

Dollar Posts Longest Decline in Seven Months on Rate-Cut BetsBloomberg

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