Strong sterling could rekindle Irish interest

Investor/An insider's guide to the market: At their recent meeting, the finance ministers from the powerful Group of Seven nations reiterated their view that "excess volatility and disorderly movements in exchange rates are undesirable for economic growth".

In the run-up to the meeting, European policymakers had expressed concern about the strength of the euro, while their US counterparts focused on the need for supply-side reforms to boost European growth.

The meeting participants also turned their attention to the lack of currency flexibility in Asia. The Japanese finance minister, speaking after the meeting, said the call for greater flexibility was not aimed at Japan and signalled that Tokyo would continue to intervene if necessary to hold down the value of the yen against the dollar.

This implies that the G7 would like to see greater flexibility from China, which continues to hold its renmimbi currency at what most analysts consider to be an undervalued rate. However, it is generally accepted that the Chinese will be extremely slow to sanction a revaluation of its currency.

This means that the brunt of the adjustment to any further dollar weakness will continue to be borne by the euro. The euro has appreciated by 25 per cent against the dollar over the past year.

Despite the hit to competitiveness caused by such a sharp appreciation, euro-zone economies have managed to increase exports, thus underpinning a modest economic recovery.

Nevertheless, forecast euro-zone growth of less than 2 per cent per annum in 2004 and 2005 pales in comparison to the 4.5 per cent expected from the US in 2004 and 3.5 per cent for 2005.

The consensus opinion among currency analysts following the G7 meeting was that there was little reason to alter the current market perception that the dollar would weaken in the long term.

Asian foreign currency policy of intervening to stem appreciation of their currencies against a falling dollar is likely to be maintained and, therefore, the euro along with sterling and other freely floating currencies will bear a disproportionate share of the required adjustment.

Activity on the foreign exchange markets last Monday, following the G7 meeting, confirmed this assessment. The euro climbed to $1.28, its highest level in two weeks, while sterling reached a11-year high of $1.86.

The UK monetary policy committee (MPC) and the European Central Bank (ECB) held meetings in the week preceding the G7 meeting. The ECB left interest rates unchanged at 2 per cent and they seem likely to remain at that level for the foreseeable future.

The MPC increased the UK base rate to 4 per cent and the money markets are now discounting sterling base rates of 4.75 per cent by year-end.

Above-trend output growth and strengthening business surveys lay behind the MPC's decision. In its statement, it also referred to a strong housing market and fears that inflation may pick up over the next couple of years.

With extremely low short-term interest rates globally, the higher level of UK rates will serve to heighten the attractions of sterling in the foreign exchange markets.

In recent months, sterling has begun to appreciate marginally against the euro and this trend could well become more established.

From an Irish perspective, this is providing a very welcome offsetting effect to the adverse competitiveness impact of the strengthening euro.

Current exchange rates imply an "old" punt/sterling rate of 87p. A rate of 85p-90p would be viewed by most economists as consistent with maintaining Ireland's competitiveness vis-à-vis the still very important UK market.

In this scenario, the potential for damage to the Irish economic recovery from further euro appreciation is substantially mitigated.

For Irish investors, the positive outlook for sterling offers some interesting opportunities.

For those investors wishing to diversify internationally, purchasing US assets has not been a rewarding experience in the past 12 months due to dollar depreciation. With further dollar weakness likely, anticipated positive returns from the US equity market are likely to be eroded through currency translation losses.

If sterling maintains its strength over the medium term, it enhances the attractions of investing in the UK equity market. The combination of a strong economy and a strong currency could rekindle interest amongst Irish investors in UK equities.