Superpound is heading for a fall

UK holidaymakers are taking advantage of the strong pound by heading stateside to bag cheap deals on the high street. But how long will things stay this way?

"Is it a bird? Maybe even a plane? No, what you see is Superpound, and you may even have some in your wallet," says David Smith in The Times. For the first time since 1981, sterling has breached the $2 level and UK holidaymakers are taking advantage. While British tourists head stateside to bag cheap deals on the high street, Americans heading to London are having to spend the equivalent of $8 for a Starbucks coffee. But for how long will it stay that way?

Fears that America's subprime woes might feed into the rest of the US economy, leading to a credit crunch and a resulting recession, are spooking investors holdings US dollar-denominated assets. "Housing fundamentals are very negative and weigh on the dollar," says Richard Franulovich, a senior currency strategist at Westpac Banking Corp, on Bloomberg. Last week, Ben Bernanke added to the despair, telling congress that there will be significant losses on loans to homeowners with bad credit. And this week's news that homeowners with good credit records are falling into arrears too will only make things worse.

So investors have begun switching out of the greenback and into higher-yielding currencies, such as sterling. At 5.75%, UK interest rates compare favourably against the 4% rate in the eurozone, with another rate hike in the offing. The pound now accounts for 4.5% of global foreign reserve holdings, from 2.1% a decade ago. "People are looking to pick up sterling for the yield and that story is continuing every single day," says Simon Derrick, head of currency research at Bank of New York on Reuters.

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So this is less a strengthening sterling story but more one of a weakening US dollar. Indeed, the dollar's plunge against 15 of the 16 most active currencies over the past month has helped to disguise the fact that sterling has in fact also shed value against everything from the Polish zloty to the New Zealand dollar. Sterling still looks overvalued by as much as 20%, says Jim McCormick, currency chief at Lehman Brothers. They predict sterling will fall to $1.93 this year and $1.79 by late 2008. "Don't be fooled by the surge in sterling," cautions Ambrose Evans-Pritchard in The Daily Telegraph. "We have not become the planet's ber-rich."

Rather the UK has been successful attrac­ting credit-hungry industries, such as hedge funds and private equity, to our shores. But a report from the Ernst & Young ITEM Club this month warns that we may have been too successful the growth of the UK economy is overly dependent on the services sector. Business and financial services make up 28% of UK GDP, it says, but account for more than half of the growth in GDP, which is partly why economic growth has surprised on the upside, despite rises in the base rate. "The Bank of England has only got one club in its armoury that's the short-term base rate," says the Club's economic adviser, Peter Spencer, in The Daily Telegraph. "That's not very effective against these kinds of industries, which borrow long term in the financial markets. [The base rate] is great for clobbering household borrowers and export firms, but useless in getting at the hedge- and private-equity funds."

But as the credit crunch takes hold, Britain's reliance on financial services will leave it beached as the "liquidity tide" recedes. Then we will discover what Gordon Brown's economic legacy really is, says Evans-Pritchard. "A bloated state sector that has risen from 37% to 45% of GDP in a decade... a budget deficit of 3% of GDP at the top of the cycle, worse than America or Italy" and "a current-account deficit of 3.4% of GDP". None of this bodes well for the pound and if our own subprime housing problems erupt, as Bank of England deputy governor John Gieve fears, then pressure to cut interest rates will hurt the pound as markets "make a harsher judgement on Brownism."