Currencies: Pound Loses Weight on EMU Speculation

By David A. Gaffen ,

In the past week, the U.K. pound has put together a performance much like Conservative Party leader

William Hague's

campaign for prime minister -- soggy. With U.K. citizens at the polls today expected to re-elect current Prime Minister

Tony Blair

to a second term in a landslide, the pound was weakening again.

There's a couple of reasons for the sterling's decline against the dollar, only part of which is the election. The recent decline in the currency reflects some expectations that Blair's governing Labour Party will push for Great Britain's entry into the

European Monetary Union

-- and the British currency is considered too strong for entry at this point.

However, the sterling's dramatic decline against the dollar is more directly related to a poor industrial production report released this morning. The report, according to U.K. analysts, underlines the fact that the U.K. manufacturing economy is suffering because of the strength of its currency relative to the euro. Of late, the sterling was trading at $1.3839, down from $1.3921 yesterday. It is currently at its lowest level against the dollar since 1986.

"The markets have woken up to the prospect of EMU entry," said Danny Gabay, chief U.K. economist at

J.P. Morgan Chase

in London. "First, they had to decouple sterling from the dollar, which they did earlier this week. Now we have to turn around and see whether this is the appropriate rate to go into the euro."

After today's report, the answer seems to be absolutely no. As of April, U.K. industrial production was down 0.8% for the previous three months, and manufacturing production was down 1.1% in the same time period. Industrial production has dropped five of the last six months, and the declines were most significant in the electric and electrical equipment sector (including technology and fiber-optic companies), which, akin to those in the U.S., had been boosting the U.K. economy for the past couple of years.

"The manufacturing numbers underline the point that sterling is overpriced," said Anne Parker Mills, senior foreign exchange economist at

Brown Brothers Harriman

. The euro/pound was at 0.6123 today, up from yesterday's close at 0.6086. But that's dramatically weaker than in 1999, when the euro was introduced -- at the time, it was worth about 0.7 pounds.

Mills believes speculation on whether Blair will push for rapid entry into the EMU is a bit overdone (the Conservative opponents have run a disastrous campaign, founded largely on the notion of keeping the pound), but Gabay believes that even without a potential entry into the monetary union, the British currency is still overvalued, which hurts U.K. exporters.

"At this level, sterling is not competitive," he said. "The consumer is consuming, but unfortunately, nothing of what we consume is produced here. The industrial sector is in recession, and as of the first quarter, our trade deficit was 4% of GDP. Today's figures tell you it's 4% and counting -- we're approaching U.S. levels of 4.5% GDP. That's not supportive of the currency."

Other currency markets were mostly quiet. The euro was mildly weaker against the dollar and the yen. As expected, the

European Central Bank

left short-term lending rates unchanged at 4.5% at its meeting today. Speaking later in the day, ECB President Wim Duisenberg reiterated that the ECB's mandate differs from that of the U.S.

Federal Reserve, in that price stability is its main priority. He said growth in the euro zone is expected to slow, which should alleviate some inflation pressures. Lately, the euro was trading at $0.8475, down from $0.8476 yesterday. The euro/yen cross was at 101.84, up slightly from 101.74 yesterday.

The Japanese yen gained a bit of ground against the dollar today. Dollar/yen was weaker, trading at 119.95, down from yesterday's 120.19 close. The Australian dollar strengthened against the U.S. dollar, lately at $0.5186, up from $0.5160 yesterday. The U.S. dollar weakened against the Canadian dollar also -- it was lately at C$1.5196, from C$1.5232 yesterday.

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