Our economy is thriving, but what happens if the pound takes a dive?

It would be churlish to moan about the state of the British economy when growth is robust, inflation low, unemployment falling and the Government's finances in good order. Still, all is not perfect. Many people working in industry are hoping the pound will fall from its present uncomfortably elevated value. A weaker exchange rate would add to the rosy assessment faster export growth and a narrower North-South divide.

It would be churlish to moan about the state of the British economy when growth is robust, inflation low, unemployment falling and the Government's finances in good order. Still, all is not perfect. Many people working in industry are hoping the pound will fall from its present uncomfortably elevated value. A weaker exchange rate would add to the rosy assessment faster export growth and a narrower North-South divide.

Unions and business leaders make a song and dance about the Bank of England's interest-rate decisions because it is assumed this is what is keeping the pound so high. But given that rates have varied between 5 per cent and 7.5 per cent with little impact on sterling, this can only be part of the explanation. In truth, nobody entirely understands why the exchange rate has stayed stubbornly high.

As it has done so, however, there has been a tendency to assume it will stay there. Indeed, Sushil Wadhwani has argued this forcefully on the Monetary Policy Committee. His view, expressed in a paper published soon after he joined the MPC, is that the Bank's inflation forecast should be based on a constant exchange rate, in place of the conventional assumption that sterling would decline in line with interest rate differentials. In last November's Inflation Report, in a classic committee compromise, the forecast split the difference.

Mr Wadhwani's argument was that the sterling-euro exchange rate (or sterling-DM before that) had moved in line with differences in the UK and German unemployment rates. The pound is strong, in other words, presumably because the economy is strong, as reflected in falling joblessness in Britain.

In real life, exchange rates rarely do decline gently as the conventional theory predicts they should. On the contrary, an overvalued currency like sterling will often fall off a cliff when it does start to weaken, just as the pound did after 16 September 1992. The problem is predicting the timing.

A new research paper from brokers Smithers & Co carries a warning about just such a possibility of a drop in sterling. It presents compelling evidence for the proposition that the UK is operating like the world's biggest hedge fund, shorting sterling to a massive degree - the kind of risky bet that is fantastic when it works and fantastically awful when it doesn't.

The starting point is that the UK has negative net foreign assets (to the tune of £145bn in 1998) yet earns high net investment income from abroad, equal to about 1 per cent of GDP. Without this income, which reflects the importance of financial intermediation in the British economy, the balance of payments would have been substantially in the red throughout the 1990s.

How is it possible for British investors to earn more on foreign assets than foreigners earn on UK assets despite being a debtor nation? The answer has to be taking more risks, that happen to have paid off handsomely. After all, it has been a pretty good decade for world bond and equity markets. The detail of the official balance of payments figures, which the authors, Daniel Murray and Andrew Smithers, have heroically burrowed through, shows that Britain has been borrowing short and lending long, in both bonds and equities, and also apparently earning a higher return by taking bigger investment risks than foreigners do on average.

They write: "Both sources of profit resemble those made by hedge funds. The profits are derived from long/short positions in equities, from maturity transformation and credit spreads."

As a higher proportion of UK assets than liabilities are not sterling denominated, a weaker pound would boost the value of the portfolio and reduce the country's net debt. Still, the diagnosis raises the alarming possibility that the UK will be the LTCM of the new decade. A period of world financial market turmoil triggered by a sharp fall in US shares, say, would turn positive net investment income into negative flows. With the dollar likely to be dropping, the pound could dive like a stone in these circumstances.

While a gentle decline in the exchange rate that posed no threat of higher inflation would be great for the economy, a sterling crisis would not be such good news, even for struggling exporters. The reason is that it would lead to increasing import price inflation. This would trim the exchange rate boost to exporters' margins. More seriously, it could feed through into domestically generated inflation.

Whether this happened or not would be down to the Bank of England. In principle, interest rates might not have to rise to offset the external inflation, any more than they have necessarily had to be cut to offset the strong pound's downward effect on import prices. In practice, the only time a falling exchange rate has not set off higher inflation in the UK was after the ERM crisis in 1992, which occurred when the economy was in a deep recession. If it happened again now, when growth is picking up sharpish, there would be greater inflationary danger.

The key would be whether a one-off jump in the sterling price of imports turned into the start of an inflationary spiral. If mostly absorbed in importers' and retailers' margins, a drop in the pound would pose no problem - and this is what ought to happen if there is any truth in the view that increased competition spells a new, permanently low-inflation era. If passed on down the price chain, on the other hand, the second-round effects would feed into higher inflation.

The conventional assumption of a gentle decline in the exchange rate - now modified because of Mr Wadhwani's arguments - factored in some probability of this scenario. It is now a problem the MPC will have to react to when it happens. The chances are that after spending the past three years explaining why the inflation forecast assumes a falling pound when it stayed stubbornly high, the committee will find itself defending a prediction of too high a level for sterling when it is diving on the foreign exchanges. Like so much else, it probably depends on what happens on Wall Street.

d.coyle@independent.co.uk

Smithers & Co Report No. 141, www.smithers.co.uk