Hamish McRae: Asian investors will see Europe and America through this bumpy period

The bumpy ride continues. When the banking system started to gum up in August it was clear that it would take several months to function normally again. It was also clear that there would be major casualties in the banking system, for the classic sign of the end of one of these periods is for a big institution somewhere in the world to have to be rescued.

That has not happened yet – Northern Rock was small in world terms. And though the past few days have seen a lot of damage to bank shares, it may well be that we scramble through without such an event. One of the most encouraging aspects of the markets in recent weeks has been the way the mainstream equity markets have held up very well. On the other hand the currency markets have been showing a lot of strain, or at least the dollar has been so doing.

What is, however, now coming to the front of people's minds is the extent to which mayhem in finance might lead to a downturn in the real economy. The problem here is that the links between the financial markets and the real economy are complex and unpredictable. There has to be a nagging doubt that something large and unpleasant is ahead and there are certainly plenty of candidates. Nevertheless it is hard to see which one of those it might be.

A good place to start is to look at what is happening in the money markets. The big point here is what matters is the actual cost (and availability) of funding to financial institutions rather than the nominal interest rates as set by the central banks. What has happened is that the markets have tightened suddenly, thereby reducing the need for central banks to do so. in the case of the US, they created both the opportunity and the need for the Federal Reserve to cut rates – the first fall in US rates merely offset the rise in money market rates.

You can see what has been happening to credit conditions in the main markets by looking at the gap between the return on three-month treasury bills and the cost of three-month money on the inter-bank markets. Spreads are still a lot wider than they were at the beginning of the year, but the mad conditions of September seem to be well past. The UK markets, after a tricky start, now seem somewhat calmer than those of Europe or the US, which suggests that maybe the Bank of England has not been doing quite such a bad job of managing the markets after all.

Still, the US has managed to get effective rates down a bit, as you can see from the second chart, and it may be that we will see some cut in interest rates here before Christmas.

That is all fairly comforting. What is happening in the foreign exchange markets is much less so. Markets in currencies, like all markets, tend to overshoot, and we are heading into overshoot territory as far as the dollar is concerned right now. There is a possibility that this will get out of hand. Some decline was appropriate to correct the US current account deficit, but that is already narrowing, and has been for most of this year. But beyond a certain point the fall starts to damage the realeconomy.

It is already damaging the oil price. Because oil is denominated in dollars, any fall in the dollar tends to push up its headline price. In euro terms oil has hardly risen at all in recent weeks and in sterling it has not gone up very much. For those currencies that link with the dollar, including for example the Hong Kong dollar, this adds to inflationary pressure. Now you could say that these currencies should not link to the dollar, and I think one of the lasting effects of these past few weeks will be for those dollar pegs to be abandoned and replaced with a peg to a basket of currencies, though this will take several months.

The question is whether the dollar will need an explicit rescue by the world's central banks, involving co-ordinated intervention on the foreign exchange markets. But you have to get the timing right, for past experience suggests that a rescue is only effective when the markets themselves are ready to turn. I don't think we are there yet, and the worst possible outcome would be for the central banks to attempt to rescue the dollar and fail. Maybe the euro at $1.50 would be the signal for a change of direction; certainly the present rate of $2.10 to the pound seems to be pushing the bounds of credibility.

Currencies affect the real economy in a way that equities don't, and a further fall in the dollar would be part of the transmission mechanism that would transfer a slowdown in the US to a similar slowdown in the UK and Europe. Some sort of slowing seems to be happening here: the advance index for UK service sector activity has turned down. But there does not as yet seem to have been any serious contagion from the slowing housing market into consumer demand. Growth here will slow of course, but as yet this looks like a gentle slowing, not a dramatic or worrying one.

The one thing we can be pretty sure about is that Asian demand will carry on strongly through next year. Leave Japan aside because it has its own problems; the rest of Asia is now big enough to replace the US as the main engine of growth in the world. That is happening right before our eyes. Why is there so much demand for energy, despite a slowing US economy? Answer: that demand is coming from Asia. Where are the world's savings coming from? Answer: Asia and the Middle East.

So I suppose anyone pondering just how bumpy the ride through the rest of the autumn will be should try to see the world through the eyes of an Asian or Middle Eastern investor. At the moment they want to cut their exposure to the dollar and to dollar-denominated assets. At some stage they will decide that the dollar has fallen enough, but that may be quite a way further down. But those investors are also confident of continued growth in China and India and will continue to place funds there.

Do the present travails of US banks matter much? Not really, for the foreign investors are there for the long haul and will know in a few more weeks just how bad the situation really is. At some stage, when the shares are really bombed out, there will be a buying opportunity.

You see, it is not only a question of Asian consumers taking over from American ones. It is also Asian investors who will help US markets through this bumpy period. It is just that they may need a rather lower dollar to encourage them to do so.