Hamish McRae: Big cities can absorb a lot of blows, but we mustn't take London's strength for granted

In what way will the London bombings affect the economy? A simple question but an extraordinarily difficult one. We can make some guesses about the reaction of Londoners from the way in which the citizens of New York and Madrid have responded, or indeed the effect on London of the IRA campaign. But each situation is different. While the New York attack was much more devastating than the London ones, we don't know how long the present wave of attacks will continue or how grave it will be.

What can be done, however, is to set out a framework for thinking through the sequence of possible consequences. The starting point is where the economy stands now. Then you have to think through the probable results, direct and indirect, of events so far. And finally you have to consider what might happen if the attacks continue.

Evidence that the economy has hit a soft patch is mounting. On Friday, we got the first estimates for growth in the April-June quarter, which, at 0.4 per cent, was quite a bit weaker than the 0.7 per cent expected by the Bank of England in its May Inflation Report. It is beginning to look as though growth this year will be around 1.8 per cent. If that turns out to be so, it will be the lowest growth since 1993, and far below the 3 to 3.5 per cent forecast by the Treasury before the election. Retail sales, on the other hand, perked up in June, though the three-month running total remains weak.

You can see this in the graph on the left. Two things are pretty clear. One is that, so far, the downturn is nothing like the early 1990s recession and much more akin to the dips of the mid- and late-1990s. The other, looking forward, is that consumption will no longer run ahead of growth in the economy as a whole, as it has done for most of the period since 2000 - the black line, showing retail sales, running higher than the grey one, which shows GDP.

The other new information last week was government borrowing in the April-June quarter, which was higher than last year. At the time of the Budget, before the election, Gordon Brown forecast that borrowing this year would be lower. You can see the extent to which government borrowing has supported the economy in the right-hand graph - the gap between the grey line, showing spending, and the black one, showing tax revenues. We are still in the early stages of a projected sharp rise in taxation, which if it happens, will be a further drag on consumption and hence growth.

So this is a slowing economy, quite irrespective of any loss of confidence or any change to our buying habits that might result from the attacks. What of them?

Trade bodies have started to gauge some of the direct consequences of the attacks, though these reflect information before the events of Thursday and Friday. The tourist groups estimated that revenues would be 2 per cent lower - so instead of rising by 4 to 7 per cent, revenues would only increase by 2 to 5 per cent. That may be optimistic. The problem for the tourist industry is that the capital is half the market, so any damage to its business has a big impact on the whole. People planning to come to London don't switch to Manchester; they choose another country or don't travel at all.

The London retailers have obviously seen a sharp cut in their takings but they have been having a hard time anyway, with those in the congestion charge zone facing a cut in revenue of up to 10 per cent. London is not as important to retailing as it is to tourism and, in any case, the proportion of people's spending on retail goods, as opposed to the wide range of services, is shrinking each year.

So, yes, demand will fall some and, yes, some sectors, such as London hotels, will be severely damaged. Yes, too, some purchases will be deferred. So there may well be a dip in spending in the July-September quarter. It is just possible that this, on top of the general slowing noted above, means we could have a quarter of no growth, but that is not yet a probability.

In the short- and medium-term, the terrorist effect, while disturbing, is not likely to be that significant economically - unless attacks on a rather larger scale are launched in the months to come, in which case we have to rethink everything.

But long-term, assuming some continuing incidents? There are several factors here.

First, suicide bombers put dense city centres at a disadvantage, for disruption pushes economic activity towards the fringes. One obvious reason is that people will prefer to work in suburban locations, to which they can drive, rather than central business districts, which they can only reach by public transport.

This is already happening, with new office developments being sited on the fringes in most large conurbations around the world. The main exception, the industry that seems to require a central location, is financial services.

And that, of course, is hugely important for London - indeed for the whole economy. Net exports last year were £19bn, up 9 per cent, and our financial services trade surplus is the largest of any country in the world.

You could say that we are too dependent on a single industry in a central location. It brings in so much of the country's bacon that anything undermining it is potentially very serious. What we have seen so far should be manageable. Remember how the IRA targeted the City with a series of bombings? That led to the "ring of steel" security cordon which reassured financial services firms and brought other benefits in terms of reduced congestion and better air quality in the Square Mile. For now, assuming that London responds appropriately to the threat, the industry is probably safe. New York has rebuilt its financial services business since 11 September 2001, but the Wall Street area still suffers.

Big cities are resilient things. They cope with crime, with congestion, with environmental pressures and still manage to attract the world's most energetic and talented youth. That is why most of the world's mega-cities are growing so fast. They will cope with some element of terrorist disruption.

However, they can reach tipping points and go into decline, as Calcutta did for a century, Shanghai for half a century and to some extent London between the Second World War and the early 1980s.

These attacks come at a time when many people take London's success as a given, its problems being those of growth rather than decline. Now it has a new layer of problems. Tackled wisely, there is no reason why growth should not continue. But no one should take this for granted, and if London falters, the entire economy will feel the chill.

China's fine tuning could shake up America

Central banks like to surprise the markets, and the People's Bank of China is no exception. It has been under considerable pressure to revalue the yuan from the US Congress, which had threatened to impose a 27.5 per cent tariff on Chinese imports. The pressure was headed off by John Snow, the US Treasury Secretary, who assured the tariff's promoters that the Chinese would act.

Well they have, but not quite in the way expected. The US Treasury reportedly expected a revaluation of about 5 per cent, with provision to move by another 5 per cent over the next year. The People's Bank has agreed only to a revaluation of just over 2 per cent. For the time being, the peg with the dollar is retained, but it looks as if it might move to a basket of currencies at some future date. The effect of this would be that were the dollar, for whatever reason, to rise, it would not pull the yuan up by the full amount.

This leads to several questions. First and most important, will the rise be enough to head off US protectionism? Of course, 2 per cent in itself is negligible but one immediate effect was for other Asian currencies to rise as well. That helps a bit and will do so more when the switch is made to a basket peg. It is probably just about enough, as protectionist sentiment in Congress seems to be on the wane.

Next, what does the rise do for the domestic Chinese economy? Not a lot, but it is mildly restrictive and hence good for Chinese inflation.

Will the Hong Kong dollar, currently still pegged to the US dollar, also shift its peg to a basket of currencies? Eventually, yes. Will this lead to a diversification of foreign exchange reserves, with China and other East Asian countries holding a larger proportion of euros and even sterling? Yes, that process is under way.

Last but not least, will that also mean that the US cannot rely on China (and Japan) financing its current account deficit? Tricky. I don't think there will be any sudden withdrawal of funds but US bond market prices have fallen, suggesting this does worry the markets. That is a most sensitive point. This modest revaluation of itself is less important than the implication that eventually the US will have to trim its current account deficit.