How low will the dollar go?

SUDDENLY, the idea of $2 to the pound does not look quite so fanciful. The once-mighty greenback has plunged almost 20% against sterling over the past 12 months - and 6% since the start of this year - leaving it languishing at 11-year lows around $1.90.

There are three main reasons - America's massive current account deficit, a perception that Washington has abandoned its long-standing strong-dollar policy, despite its denials, and rock-bottom US interest rates.

The current account deficit is not new but has only recently been seen as a problem. For years, foreigners were happy to take dollars earned by selling goods to Americans and recycle them into US assets, including shares, bonds and property.

But the huge inflows of foreign direct investment, including billions for global mergers and acquisitions, largely dried up after the dotcom bubble burst. Virtually overnight, US assets fell out of favour, prompting concerns about how the deficit, now approaching $500bn (£265bn) - or 5% of gross domestic product - will be financed.

The dollar's woes have been compounded by mounting suspicions that President Bush, in an election year, is happy to watch it slide in order to help America's manufacturing exporters, many of whom live in key 'swing' states. Interest rates at 1% - the lowest since 1958 - do not help.

Nick Parsons, chief currency analyst at Commerzbank, says: 'The attitude in the White House is that it's America's dollar and everyone else's problem. There hasn't been the slightest hint of concern from [Federal Reserve chairman] Alan Greenspan either.'

But how low will the dollar go and what will turn the tide? While currency movements are notoriously difficult to predict, there is a consensus among analysts that the dollar has further to fall, although $2 to the pound is still seen as an outside bet.

Mark Cliffe, chief economist at ING Financial Markets, says: 'Verbal intervention by the European Central Bank has not had an echo in London. As long as the Bank of England is happy to let the dollar slide, markets are pushing on an open door.'

Parsons says technical charts show $1.92 and $1.95 as the next key levels. 'Beyond that, there is an almost fatal attraction of round numbers and $2 doesn't look that far away,' he adds.

Simon Rubinsohn, economist at fund manager Gerrard, says: 'No one's going to bet against $2 now. And it could go much further, to $2.10 or $2.20.'

These sort of levels, reminiscent of Margaret Thatcher's early years as Prime Minister and the damage inflicted on British industry, are not sustainable. But analysts say there will have to be clear indications that US rates are heading higher before the slide is stemmed.

Parsons adds: 'The dollar needs a rise in US rates, all the election uncertainties out of the way and signs the US administration is willing to tackle the current account and budget deficits. Until then, it's going to be a slow grind lower.'

Meanwhile , there is mounting concern about the damage that could be inflicted on Britain's exporters by the relative strength of the pound. America is our single biggest export market, accounting for roughly 15% of overseas business.

While it is good news for British tourists, a stronger pound makes our exports more expensive for US customers, potentially hitting demand. It is also a worry for UK firms with large US subsidiaries. More than half of sales generated by FTSE 100 companies are denominated in dollars, and the likes of miner Anglo American and drugs giant GlaxoSmithKline would be hit when converting US profits into sterling.

On the other hand, UK firms are benefiting from cheaper dollar-denominated commodities such as oil. A stronger pound, by bearing down on inflation, should also help keep interest rates low. But experts warn a prolonged dollar slump could hinder economic recovery.

Doug Godden, head of economic analysis at the CBI, says: 'The movement in the dollar so far should not hold back the UK recovery. But it is seen as a growing risk and will have an adverse impact on a number of firms and sectors.'

Rubinsohn adds: 'It's clearly a worry and, the longer the dollar stays at these sorts of levels, the more protracted the pain. But unless we see sterling appreciate sharply against the euro as well, I suspect the economy will weather the storm.'