YOU’D need to have been living on a desert island not to have noticed the beating that sterling has taken lately. The pound has lost nearly a quarter of its value in the last two years, but saw the losing streak gather pace in the last week. True to form, that was accompanied by an avalanche of media speculation on the plight of our beloved currency. When will the collapse end? What is behind the plunge? And most importantly, for the forex trader, will it continue?<br /><br />Much of the blame for the current state of the pound has been directed towards Bank of England governor Mervyn King, after his comments seemed to welcome a weak pound is a crucial component of the UK's economy recovery.<br /><br />Speaking to a newspaper last week, he said: “The fall in the exchange rate that we have seen will be helpful, but there is no doubt that we need to see a shift of resources into net exports that compete with imports and help to reduce the trade deficit.”<br /><br />Some have gone as far as to suggest that policymakers have deliberately sought to weaken sterling, to make the pound more competitive. The clamour was such that Alistair Darling was forced to publicly deny the speculation.<br /><br />So should we thank Mervyn for his harsh medicine which will, he says, return economic stability to the UK? In fact, his recent words merely echo those of Peter Mandelson earlier this year, when he said the UK needed to be “less financial engineering and more real engineering”.<br /><br />Actually, Britain’s role in global export trade isn't quite the disaster that most opinionated taxi drivers would have you believe. The UK still enjoys a leading position in the worldwide automotive and aerospace industries, supplying precision engineered components and sophisticated electronics, for example.<br /><br />UK companies like Rotork, Renishaw, Ultra Electronics, or Cobham are all leaders in the highly specialist niches they occupy. Another UK plc, Xaar, which supplies ultra high-end printing technology, has relocated its entire production facility in the UK, closing a Swedish factory rendered uneconomical by the strength of Krona.<br /><br /><strong>SLOW EXPORTS</strong><br />But according to the official data at least, British exports haven't recovered much so far. The ONS’s figures show that exports rose 5 per cent to £19.2bn in June, a slower rate of recovery than some economists had expected. Of course, it's hard to expand exports when no one else is buying.<br /><br />In the absence of orders, business investment has slowed too, curtailing the ability to capitalise an economic upswing in the UK’s key trading partners when it comes. UK manufacturing investment fell 16.2 per cent coming into the second quarter, and capital expenditure is predicted to remain weak for some time.<br /><br />And with the pound so weak, British companies are vulnerable to takeover. Take Cadbury, for example, whose defence of an unwanted approach from US food group Kraft just three weeks ago suddenly looks a lot more wobbly. Overseas buyers are snapping up commercial property, too – the Australian government’s purchase of a stake in Birmingham’s Bullring shopping being just one notable example.<br /><br /><strong>LOW PPP</strong><br />What it all adds up to is the data from the Office of Economic Development, from July, which shows that UK purchasing power parity (PPP) is already well below that of most of our trading partners. Of course, sterling has weakened further since, and while PPP theory suggests it is now undervalued against the euro and will move into line over time, these imbalances have been known to persist for years.<br /><br />Again this has major consequences for many UK businesses, in particular those focused on selling to the domestic market. “By pushing up import prices, a weak pound will have significant inflationary consequences,” says Howard Archer, chief economist at IHS Global Insight.<br /><br />That’s bad news for companies needing to import raw materials, which are priced in dollars – a dynamic which threatens to undermine the recovery of manufacturing export demand that a weak pound is supposed to help.<br /><br />Retailers will also face higher sourcing costs, and will have to either increase prices to avoid pressure on profit margins. That’s fine for a supermarket or food producer, which sells staple goods that are relatively impervious to the ups and downs of the economy, but not for a shop selling goods considered discretionary. Such a strategy runs the risk of putting a dampener on consumer demand, even before the recovery has a chance to take root.<br /><br />It’s not all bad news though, and sterling’s decline could be seen as an opportunity to rebuild. More expensive imports could accelerate the shift towards domestic suppliers – although, of course, there remains the risk that producers will target more profitable create markets instead, and create inflation-inducing supply shortages at home. Either way, this will further strengthen the UK’s manufacturing sector and push the country towards Mervyn King’s vision of a “rebalanced” economy that is less reliant on financial services.<br /><br />That said, it will be a long process and by no-means pain free. Sterling will remain weak for the foreseeable future. But Britain and its companies now have little choice but to adapt to the inevitable hardships that weaker currency will bring. In the long run, though that change is long overdue and can only be a good thing.