MIKE DOLAN: The pound’s position as a reserve currency is in question

London — Perhaps remarkably, some of the world’s major economies still hold at least part of their rainy-day savings in sterling and British government bonds, raising questions about whether long instability in both will keep them doing so.

A pound plummeting to record lows and an illiquid and sometimes unstable gilt market has sent shock waves around global markets since late last week, adding credence to recent fears that Britain, still the world’s sixth-biggest economy, risked a balance of payments crisis on current policy trajectories.

The decision by Prime Minister Liz Truss to go for broke and slash taxes during raging inflation, an energy shock, mounting borrowing needs and rising interest rates has perplexed the sort of foreign investors Britain sorely needs to attract to keep balancing its books. Sterling and gilts have taken the immediate heat and no-one’s clear yet what happens next.

And yet despite many jibes about Britain being seen as an emerging market, it has retained an enviable position as printer of one of the world’s five main reserve currencies.

At the IMF’s  last count in the first quarter of 2022, almost 5% of the world’s foreign currency reserves were denominated in sterling — a total of $625bn in sterling and sterling assets on a crude calculation from the $12.55-trillion total.

In context, that is more than two-thirds of the Bank of England’s (BoE) own bloated balance sheet, which has been amassed since the 2008 banking crash and doubled up during the Covid-19 pandemic.

In other words, that stable foreign demand for sterling assets is a powerful buffer against the sort of “sudden stop” creditor strikes many developing economies experience and one reason many analysts think calm can return.

As ING economist Chris Turner says: “UK authorities will probably just have to let sterling find its right level. The UK has a reserve currency so it can always issue debt — it’s just a question of the right price.”

But what if that reserve currency position is threatened and foreign central banks balk at holding so much sterling in their national savings stashes?

As the pound nosedived by an eye-watering 5% to record lows against the dollar in a matter of minutes in Asian trading hours on Monday — before London trading had even started — there was some suspicion of major investors there bailing out of British holdings.

Seven of the world’s top 10 reserve holding central banks are in Asia or the Middle East. China and Japan account for the lion’s share of total holdings with about $4.5-trillion between them.

Jim O’Neill, a former Goldman Sachs global economist and UK treasury minister, said the timing of sterling’s lunge in Asia reasonably raises questions about whether big and reliable players exited pounds and underlines the scale of the misconception and miscommunication of government and BoE policy.

O’Neill described what he saw as policymaking “naivety” and the “huge mismatch” between government thinking and what markets wanted to hear.

Sterling’s now distant history as the world’s dominant reserve early in the last century makes it no stranger to decline. It rapidly ceded pole position to the dollar after World War 2 and remained only a minor holding as the euro consolidated the second place roster after launch in 1999.

But for a country now running a current account deficit of more than 8% of national output, it’s critical Britain and sterling don’t lose the remaining valuable and often sticky friends in overseas central banks.

The criteria typically used to choose foreign currency for reserves are based on liquidity, security and returns — but also structural issues like being part of the five currencies forming the IMF’s unit of account, a basket known as special drawing rights (SDRs). Economic size, share of world trade and commodity invoicing as well as loose membership of currency blocs and zones also play a significant part in allocation over time.

Right now, sterling remains part of the SDR along with the dollar, euro, yen and renminbi, and inertia around this sort of mechanistic allocation matching probably helps the pound.

An annual UBS survey of global reserve managers in June ominously showed that a net 13% expected to cut allocations to sterling going forward, more than any other currency. None said they planned to increase.

On the other hand, changes to allocations tend to be glacial unless there is a massive shock or change of circumstances.

“Central banks tend to go against the market and do what it takes to preserve their allocations, unless they come to the opinion that something major has changed from a long-term perspective,” said hedge fund manager Stephen Jen at SLJ Eurizon. “I don’t believe that’s the case with the pound.”

Whether this is a paradigm shift or a major rethink of the credit quality or debt sustainability of Britain is now key to the story and will play out over the coming months.

Reuters