London: Some of the world’s biggest economies still keep at least some of their savings in sterling and British government bonds. This may seem strange, and it raises questions about how long they will keep doing this.
Since the end of last week, the falling value of the pound and an illiquid and sometimes unstable gilt market have sent shockwaves through global markets. This has given more weight to recent fears that Britain, which still has the world’s sixth-largest economy, could face a balance of payments crisis if policies continue as they are.
Liz Truss, the new Prime Minister, decided to cut taxes even though inflation was high, there was an energy shock, Britain needed to borrow more money, and interest rates were going up. This confused the kind of foreign investors Britain needs to keep its books in order. Sterling and Gilts are getting the most attention right now, and no one knows what will happen next.
Related: Mike Dolan’s column: Weary tolerance of Italian market instability
Even though many jokes have been made about Britain being an emerging market, it has kept its enviable position as a printer of one of the world’s five main reserve currencies, behind only the US and the euro zone, about the same as Japan, and ahead of China.
The last time the International Monetary Fund counted, in the first quarter of this year, almost 5% of the world’s foreign currency reserves were in sterling. A rough calculation of the $12.55 trillion total comes to $625 billion worth of sterling and sterling assets.
In the big picture, that’s more than two thirds of the Bank of England’s own bloated balance sheet, which has grown since the 2008 banking crash and doubled during the COVID-19 pandemic.
In other words, the stable foreign demand for Sterling assets is a powerful buffer against the “sudden stop” creditor strikes that many developing economies face. This is one reason why many analysts think calm can return.
Chris Turner, an economist at ING, says: “Most likely, the UK government will have to let Sterling find the right level on its own. Since the UK has a reserve currency, it can always issue debt—it just depends on the price.
But what if that reserve currency position is threatened and foreign central banks don’t want to hold so much Sterling in their national savings stashes?
Sterling in World FX Reserves: https://fingfx.thomsonreuters.com/gfx/mkt/byvrjzjarve/One.PNG
Trade-weighted pound, gilts, and volatility: https://fingfx.thomsonreuters.com/gfx/mkt/Dwvkrormlpm/Three.PNG
ASIA EXIT?
When the pound fell by an eye-popping 5% against the dollar in just a few minutes during Asian trading hours on Monday, before London trading had even begun, some people thought that big investors in Asia were getting out of their British holdings.
Seven of the top ten central banks in terms of reserves are in Asia or the Middle East.China and Japan have about $4.5 trillion in total reserves between them. India, Taiwan, Saudi Arabia, South Korea, and Hong Kong also have about $2.5 trillion in total reserves.
Jim O’Neill, a former UK Treasury minister and global economist for Goldman Sachs (NYSE:GS), said that the timing of sterling’s big drop in Asia raises questions about whether big, reliable players sold pounds. This shows how much government and BOE policy is misunderstood and miscommunicated.
O’Neill talked about what he thought was “naivety” in policymaking and the “huge mismatch” between what the government thought and what the markets wanted to hear. “If we had a few more days like the ones we just had, everything would be a mess,” he said.
go up and down
Sterling used to be the most important reserve currency in the world at the beginning of the last century, but that was a long time ago. After World War II, it quickly lost its top spot to the dollar, and even after the euro took over second place in 1999, it was only a small player.
But for a country with a current account deficit of more than 8% of its gross domestic product, it’s very important that Britain and sterling don’t lose the last few valuable and often reliable friends in central banks abroad.
Most of the time, liquidity, security, and returns are used to choose foreign currency for reserves. Structural factors, like being one of the five currencies that make up the IMF’s unit of account, a basket known as Special Drawing Rights, are also taken into account (SDRs). The size of an economy, its share of world trade, how commodities are priced, and how loosely a country is a part of currency blocs and zones all play a big role in how money is given out over time.
At the moment, sterling is still a part of the SDR, along with the dollar, euro, yen, and renminbi. The pound probably benefits from the fact that this sort of automatic matching of currencies hasn’t changed yet.
Even though it’s hard to find detailed breakdowns, it’s clear that each country is different in many ways. For example, the Riksbank in Sweden has 7% of its reserves in British pounds, but the European Central Bank has none.
And surprisingly, IMF data showed that sterling’s share had risen to its highest level in over 20 years this year. It was almost twice as high as it was in 2000 and hadn’t changed much since then, even with the 2008 banking crash and Brexit.
Related: Column-The “reverse currency wars” world is real: Mike Dolan
It might have even gone too high.
In June, a worrying annual UBS survey of global reserve managers showed that more than any other currency, a net 13% expected to cut their allocations to sterling in the future.
None of them said they were going to grow.
On the other hand, allocations rarely change unless there is a big shock or a big change in circumstances.
Stephen Jen, a hedge fund manager at SLJ Eurizon, said, “Central banks tend to go against the market and do whatever it takes to keep their allocations,” unless they think that something big has changed in the long run. “I don’t think that’s true of the pound,” she said.
Whether or not this is a paradigm shift or a major rethink of Britain’s credit quality or ability to pay back its debts is now the most important part of the story, and we’ll find out over the next few months.
GRAPHICS: https://fingfx.thomsonreuters.com/gfx/mkt/klpykxkrmpg/Two. PNG UBS chart on its survey of world reserve managers for 2022:
These are the thoughts of the author, who writes a column for Reuters.
(By Mike Dolan, @reutersMikeD on Twitter (NYSE:TWTR); editing by Josie Kao)
