October 11, 2016

Simon Derrick: The Default Option – Sterling Takes the Strain

Simon Derrick

Simon Derrick

BNY Mellon’s Markets Strategy team argued back in July this year that allowing sterling (GBP) to take the strain (rather than local markets) has often been the default option for politicians over the past century, most notably in 1931 when the UK abandoned the gold standard and in 1967 when Prime Minister Harold Wilson's Government devalued the GBP against the US dollar (USD) by 14%. While UK governments have intermittently attempted to hold a line in the sand, often at significant cost, the reality of market and political forces has typically led them to abandon these efforts and allowed the GBP to take the strain.

This, however, raises two interesting questions about the present situation. First, what is the current position of the UK authorities towards the GBP? Secondly, do they have the resources to counteract GBP weakness should they wish to do so?

The first question can be tackled fairly straightforwardly by considering what both the Governor of the Bank of England, Mark Carney, and the UK Chancellor, Philip Hammond, have had to say in recent months on the GBP.  Given what the Governor of the Bank of England has said so far, it seems fair to say that while he might not be comfortable with bursts of high volatility, he is prepared to tolerate a weaker GBP unless it threatens a significant rise in imported inflation. This is hardly surprising but a useful reminder. Equally, Philip Hammond's comment that "there's been a market reaction and it's part of a pattern of turbulence that I would expect to see"1 seems a rational response to the events of last Friday. In other words, the Bank of England and the UK Treasury both seem accepting of a weaker GBP for the moment.

The second question is a more interesting one. If it is assumed that the Bank of England would prefer not to tighten monetary policy unless absolutely necessary, this would imply FX intervention. According to the International Money Fund (IMF), the UK's Official Reserve Assets stood at USD 173 billion by the end of August 2016. Of this, USD 117 billion was the nation's foreign currency reserves; USD 7 billion was the IMF’s reserve position; USD 10 billion was in Special Drawing Rights; USD 13 billion in gold; and USD 26 billion in other reserve assets. This gives the UK roughly the same level of reserves as Mexico (USD 177 billion). In contrast, Japan holds USD 1.26 trillion (as of the end of September 2016).

On the face of it, USD 173 billion would seem a more than adequate amount with which to protect the GBP if action was needed. However, it is worth recalling that the last intervention campaign by Japan's Ministry Of Finance saw it spend JPY 9.09 trillion (USD 115 billion) in a matter of days in late October/early November 2011 in an attempt to weaken its currency. It is also worth recalling that Russia saw its currency reserves collapse from around USD 500 billion at the start of 2014, to close to USD 350 billion by mid-2015 to little real effect, and that China ended up spending in excess of USD 500 billion in an attempt to fight outflows between the summer of 2014 and early 2016. This indicates that in the current market environment, central banks may need to spend far more than they would have 10, 20, or 30 years ago in order to defend their currencies from untoward strength or (in this instance) weakness. It is therefore difficult to say whether USD 173 billion would be sufficient to defend the GBP or not.

See here for commentary disclosures