Could Brexit Trigger the Demise of Sterling as a Reserve Currency? – Part Two

In part one of this series we looked briefly into the history of sterling crises that originated after the end of World War II.

Two important aspects were highlighted. The first is that over the past seventy years, a depletion of international sterling reserves has routinely coincided with exchange rate crises, whilst the second indicates that a slew of sterling downturns since 1945 have weakened substantially its role as a reserve currency.

We will now examine why Britain leaving the European Union through a ‘hard‘ Brexit may prove a harbinger for the first major sterling crisis of the 21st century.

In 2018 the media began publishing what mutated into incessant warnings about the dangers of leaving the EU with no withdrawal agreement. The majority were and continue to be focused on possible disruptions to food and medical supplies, the UK’s beleaguered car industry and the prospect of a Brexit induced recession.

What has not been given the same degree of analysis is the impact a no deal scenario could have on the position of sterling as a reserve currency. Ever since the post referendum decline of the pound, it generally only attracts attention if its value against the dollar rises significantly above daily fluctuations, or declines a percentage point or more amidst fears of a ‘disorderly‘ exit.

Let’s briefly summarise the few occasions where the pound’s reserve status has been called into question since 2016, as well as matters interconnected with the subject.

May 2016

A month before the referendum, ratings agency Standard and Poor’s issued a warning that sterling could cease to be a reserve currency if the UK left the EU. They also declared that Britain’s triple A credit rating could come under pressure. The line was that national governments might seek alternatives to the pound as a store of value should a leave vote materialise. As for why they could do this, a breakdown in existing trading arrangements, a depreciation of sterling and an increasing current account deficit were all cited as reasons by S&P.

July 2016

With S&P having stripped the UK of its triple A credit rating (as they suggested would happen following a leave vote), Reuters reporter Jamie McGeever penned an article which detailed how the decline of sterling since the referendum had so far been the biggest of any of the world’s four major currencies since the collapse of the Bretton Woods system in the early 1970s.

The day after the vote (June 24th) saw sterling’s value drop by 8%, marking the largest one day fall in the pound since the introduction of free-floating exchange rates following the collapse of Bretton Woods.

October 2016

Five months before Article 50 was invoked, Standard and Poor’s issued a new warning about the pound’s reserve status.  Ravi Bhatia, the director of sovereign ratings for Britain, was reported by The Independent as saying a ‘hard‘ Brexit eventuality could jeopardise sterling’s reserve currency role. Bhatia summarised reserve status as countries having trust in a currency, with governments and traders content to hold assets in a particular denomination.

At the time of S&P’s latest intervention, the pound was down 17% against the dollar since June 2016.

S&P were at it again later in the month, with the Financial Times detailing that pronounced falls in sterling could end up ‘reducing confidence and eventually threaten its role as a global reserve currency.’ They added that sterling would no longer be considered a reserve currency by the S&P if its share of reserves dropped below 3%. They currently stand at 4.49%.

On top of this, S&P warned of further cuts to Britain’s credit rating should they ‘conclude that sterling will lose its status as a reserve currency or if public finances or GDP per capita weaken markedly beyond our current expectations‘.

November 2016

Reuters Jamie McGeever followed up his article from July 2016 by questioning the pound’s position in global foreign exchange reserves. Here, McGeever linked sterling’s role as a reserve currency to the UK’s current account deficit, which to this day remains one of the largest in the world. He pointed out that this particular deficit requires hundreds of billions of overseas capital inflows every year to balance Britain’s books. According to McGeever, central bank demand for sterling reserves are a vital and stable source of these inflows. He went on to report that the amount the UK needs to attract in order to balance its books is around £100 billion a year.

S&P’s fellow ratings agency Moody’s were credited by McGeever as warning about the danger of ‘substantial and persistent‘ capital outflows, and how this would raise serious doubts about the pound’s reserve status.

McGeever also quoted Brad Setser, a senior fellow at the Council on Foreign Relations and former economist at the U.S. treasury, as saying that a fall in reserve share to 3% would be sterling ‘punching a little below its weight‘.

August 2018

As no deal Brexit coverage gathered momentum in the press, an article again published by Reuters on sterling’s future as a reserve currency gained next to no attention. This time it was the turn of Bank of America Merrill Lynch (BAML), who made a connection between the UK leaving the EU with no withdrawal agreement and central banks selling the pound in response. BAML estimated that a 1% decline in sterling’s share of international reserves would equate to upwards of £100 billion of selling. This calculation was based on the pound’s average share of 3.6% of reserves since 1995. Should banks re-denominate their holdings in line with this long term average, the theory goes that this would point to over a £100 billion reduction in reserves.

BAML stressed that this potential scenario would be off the back of a no deal exit from the EU. ‘Central bank flows are an important source of flow which could determine whether sterling succumbs to a more protracted current account crisis‘.

December 2018

As demonstrated above, both Jamie McGeever at Reuters and Bank of America Merrill Lynch have touched on the subject of Britain’s current account deficit. Latest figures released in December showed that the deficit in the third quarter of 2018 was the highest in two years at £ – 26.5 billion (4.9% of GDP).

When you look at how this was interpreted within the financial media, the link back to sterling’s position as a reserve currency – although not raised directly – lingers in the background. The current account deficit has not only called into question its sustainability, but also whether foreign investors will continue to finance the deficit to the same level by purchasing UK assets after Brexit.

Other noteworthy data released at the same time as the current account numbers included a cut in investment by firms of 1.1% from July to September. This represented three consecutive quarters of cuts, the first time this has occurred since 2008-2009. Households were shown as net borrowers for the eighth straight quarter – the biggest stretch since the 1980s. Lastly, the UK’s household savings fell to 3.8%, the lowest on record.

Conclusions

Looking back on the EU referendum of 2016, my perspective is that the depreciation of sterling in the aftermath cannot be construed as a crisis. Before the result was confirmed, the pound was trading as high as $1.50. Once the reality of the leave vote had dawned, an initial sharp drop of 8% was followed by further declines leading to a low of $1.19 recorded in January 2017. In seven months, sterling had shed as much as 20% of its value (for a limited time at least).

The reason why this is not befitting of a crisis is due to global reserves of sterling remaining consistent throughout the period. Indeed, international reserves of the pound grew in 2018 amidst the rising uncertainty of the Brexit withdrawal process.

At no stage so far have the Bank of England acted to defend the currency from speculators or central banks adapting their compositions. Their initial reaction post referendum was to cut interest rates by 0.25% and expand quantitative easing by £60 billion.

Fifteen months later, with inflation running at over 3% and the value of sterling remaining suppressed, the BOE raised interest rates for the first time in a decade. They followed this up with another quarter point hike in August 2018.

It is logical to think that the impact of a ‘hard‘ Brexit on sterling would precipitate a far steeper decline than witnessed three years ago. Consider that the fall witnessed then was simply off the back of a referendum result. Nothing material had changed in the relationship between the UK and EU.

I believe it is also logical to surmise that in response to a renewed depreciation, not only would inflation pick up once more, but the Bank of England would defy conventional wisdom and raise interest rates. The bank themselves have indicated that the most likely ramifications of a no deal Brexit would be inflationary. They continue to state publicly that the response to such a scenario would likely be to tighten rather than loosen monetary policy.

However, this does not account for what would happen to global reserves of sterling. Historically, exchange rate crises have seen a depletion in reserves of the pound. Whereas inflationary pressures take time to feed through the system, a run on sterling can materialise in a matter of minutes. Therefore, it is conceivable that the Bank of England could raise interest rates in response to try and stabilise the currency, a measure entirely separate to their mandate of 2% inflation.

Allied to this measure would likely see the BOE convert foreign currency holdings into sterling to counteract international holders dumping the pound.

As documented in part one, the BOE hold close to $150 billion in foreign currency total reserves. Total reserve assets amount to around $180 billion. The majority of these assets are denominated in dollars and euros.

How sustained any selling could be is impossible to gauge at this stage, as is the scale of damage which may be inflicted on sterling reserves.

If warnings issued by Standard and Poor’s and Bank of America Merrill Lynch are taken at face value, the pound is in danger of diminishing to the level of no longer being a global reserve currency should a ‘disorderly‘ Brexit happen. Only if this does occur would we be able to assess the validity of their warnings.

Anyone who regularly follows communications emanating from national central banks, the IMF and the Bank for International Settlements will have seen a developing narrative of ‘money in the digital age‘ and how currencies in future could be provided. The combination of a possible ‘hard‘ Brexit and an escalation in the ‘trade war‘ between the United States and China may not only put sterling at risk, but also the role of the dollar as world reserve currency. Brexit is one strand of what I have suspected for some time is an attempt by globalists (think the IMF and the BIS) to administer institutional reforms in the manner of a currency framework, which would mean a realignment in currency compositions with the IMF’s Special Drawing Rights part of this process.

As ever, to achieve this scale of reform globalists would require sustained crises events to distract away from what are long held intentions. Will Brexit and actions stemming from the Trump administration prove to be to their benefit? 2019 will surely begin to answer that question.

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6 comments

  1. Thanks for this Steven. Excellent as always.

    I think the scenario you describe is going to prove accurate: Brexit with no trade deal, sterling down, inflation up, interest rates up. And blame the populist leave voters with accompanying vitriol (which the media will pour petrol on and fan the flames.)

    Tell me, if sterling and the US dollar percentages were both to fall in the SDR basket, which currencies do you think would be the major beneficiaries?

    I was thinking that the euro could easily suffer as well what with political problems and dodgy banks aplenty. The yen has been “QE’d” for years as well and China has a lot of delinquent loans. I hear people talking about the “least dirty shirt” theory but there are lot of dirty shirts in the basket !

    Also, it’s a big week for Brexit. Do you still think they will make us vote again in a second referendum?

    The talk of the People’s Vote hasn’t gone away, indeed Labour now officially support it – and they really have made it appear as if they have exhausted every other avenue ….(“Reluctantly, we must let the people decide”)….it’s all looking like you predicted.

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  2. The IMF’s role through quotas valued in SDR’s is something I want to get into more. At present the dollar has a weighting of 41.7%, with the euro on 30.93%. When the Chinese renminbi was included in the SDR (interestingly just in time for the onset of Trump’s presidency), it took a 10.9% share of quotas. Sterling’s share of 8.09% is the smallest of all SDR currencies.

    In the upcoming years the renminbi will likely gain a greater percentage, as might the euro. This October the IMF holds its 15th General Review of quotas where they will attempt to gain a consensus on increasing them. The IMF’s website states that these meetings are ‘an opportunity to assess the appropriate size and composition of the IMF’s resources.’ In other words, it’s a chance to adjust the weighting of currencies.

    IMF quotas are one thing, but currencies reserves are a different matter. Here, the dollar has 61% of global reserves, the euro 20% and the renminbi just 1.7%. If there was to be a flight from the dollar and its world reserve status was put in jeopardy, watching how the composition of reserves changes would be important in determining any realignment of currencies.

    One thing I’ve learnt this year is that for a currency to advance in the manner that the dollar did from World War I onwards requires substantial global liquidity. Over the past decade China has significantly expanded their FX markets and have also internationalised their bond markets. China have also been calling for a new global reserve currency under the management of the IMF.

    The road towards the euro was ploughed gradually. Since the end of World War Two globalists began what were incremental steps into introducing a single currency. It took them pretty much 50 years. 2030 is a date which globalists regularly cite in their communications. The UN’s Agenda 2030 programme of sustainable development ties in with it all. If globalists are successful, then by that point the dollar’s world reserve status will probably have been eroded in favour of a currency framework valued in SDR’s. Brandon Smith at Alt-Market described it best – the SDR system acting as a bridge towards the goal of introducing a new global currency.

    As for Brexit, I maintain that a second referendum (with a no deal WTO option on the ballot) appears the most likely outcome in this stage of the Brexit process. I said recently that the upcoming march in London on March 23rd to demand a ‘People’s Vote’ was perhaps an indication that the matter will not be voted on in parliament before the event takes place. Interestingly enough the next EU council summit happens on March 21st and 22nd. A well timed pre-cursor to a second referendum taking centre stage in the news cycle.

    To me this now looks like a referendum will be presented as the last solution left standing to prevent leaving on March 29th with no deal.

    Liked by 1 person

  3. Thanks for replying Steven. I remember reading about the Chinese making strides to expand the use of the yuan – a move accepted with open arms by London. It’s virtually impossible to imagine that the yuan is not going to be more widely used internationally.

    https://www.thedailybell.com/all-articles/news-analysis/directed-history-of-the-citys-alliance-with-china/

    Just on your last point, could you clarify something please? Are you saying you think that Parliament will wait until after the “People’s Vote” march has happened on 23rd March and then set about preparing a he second referendum?

    Something like “Yes we saw how passionate you all are about a second vote, we listened, we’ll give you a 2nd referendum” ….after which they will presumably have to extend Article 50 and then set about making some legislation to enact a second referendum, including deciding what questions goes on the ballot ?

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    • I’m guessing that’s what might happen. The march is to demand that a referendum takes place. Were parliament to approve one prior to the march, it would no longer be necessary. It will more likely be used to galvanize support amongst MP’s. It’ll be interesting to see where things stand by the end of the week and whether the expected votes in the commons take place as planned.

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  4. Steven,
    Your assumption that the Bank of England would raise rates following a “hard BREXIT” is so wrong on many levels.

    Mark Carney has shown on numerous occasions that his threats of raising interest rates are nothing more than jawboning and are now contemptuously ignored by the market( how many times have we heard “interest rates may rise sooner than the market expects”?), in fact after threatening to raise rates before the referendum he actually CUT them shortly after in order to add downward pressure on sterling. Since the financial crisis the Fed has raised interest rates NINE times and Mark Carney has raised them just once by a paltry 0.25%. I therefore think it has become obvious that he is a tool of the globalists as he was brought over by Cameron to reflate the housing bubble in the UK (after creating a similar bubble in Canada) and everything he has said or done since has been done to prevent interest rates from rising and house prices from falling. Since BREXIT on any announcement of good economic news or a rally in sterling he has been a consistently negative voice on economic conditions and the outlook for the economy. To any independent observer, it appears he wants sterling to go down.

    And this is where his role is critical should we leave with a hard BREXIT, and this is also confirmed by his contract extension to ensure a hard BREXIT is financially disastrous the UK.

    Rather than put up interest rates to defend sterling in the light of the predictable falls after the result and to counter the inflationary pressures from the higher import prices he will CUT rates, thus ensuring the complete collapse of sterling. This will have two effects, immense pressure will be put upon the government to rejoin the EU in order to stabilise the exchange rate and also it will eventually lead to the ultimatum I have predicted for years – that of the UK government being given an ultimatum of accepting the Euro as part of any deal to rejoin or any loan from the IMF to shore up the government finances.

    As you are from the UK I do not need to explain to you the size of the current housing bubble and the impact any collapse would have on the UK economy, it simply will not be allowed to happen, and barring a sudden rise in unemployment the only thing that could burst it is a sudden rise in interest rates, the very thing Mark Carney has been put in place to prevent, if he also maintains this policy and it causes the collapse of sterling well it is a win win for the globalists since it ensures the eventual adoption of the Euro and then guarantees any future attempts by the UK to leave will be even more catastrophically damaging. We have all seen how difficult is has been to effect withdrawal with our own currency – imagine how much more difficult it would be if we had to replace our currency as well.

    Any country that faces a 50% devaluation of its currency as sterling surely will following a hard BREXIT, or a similar haircut on the reintroduction of its currency prior to joining the Euro will more than likely back down(Greece anybody? and Italy next), and the EU know this, they always have this economic threat to play as the final trump card should all previous threats and blackmail attempts fail.With the worlds central banks and the likes of George Soros shorting sterling and Mark Carney at the Bank of England it is literally all over.

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    • With respect, unless you speak from a position of authority on the subject e.g. you have access to knowledge that I do not, you cannot know for certain that my ‘assumption’ is wrong.

      I’m not going to repeat the arguments I’ve made in previous posts over why I believe the Bank of England would tighten policy off the back of a no deal Brexit. But there’s a couple of things you mentioned that i’ll pick up on.

      Yes, Carney’s commentary during the Brexit process has on numerous occasions served to manipulate the value of sterling. This is something I have written extensively about. Based on what the BOE have been communicating, and the fact that they tightened rates at all since the referendum (something very few in the mainstream and in alternative circles thought they would ever do), I think the notion that they would cut rates during a run on the pound is curious to say the least. That would accelerate sterling’s decline, and in such a scenario would make the BOE directly culpable. I highly doubt the BOE will be accommodative if sterling is being sold off globally and inflation is back towards the 3% level or more.

      I would also suggest that cutting rates to counteract inflationary pressures is a contradiction in terms. The IMF’s official position is that central banks should cut interest rates where inflation is consistently below target, and raise them when it is over. I have seen nothing from the IMF or other central banks to contradict this position.

      The current narrative of central banks having ‘u-turned’ on tightening policy is a fallacy. To quote Borio at the BIS, banks have ‘paused’ on tightening. Unless they actively start cutting rates and restart QE, then it’s rhetoric without substance.

      My belief is that the fallout from a no deal will be placed squarely at the feet of a resurgence in nationalistic tendencies. That narrative has been evident ever since the vote to leave. No deal will be portrayed as an anti globalist event, one that I do not believe the BOE will backstop. Brexit is primed as one of numerous globalist scapegoats that will be utilised to take the rap for an impending economic downturn word wide.

      Assistance from the IMF is a possibility somewhere down the line. You also make some interesting points on the UK adopting the euro in the future. But make no mistake – if a no deal happens, globalists like Carney and institutions like the IMF and the BIS won’t be the ones pilloried throughout the mainstream.

      Where I think we differ is that you believe the BOE won’t allow the economy to collapse, and that raising interest rates will achieve just that. I don’t have a monopoly on truth. You might be proven correct. Raising rates would prompt an eventual collapse, but it’s how globalists justify such measures that I think would be key.

      Good to hear from you. Thanks for taking the time to read my post.

      Liked by 1 person

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