Could Brexit Trigger The Demise Of Sterling As A Reserve Currency? - Part One

Authored by Steven Guinness,

If we have learnt anything since the UK voted to leave the European Union three years ago, it is that the ideological bias pervasive throughout Brexit discourse has worked to marginalise objective analysis of the process.

Whilst ‘leavers‘ and ‘remainers‘ constrain themselves to their preferred prejudice, others who possess no allegiance to either camp have attempted to see past the daily theatrics and hysteria that Brexit has become.

As I have reasoned over the past couple of years, Britain’s withdrawal from the EU is chiefly an economic phenomenen. If considered through this context, it embodies a new identity beyond the repetitive strains of ‘project fear‘ and elites orchestrating a ‘great Brexit betrayal‘. The preoccupation with the political side of Brexit masks what has been the gradual encroachment by globalist institutions (namely the International Monetary Fund and the Bank for International Settlements) to use a rise in ‘nationalism‘ and ‘protectionism‘ as vehicles towards achieving full spectrum control of the global financial system.

The manipulation of sterling, both before and after the 2016 referendum, is an important part of this process.

The fallout from the referendum was largely confined to a sustained depreciation of the pound. Hours before the vote, the value of sterling against the dollar was $1.48. After the result was announced, it dropped 8% in twenty four hours. By mid January 2017 it’s value had fallen to a low of $1.19.

The eventual ramifications of sterling’s decline were twofold – heightened inflation and subsequent interest rate hikes by the Bank of England.

To this day, the pound remains highly susceptible to Brexit led developments. A mixture of rumours, falsehoods and calculated commentary from BOE governor Mark Carney and central bank officials have combined to keep its value suppressed as the two year Article 50 negotiating window winds down.

But what about the broader realities of sterling beyond Brexit?

According to data provided by the IMF, the pound is ranked as the 4th largest currency in terms of global foreign exchange reserves. As of the third quarter of 2018, sterling reserves were valued at $480.83 billion. Despite the pound’s fall since June 2016, reserves have steadily risen over the last three years.

What has also been maintained is the inclusion of sterling in the IMF’s Special Drawing Rights basket of currencies. The SDR is a reserve asset which member states pay into through a quota share scheme. It is restricted to only major foreign currencies, which besides the pound are the dollar, the euro, the Japanese Yen and the Chinese Reminbi. The pound makes up the smallest share of SDR’s with a weighting of 8.09%.

Decades before the inception of the SDR system in 1969, sterling held the position of the world’s foremost reserve currency. For context, at the time the International Monetary Fund was established in 1945, sterling reserves internationally were in the region of $15 billion.

In 1947, following World War II, the pound amounted to over 80% of world reserves. About half of global trade was financed using sterling, emphasising it’s importance.

Gradually, though, sterling’s status began to diminish as international liquidity of the dollar gained traction.

In 1949, sterling was devalued 30% from $4.03 to $2.80, with currency reserve losses for that year valued at $564 million. UK current account and balance of payments deficits were said to be leading factors for the devaluation.

By 1950 the pound’s share of reserves had fallen to about 55%. The Korean War (from 1951 to 1952) reduced reserves further in the dollar’s favour, with losses of $900 million.

Come the ten year anniversary of the end of World War II, dollar reserves had for the first time exceeded those of sterling. In 1955 alone sterling reserves declined by $248 million.

Detailing the reasons behind sterling’s reduced prominence from this point onwards is a long story, but we can summarise a series of key events that triggered the currency’s demise on the global stage. Here are some examples:

The Suez Canal Crisis

The official story of Suez states that the crisis was caused when Israel invaded the Sinai peninsula in Egypt in November 1956. The canal, under Anglo-French control, was nationalised by Egypt in the build up to conflict. It was a conflict under the operation of the UK, France and Israel, and according to the IMF became the first major financial crisis post World War II.

Most significantly, the United States and others were opposed to UK involvement, which triggered a series of speculative attacks on the pound prior to and during the crisis. At the time sterling had a fixed parity against the dollar of $2.80, a level that was tested as the Bank of England depleted their dollar reserves in what was recorded as an attempt to defend the parity.

Reserve losses from July to December 1956 came to $655 million. This is where the IMF enter the story. It was they who provided assistance to the UK, under the pretext of financing external payments imbalances. $561 million was used to replenish UK currency reserves, with a further $739 million on stand-by. The IMF’s actions led to it becoming known as an ‘international crisis manager‘.

The global standing of the pound was only to decline further.

The 1960s

As the sixties dawned, international reserve share of sterling fell below 40% and carried on falling, as did the financing of world trade using the pound. Whilst half of trade was undertaken using sterling in the 1940s, by 1965 this was down to a quarter.

A series of sustained attacks on the pound led to it being devalued in 1967 from $2.80 to a new parity of $2.40. Prior to this, speculation against sterling resulted in short term assistance measures that were engineered by both the Bank for International Settlements and the IMF. Chief amongst the reasons for the pound coming under persistent pressure was the UK’s growing balance of payments deficit.

In the period from July to November 1967, sterling reserves in the non-sterling area (countries outside the Commonwealth) fell by around £500 million.

The sixties also saw the introduction of what were termed ‘Group Arrangements‘, all of which were facilitated through the BIS and designed on paper to stabilise sterling.

With the new parity of $2.40 coming under scrutiny, it marked a further step in the road towards the end of the post World War II Bretton Woods agreement.

The 1970s

The seventies began with global sterling reserves down to 13%. Pressure on the pound grew in magnitude, leading to three notable events. 1971 marked the beginning of the end of Bretton Woods, which when conceived in 1944 was predicated on fixed exchange rates and the ability to convert dollars into gold at the fixed price of $35 an ounce. Under President Nixon it was announced that the dollar would no longer be convertible into gold, meaning the greenback became a fiat currency that was floated freely on the foreign exchange market. It was subsequently recognised as the undisputed world reserve currency. By now, sterling was no longer the leading form of payment in global trade.

In 1972 the pound was also freely floated, which led to a general float of currencies world wide in 1973. Coincidence or not, this was the same year that the Trilateral Commission was formed. The commission’s agenda was to foster the creation of a ‘new international economic order.’ Their first paper – ‘Towards a Renovated World Monetary System‘ -supported this aspiration.

It was during the seventies that sterling reserves dropped below 10%. By 1974 they had declined to 7%.

Black Wednesday

On 16th September 1992, Britain withdrew from the Exchange Rate Mechanism (ERM), a system they had been part of since 1990. The ERM was established in 1979, and was part of the European Monetary System (EMS). The goals of the EMS were described as reducing exchange rate variability and to achieve monetary stability in preparation for the inception of the Economic and Monetary Union (EMU) in February 1992. The EMU was essentially a pre-cursor to the introduction of the Euro in 1999.

The UK’s membership of the ERM came with specific rules attached. Britain must be anchored economically to Germany, on the basis of the strength of the deutsche mark and the independence of Germany’s central bank. The Bundesbank had a duel policy of low interest rates and low inflation, and it was the job of fellow ERM members to work at following the monetary policy of the bank. However, German interest rates in 1992 were over 7%, which forced the UK to keep rates elevated.

The ERM itself was touted as a mechanism for bringing inflation – and by extension interest rates – under control through a regimented set of regulations.

Keep in mind here that throughout this period the UK government was responsible for inflation targeting and the setting of interest rates, not the Bank of England.

On entering the ERM, sterling had a parity of 2.95 deutsche marks, which many considered too high and unsustainable in the long run. ERM rules required that the pound remain within a 6% trading band of the parity, in the name of exchange rate stability.

Black Wednesday‘ was triggered after the sterling / deutsche mark exchange rate dropped to the lower end of the permitted 6% trading band. And so began a renewed round of speculative attacks on the pound with traders piling in to sell sterling for deutsche marks.

In accordance with ERM rules, the Bank of England intervened to purchase an unlimited amount of sterling to stabilise the currency. It has since been reported that the BOE was buying £2 billion of sterling an hour to fend off sellers. Altogether, they spent $15 billion in interventions, around half of the bank’s currency reserves.

The pound fell about 15% amidst the crisis, with confidence having evaporated that the UK had the capability to stabilise the currency. The Conservative government of the time responded by raising interest rates from 10% to 12%. A further rise of 15% was not administered due to the UK departing the ERM.

As documented at the time, chancellor Norman Lamont used Britain’s exit from the ERM to push for the Bank of England to be given independence over monetary policy. The goal of a long term inflation rate of 2% was also targeted (inflation was running at over 10% when the UK joined the ERM).

Immediately following the election of a Labour government in May 1997, the Bank of England was granted full independence. The goal of 2% inflation is now a global standard throughout the central banking fraternity.

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What the events spanning from Suez and beyond show is that sterling was part of a major realignment of currencies, with the pound diminishing as the dollar grew in stature. The evidence points to the loss of sterling reserves routinely coinciding with exchange rate crises.

The shift from the pound to the dollar took a big step with the creation of the Federal Reserve in 1913. The U.S. went from a net debtor to a net creditor, with Britain moving in the opposite direction. The UK borrowed from the U.S. in both world wars, which accentuated the international role of the dollar. Global conflict served to increase dollar liquidity, a major factor in the demise of sterling from a global currency to what is predominately now a national currency.

What we have also learnt is that sterling crises have significantly weakened the status of the pound as a reserve currency.

If we fast forward to the third quarter of 2018, we find that the pound accounts for 4.49% of international reserves. By comparison, the dollar accounts for 61.9%. Whilst sterling reserves today of $480 billion far exceed historical holdings, it is important to realise that the global expansion of liquidity since the U.S. came off the gold standard – particularly the increase of dollars – outweighs sterling by a considerable margin. The amount of reserves have undeniably increased, but the pound’s percentage of those reserves remains low by historical standards.

As for the UK’s foreign currency reserves, according to the Bank of England the latest holdings come to $136,306 billion. In the event of a renewed crisis in sterling where the currency came under sustained attack, it is these reserves which the bank would likely use to try and defend the pound.

In part two of this series, we will look at whether a ‘disorderly‘ Brexit might prove the trigger for the first major sterling crisis of the 21st century.