By David Marsh
LONDON (MarketWatch) — It’s a rough-and-tumble old world out there. Greece, Ireland and Portugal know that now, shunted off into the emergency wing of the European Monetary Union’s long-stay rest home for acute breakdown cases. Although Britain is not part of the euro, the perception is deeply embedded in the government and civil service that the U.K. could go down a similar route.
This is the background to the unpopular but necessary budget cuts being pushed through by Chancellor George Osborne. It also provides the main reason for a surprising announcement by the British Treasury of a plan to double U.K. currency reserves. The message from the British monetary authorities is that sterling is vulnerable to attack. Munitions have to be hauled into place to mount a sturdy defense.
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The news seeped out via a laconic statement from Osborne in last month’s budget speech, followed by a note on the Treasury website. An explosive message: the size of Britain’s currency reserves will be increased to roughly $80 billion within the next four years from the current $40 billion through accruals of £6 billion ($9 billion) a year.
Read more on the Treasury website.
Some of the strengthening is motivated by the need to channel more official resources to the International Monetary Fund to expand its greatly increased credit activities. Mainly, though, the measure is grounded on the pound’s location at the edge of a European currency area coming under heavy bombardment. Britain’s sluggish recovery from the 2009 recession and the declining credibility of the Bank of England in the fight against inflation don’t bode well for currency stability.
The reserve increase will be carried out primarily through issues of sterling-denominated government bonds, the proceeds of which will be swapped into dollars and other currencies. It will be interesting to see if the British start to diversify into Asian currencies, following the lead of the Swiss National Bank. According to the Treasury, this procedure should cause no negative impact on the pound. Nevertheless the announcement contributed to a weaker tone to sterling in the last two weeks
The U.K. lost all its $20 billion foreign-exchange reserves (and more — the reserves went into a significant negative position) on Sept. 16, 1992, the famous “Black Wednesday” when Britain departed from the Exchange Rate Mechanism of the European Monetary System. Since then, the reserves have been steadily rebuilt and have seldom again been in the public eye.
Compared with the massive holdings of emerging economies (China, with its nearly $3 trillion but also Russia and Saudi Arabia with $400 billion to $500 billion, as well as Taiwan, Brazil, India, Hong Kong, Korea, all with well over $200 billion) the British reserves are tiny. They are also a lot lower than smaller economies outside monetary union: Denmark’s reserves are around $80 billion, while Poland owns $100 billion. (Germany, by contrast, has only around $40 billion in foreign exchange, but more than four times that amount in gold reserves).
For the U.K., a total of $80 billion seems to be appropriate as a fighting fund if things go awry. As it prepares for possible action in a crisis, the message from the Treasury is “Every little helps.”
David Marsh is co-chairman of the Official Monetary and Financial Institutions Forum.