The UK’s currency crisis, with the pound falling to its lowest-ever level against the US dollar this week, is made all the worse by a lack of options to solve it.
One common move by central banks in this situation is to buy the home currency on foreign-exchange (FX) markets. The UK did that in 1890, and Japan did it just last week. Becoming a buyer of your own money is a quick way to strengthen it, though the effect doesn’t always last.
To buy your own currency, you need a wallet full of euros, dollars, renminbi, etc. A vault of gold is also helpful—anything that’s like cash, as long as it’s not your own. Japan was able to step in to support the yen because it had $1.2 trillion in FX reserves as of August. Switzerland, responsible for another of the world’s major currencies, also maintains close to a trillion-dollar reserve.
The UK’s FX reserve is relatively small
The UK’s reserve of gold and foreign currencies, by contrast, is $80.7 billion, hardly enough to have a lasting effect on the strength of the pound. “It has simply not been a priority to build FX reserves,” economist Jens Nordvig explained in a Twitter thread. The Bank of England, which controls the reserve, has let it decline for 12 straight months, according to the central bank’s data.
As a result, despite having the world’s 5th-largest economy, the UK has only the 18th-largest reserve of foreign currencies and gold, according to the World Bank.
Declining faith in UK fiscal policy doesn’t help
There’s no hope of amassing enough foreign currency to address the current crisis, and many argue that a free-floating currency like the pound shouldn’t worry about it, either. The pound is known as sterling because it was once minted from silver and derived its value from the metal, too, but those days are long over, and the pound is now backed simply by faith in the United Kingdom.
But investors have clearly signaled a lack of faith in the government’s fiscal policy, which aims to catalyze the stagnant UK economy largely through tax cuts for the rich and relief for corporations, while borrowing at increasingly high rates to pay for it.
“It makes me very sorry to say, but I think the UK is behaving a bit like an emerging market, turning itself into a submerging market,” former US Treasury secretary Larry Summers told Bloomberg.
In that context, with markets weighing their very faith in the UK government, the FX reserve doesn’t just speak to its ability to defend the pound. Also at issue is the UK’s ability to weather a full-fledged financial crisis like several it has faced before. In 1976, the UK was forced to borrow $3.9 billion from the International Monetary Fund (IMF) to stop the pound from slipping further. Then it was worth about $2, and now the pound is approaching $1.
The composition of the UK’s international reserve
So what’s in the UK’s meager FX reserve these days? Mostly dollars, euros, and gold, in roughly equal parts, which together comprise more than three-quarters of the horde. Like other countries, the UK maintains “special drawing rights” at the IMF to withdraw from an account of major currencies and gold.
Looking at the type of securities held by the UK, only about $15 billion is in hard cash. Another $17 billion is in gold. Much of the reserve is held in sovereign bonds, like US treasurys, which are considered as good as cash.
The Bank of England also maintains positions in money markets and repo markets, where cash can be parked safely. Most of the UK’s foreign liabilities, which reduce its net assets, come from trades known as interest-rate swaps, which protect the central bank from fluctuations in other countries’ borrowing rates.
With the pound historically weak and faith in the UK economy faltering, the FX reserve will receive a lot more attention than usual for a developed economy. The Bank of England’s next update on the reserve is due in early October.