Could Sterling Lose Reserve Currency Status?

June 29th, 2016 6:53 am | by John Jansen |

Via WSJ:
By Mike Bird
Updated June 28, 2016 8:09 p.m. ET
3 COMMENTS

Britain’s vote to leave the European Union knocked sterling to the lowest in decades and could now erase a distinction that is centuries-old: its status as a reserve currency.

In the two sessions after last Thursday’s Brexit vote, the pound fell 11% against the U.S. dollar, its steepest two-day decline in nearly 50 years.

On Tuesday, the pound snapped its two-session losing streak, rising 0.9% against the dollar to $1.3343 in late New York trading. But investors expect the U.K. currency to continue its decline given the political and economic uncertainty in the U.K.

Some analysts ask whether the long-term fallout for the pound could be more severe than its latest tumble, threatening its long-held position as a reserve currency. Whether sterling can hold that status is one of the many unanswered questions posed by the U.K.’s historic referendum.

The dollar, euro, yen, yuan and pound are the usual constituents of the International Monetary Fund’s reserve-currency basket. Central banks and governments buy assets denominated in reserve currencies to give them a pool of liquid securities that, in an emergency, can be sold to prop up the value of their own foreign exchange.

The designation is also a stamp of stability, making reserve currencies more attractive across the investment world.

So if the pound loses that status, it isn’t just about Britain’s international prestige. It could end up raising the cost of capital for local businesses as investors chose to hold fewer U.K. assets.

“As any particular economy’s importance in international trade wanes, so does the willingness of the rest of the world to hold their currencies as a store of value,” said Frank Gill, Standard & Poor’s senior director for sovereign ratings.

On Monday, the ratings company removed the U.K.’s triple-A credit rating, the highest available, cutting it two notches to double-A after warning that demand for the currency among international governments and central banks could dwindle.

“What people look for is something that’s an insurance policy, an asset that holds its value in times of trouble,” said Avinash Persaud, senior fellow at the Peterson Institute for International Economics. “You don’t want uncertain reserve assets.”

If fewer global investors want to buy British debt, that could push up the cost of financing by 0.25 percentage point in the country, according to S&P analysis. For a country such as the U.K., with extremely high debt levels, such a change in the cost of capital would be equivalent to 1% of annual gross domestic product, the company said.

With bonds maturing and being bought back by companies, the universe of sterling corporate bonds already has started to contract.

The pound is a much smaller part of the global system of foreign reserves than it once was. It made up just less than 5% of reserves at the end of 2015, according to the IMF. That is well behind the dollar at 64.1% and the euro at 19.9%, but ahead of the Japanese yen.

Sterling ceased to be the world’s pre-eminent trading and financial currency in the first half of the 20th century. The dollar became dominant by the 1950s. In the 1960s, sterling still made up 30% of global reserves. Then, in 1967, the British government devalued its currency by 14% against the dollar and sterling slid.

Given the pound’s diminished importance, some analysts say the reserve-currency designation doesn’t matter as much. “At the margin, the number of gilts held by foreign central banks will decline,” said Kit Juckes, global head of foreign-exchange strategy at Société Générale SA . “But sterling isn’t much of a reserve currency.”

But others say the pound’s attractiveness abroad is particularly important for the U.K. because of its record current-account deficit. The U.K. imports more goods and services than it exports, and sends more investment income overseas than it receives from abroad. That means the economy relies on the willingness of investors in the rest of the world to finance the gap, requiring constant demand for sterling-denominated assets. The attractiveness of such assets already has soured in the eyes of some investors.

Our safe-havens status is being diminished,” said Mark Dowding, senior portfolio manager at BlueBay Asset Management. “Any international investor is going to be looking at the U.K. and seeing a place with a very uncertain future. That’s going to deter investment.”

—Georgi Kantchev and Christopher Whittall contributed to this article.

Write to Mike Bird at Mike.Bird@wsj.com

 

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