Sterling world’s most stable reserve currency
Mirroring fluctuations stabilise IMF special drawing right
by Bhavin Patel in London
Wed 15 Feb 2017
Over the past five years sterling has been the most stable currency of those that comprise the International Monetary Fund's special drawing right, despite the major depreciation over the past year. Among the other four – the yen, euro, dollar and renminbi – the yen has been the most volatile.
The SDR itself has been relatively stable over the past two years, as the fluctuations of its constituent currencies have tended to balance each other out. This is evident when taking the average of the trade-weighted exchange rates across all five currencies. The sharp movements of the renminbi and the yen neutralise each other, while the dollar’s rise is matched by a sterling depreciation.
Tracking the deviation from average values of the major currencies, using real trade-weighted indices, during the past five years the yen has a standard deviation of 19.8. In comparison, the renminbi has a deviation of 11.4; the dollar, 7; the euro, 5.2; and sterling, 4.4.
It would be simple to argue that a crisis for one currency would cause risk averse investors to flock from one major unit to another, allowing for the mechanism of depreciation and appreciation to balance. However, for decades the dollar has dominated the role of the world’s safest reserve currency, appreciating during times of both domestic and global shock. Seven months after the collapse of Lehman Brothers, the trade-weighted dollar appreciated 18.5%.
This explains why China’s economic rebalancing, the decline of the yen, and the euro area and sterling crises have contributed to the trade-weighted dollar appreciating by 26.8% (10.7% annually) between July 2014-December 2016. This is the sharpest rise in the dollar since the second world war.
China’s rebalancing away from an export-led growth model into one with greater role for consumption and services has been accompanied by a spike in stock market volatility. It likewise triggered capital outflows and a renminbi depreciation of 10.7% (6.4% annually) against the dollar between April 2015 and December 2016. This depreciation took place at the same time as an appreciation of the dollar and yen. Sterling’s depreciation, which started in December 2015, accelerated following Britain’s June 2016 referendum to leave the European Union.
Both the direction and magnitude of these currency movements were unpredictable, but were mirrored sufficiently to allow the SDR to remain stable. This illustrates how diversification through investing in this quintet of major currencies is nearly a zero-sum enterprise. Investors holding SDR-denominated assets or central banks pegging their exchange rate to the SDR will take lower risks and enjoy the advantage of greater stability compared with having invested in any one of the five currencies in the basket alone.
2017 may see the dollar continue to dominate, but the importance of the SDR components within multicurrency reserve management will be crucial to understanding exchange rate risks.
Bhavin Patel is Economist at OMFIF.
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