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Analysis

Sterling will survive Brexit

Reserve currency status set to endure

by Gary Smith in London

Thu 14 Sep 2017

Saturday 16 September marks the 25th anniversary of Black Wednesday, the day sterling left the exchange rate mechanism of the European Monetary System. As happened in 1992, questions are again swirling around the future status of the UK currency.

There has been speculation that Britain's exit from the European Union will lead to a decline in the attractiveness of sterling as a reserve currency. After both the September 1992 ERM exit and the Brexit vote, the value of the pound fell sharply.

However, as proved to be the case with the ERM exit, a near-term fall in value – especially if viewed as an isolated consequence of Brexit – is unlikely to erode significantly sterling's reserve currency status.

It is important to differentiate between the UK as a destination for foreign direct investment, and the appeal of sterling as a reserve currency. This is a failing on the part of some commentators; the two ideas are separate. Reserve currency status is conferred on currencies by the decisions of foreign reserve managers. These holdings then find their way into International Monetary Fund reports.

The IMF releases individual data for eight currencies in its reporting on foreign reserves. As well as being one of these eight, sterling has a role as one of five currencies that make-up the special drawing right, the IMF's composite currency unit. This is not going to be changed by the Brexit vote.

The share of sterling in global currency reserves has been roughly 5% for around 40 years, and was the approximate share in 1992 when Britain left the ERM. This low reading is an argument against further decline. The share is unlikely to fall to zero, regardless of potential FDI volatility or the mercurial journey towards exiting the EU.

The world has a latent demand for more, not fewer, reserve currencies. Interest rates matter too; the interest rate premium on UK Treasury bonds following the June 2016 referendum – especially in comparison to euro area bonds – will help to sustain the appeal of sterling-denominated bonds.

The question of who holds foreign reserves is of great significant as well. By far the largest holders in the world are the key Asian nations with which the UK will be trying to forge new trade agreements after Brexit. Although this would be a longer-term factor, trade flows matter a great deal to foreign reserve managers, as the internationalisation of the renminbi and its subsequent rise as a reserve currency and newest member of the SDR highlights.

Reports of the demise of sterling as a reserve currency are likely to prove to be incorrect.

Gary Smith is a Member of the OMFIF Advisory Council and Member of the Strategic Relationship Management Team at Barings.

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