Wary of appearing panicked by sterling’s nosedive, the Bank of England has only said it is “monitoring developments” and hinted at a hefty rate rise when policymakers next meet. Unfortunately that is virtually all they can do at this stage.
Some have suggested that the BoE could follow the Bank of Japan in intervening directly in foreign currency markets to prop up sterling and bloody the noses of a few hedge fund magnates betting against it.
The problem — beyond the futility of the BoJ’s own efforts — is that the UK actually has very little firepower to do so. Here is the World Bank’s data for the international reserves of all the G20 countries as of the end of 2021.
As you can see, the UK ranked between Mexico and Indonesia at the time. And the actual level of true, available liquid foreign reserves is even lower, as things like gold (about $17.2bn worth sitting in the BoE’s vaults) and the IMF’s special drawing rights ($38.9bn) aren’t easily used to support sterling.
The latest statement from the BoE indicates that the UK’s gross foreign currency reserves were actually just $107.9bn at the end of August (you can find the full breakdown in an Excel spreadsheet here).
For comparison, Japan’s FX reserves stood at $1.17tn at the end of August. Even Indonesia has $118.9bn of liquid FX reserves — slightly more than the UK’s available firepower.
Given how large and liquid the sterling market is, attempting to intervene directly would likely not just be futile — like shooting a water pistol at a raging fire — it could even backfire, given the paucity of the UK’s reserves. Exante Data’s Jens Nordvig has a good Twitter thread on the subject:
The GBP had a VERY bad day on Friday
What can UK policy makers do to stabilize financial markets (currency, bonds, equities)?
Is currency intervention an option?
= A Thread
— Jens Nordvig ???????????????????????? (@jnordvig) September 24, 2022
However, in the UK’s defence this is not quite as inadequate as it might seem. There are good reasons for why the UK’s foreign currency reserves are much more modest than countries like Indonesia and Mexico.
The UK might not have the world’s dominant reserve currency any more, but despite a century of relative economic decline the pound remains a reserve currency, as you can see from the IMF’s latest central bank reserve composition data.
That means that the UK is less vulnerable to the vagaries of global capital flows. Sterling also trades completely freely — unlike some of the “crawling pegs” of the developed world — and the UK hardly borrows at all in foreign currencies. Given this, it doesn’t make much sense for the UK to lug around massive amounts of FX reserves.
That said, it does mean that the pressure on any desired support for sterling has to come from the BoE’s monetary policy toolkit, leaving it in a bit of a pickle right now.
An emergency hike would just strengthen the emerging-markets vibe and possibly send sterling lower. Yes, the BoE probably should have raised rates by more than 50 basis points when it met last week, and with hindsight it certainly would have liked to, given the market-shocking “mini-budget” the government unveiled soon after. But acting now would stink of panic.
However, it does mean the BoE is going to have to sound very tough until it next meets in early November, and then meet and possibly exceed expectations for a whopper of an interest rate increase. For context, markets are currently pricing in at least a 150bp rate increase on November 3.
Still, what might be needed for sterling to regain its footing on a more durable basis is a shift in policy from the UK government. Otherwise the danger is that the BoE inevitably disappoints and sterling gets taken to the woodshed again. Here’s JPMorgan’s Allan Monks:
By delaying expectations on when rates will next be set, the BoE is allowing some space for the government to do something in the meantime to stabilise the situation. If successful, that will reduce the amount by which the BoE ultimately has to raise rates . . . Unless something more concrete comes from the Chancellor prior to the next meeting, which . . . there is little indication of at the moment, we think the BoE will be forced to validate market rate expectations or else risk delivering a dovish disappointment which ends up raising longer term inflation expectations.
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