(This November 1 story corrects size of UK current account deficit in fourth paragraph to 5.9 percent of GDP from 5.1 percent)
By Jamie McGeever
LONDON (Reuters) - While changes in hard cash reserves at global central banks tend to be glacial, the hit to sterling from a potential ‘hard’ UK exit from Europe’s single market after more than 40 years could eventually undermine the pound’s position in their coffers.
With one of the biggest current account deficits in the world, Britain needs hundreds of billions of pounds of capital inflows each year just to balance its books.
Central bank demand for sterling reserves has been a critical, stable and reliable source of that overseas funding, and even the slightest decline in percentage holdings of pounds could have a magnified effect on Britain’s fiscal well-being.
Its current account deficit is now running at around 5.9 percent of gross domestic product, and last year’s 5.4 percent was the highest for a single year since records began in 1948.
That means that in nominal terms, Britain needs to attract around 100 billion pounds, or $122 billion at current rates, from abroad each year to balance its books.
Global FX reserves stand at $11 trillion, of which the currency composition of $7.51 trillion is known. Some 4.69 percent of that is in sterling, according to the International Monetary Fund.
IMF data indicates that central banks have accumulated up to $30 billion of additional sterling reserves on average each year since 2000 - funding at least a quarter of Britain’s annual overseas deficit.
Sterling’s share of FX reserves is a distant third behind the euro (20.18 percent) and the dollar (63.39 percent), and the concern is that its share could eventually slip more.
Ratings agency Standard & Poor’s last week said a fall below 3 percent would mean it would no longer classify sterling as a reserve currency, which could ultimately lead it to cut its UK sovereign credit rating again.
“Recent sharp falls in sterling’s value ... could reduce confidence in sterling and eventually threaten its role as a global reserve currency. We could lower (Britain’s credit) rating if we conclude that sterling will lose its status as a reserve currency,” S&P said.
Brad Setser, senior fellow at the Council on Foreign Relations in Washington, D.C. and a former economist at the U.S. Treasury, said sterling has punched above its weight over the last decade as reserve managers saw it as an alternative to the dollar for diversification purposes and as a higher-yielding alternative to the euro.
“It became a significant reserve currency. It’s now an open question if it remains as significant. Three percent would be sterling punching a little bit below its weight,” he said.
As a reserve currency the pound is similar in significance to the yen, even though Japan’s economy is the third-largest in the world with an annual GDP of almost $5 trillion.
The yen’s share of global reserves is 4.54 percent, the highest since 2002. It was as high as 6.77 percent in 1995, but below 3 percent as recently as 2010.
Yet it’s hard to compare the impact on sterling and the yen from changes in global reserves data because while Britain runs a large, long-running current account deficit, Japan has run a surplus every year since 1980. It reached 5 percent of GDP in 2007.
All else being equal, this means the yen has a structural, natural tendency to strengthen, unlike the pound.
Bank of England data this week showed that foreign investors bought a net 13.27 billion pounds of UK government bonds in September, the most in almost a year.
But that was before UK Prime Minister Theresa May’s speech at her Conservative Party’s annual conference in early October, which investors interpreted as a sign that a ‘hard Brexit” of prioritising immigration control over economic concerns was much more likely than not.
The pound slumped to a 31-year low against the dollar and a near-record low on a trade-weighted basis. Crucially, the latest slide has been accompanied by a selloff in gilts, breaking a link that had held firm for the past year.
This shows that investors are now turning their back on sterling and UK bonds, a potential nightmare scenario for UK policymakers if it persists.
For a country that relies on “the kindness of strangers”, in the words of BoE governor Mark Carney, to balance its books, even the hint that capital inflows might dry up could have serious consequences.
S&P’s fellow rating agency Moody’s has also said downward pressure on sterling from “substantial and persistent” capital outflows would raise fundamental doubts about its reserve currency status and could lead to a UK sovereign credit downgrade.
Perhaps counter-intuitively, central banks often increase purchases of a particular currency when it declines in value. This is because they may have longer-term investment horizons and so ignore shorter-term fluctuations, they need to maintain FX reserves in line with broader trade flows, or they wish to keep the composition of their reserves stable.
Central banks aren’t spooked into action by daily, weekly or even monthly exchange rate fluctuations. But they can gradually tweak their portfolios via passive management.
This could mean buying less of a certain currency over time, or the same nominal amounts but less as an overall share of reserves.
“I don’t think too many central banks will be rushing out to buy sterling now because they think it’s cheap,” Setser at the CFR said.
Reporting by Jamie McGeever; Editing by Hugh Lawson