UK Boosts its FX 'Warchest' to Protect the Pound in Event of a 'No Deal' Brexit Sell-Off

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- UK boosted currency reserve buffers ahead of March Brexit deadline

- Expect war chest to build again ahead of October 31 Brexit deadline

- Building of reserves to act as headwind to Sterling appreciation

The UK grew its reserves of foreign currency at noticeable rate in the run up to the original March 29 Brexit deadline, data shows.

Described as the UK's "warchest" against a currency crisis, the UK government appears to have been fattening up its currency reserves should it need to stage a defence of the Pound.

And it appears the Euro has been the currency the UK is paying a particularly close interest to.

IMF data shows the UK's foreign exchange reserves rose $23BN in the fourth quarter to total $146BN.

This represents a nominal increase of 19% Quarter-on-Quarter in the fourth quarter. Compare this to U.S. FX reserves which grew by only 0.3% at the same time, while Swiss FX reserves fell 2.4% according to IMF COFER data on global foreign exchange reserves for the fourth quarter.

"In our view, the accelerated reserve build toward the end of last year has not been coincidental to the impending 29 March Brexit deadline where the risks of a no deal and Conservative leadership uncertainty were at their peak," says Kamal Sharma, an analyst with Bank of America Merrill Lynch Global Research.

The UK's international currency reserves are made up of two components: the Treasury's and the Bank of England's reserves. Research by Bank of America finds the major driver of reserve accumulation since 2010 has been the growth in the UK Government's FX reserves.

FX reserves held at the Bank of England have averaged £10BN since 2013. "The significance of this is that reserve accumulation has been undertaken exclusively by the central government whose reserves form part of the Exchange Equalisation Account (EEA), established in 1932," says Sharma.

The EEA holds the United Kingdom’s reserves of gold, foreign currency assets and International Monetary Fund (IMF) Special Drawing Rights.

This account is intended to be used for "checking undue fluctuations in the exchange value of sterling".

"In other words, this is the UK governments' intervention war chest," says Sharma.

A dig into the data shows that the majority of the currency purchased were euros, which Bank of America say is consistent with data from the ECB balance sheet, which show that liabilities from the non-Euro Area denominated in Euro spiked in 4Q before tapering off in 2019.

Subsequent data does reveal the UK has shed some weight and whittled down the savings as it became clear a 'no deal' Brexit would likely be avoided in March when Parliament voted to extend the deadline which now sits at October 31.

Might we see a similar build up of reserves ahead of the next deadline?

"In our view the UK has been engaged in a concerted effort to build reserve liquidity into 2019 Brexit deadlines," says Sharma.

Bank of America analysts have been concerned about the implications of a 'no deal' Brexit on the Pound due in large part to the UK's current account deficit position, "but also because of its reserve currency status: global reserve managers hold $500BN in GBP reserve assets."

Bank of America estimated a 1% drawdown in GBP reserves could result in $100BN sales.

"The UK authorities are rightly concerned about the implications of a no-deal scenario and have correspondingly reacted. Looking ahead, we could easily see a re-run of 4Q events as we head toward the next A50 deadline in October. For now, with GBP implied vol contained versus its counterparts, the urgency to ramp up FX reserves has diminished, but we think this could provide some near-term headwinds to the Ppound," says Sharma.

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