Pound Sterling Growing in Popularity as Central Banks Seen Boosting Reserves of Sterling

The ongoing recovery in the British Pound may be in part attributable to central banks increasing reserves of Sterling once again.

After the Brexit referendum, the Pound became something of a global pariah, from the point of view of central bank buyers.

The heightened uncertainty triggered by the political situation in the UK meant that for a time after the referendum FX reserve managers at central banks around the world gave the Pound a wide birth.

After all, here was a currency which had lost over 10.0% in a volatile dive overnight after its people voluntarily decided to end a decades-old trade agreement with their closest neighbours; and there was clearly a risk of more bouts of volatility ahead.

Central bank reserve managers are a relatively conservative bunch, unlike traders, and also unlike traders, they don't like volatility and research shows moves in a currency can impact that currency's share of international reserves.

Indeed, not long after the referendum, China had slashed their GBP FX Reserves from 8% down to 3% whilst information from the Bank of International Settlements (BIS) showed other central banks also reducing their share of Sterling FX holdings.

Overall it was a huge thumbs down for the Pound from the international financial community and marked the low point in a trend which had begun ever since the UK lost its role as the main international reserve currency in the 1960s.

At the time we reported, Sterling was becoming ‘increasingly irrelevant’ as global reserve currency.

One year later and we can report this position might be reversing.

Central Banks Backing the Pound Again

New research for BNY Mellon's Chief Currency Strategist Simon Derrick, however, suggests the tide may be turning once again, and the Pound is gaining favour with reserve managers.

"It seems reasonable to say that central banks were on something of a GBP buying spree in the first three quarters of last year," says Derrick after noting that the share of total reserves in Pounds rose by $67.7bn between Q4 2016 and Q3 2017 (to a total of 433bn)  and that not all the rise can be attributed to the Pound's exchange rate appreciation over the period.

Derrick sees the move as a possible explanation for the outsized move by the Pound versus the US Dollar over recent months irrespective of the state of traditional drivers which would seem to suggest flows favouring the Dollar instead - or at least a more muted rise in GBP/USD.

"On the face of it both GBP and the EUR should be suffering," says Derrick, observing that for Sterling the uncertainty engendered by the Brexit negotiations, domestic political uncertainty and a glacially slow monetary policy tightening cycle "would seem to reasonable reasons for caution."

With regards to the Euro, he says, "the current monetary policy settings would appear a good reason for avoiding exposure."

However, both have proved particularly indifferent to these factors in recent months. The question is why.

Derrick says it appears part of the answer is the rise in demand from central banks who are 'diversifying' their holdings again following reductions in European currencies previously because of the rising risk and volatility associated with them.

Another reason why holdings could be increasing is also demand from central banks who are actively trying to devalue their domestic currency so as to improve export competitiveness.

"What is certainly clear is that the 9.6% y/y decline in the Dollar Index has been matched by a pick-up in the pace of FX reserve growth in a number of nations - including Taiwan, Hong Kong, India Singapore, Thailand and Indonesia - that looks highly reminiscent of that seen during the height of the currency wars (2009 to 2014)," says Derrick.

The positive outlook for the global economy, the global reflation story and the tendency for central banks to begin raising interest rates, means many emerging market currencies are forecast to rise this year, especially versus the US Dollar.

Taken in conjunction with evidence that international central banks are increasing and diversifying their FX reserves, this could imply that the Pound and the Euro may remain resilient directly as a result of reserve buying, for the foreseeable future, provided their risk profiles do not radically alter.

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