The $146bn war chest built by Bank to ride out no-deal sterling crisis

The British authorities built up a $146bn war chest of foreign exchange reserves late last year to defend sterling and ride out a possible currency storm in the event of a no-deal Brexit.

Exchange data from the International Monetary Fund show an extraordinary rise in reserves in the final quarter of 2018 when political

tensions were running high and contingency planning was moving into a higher gear.

“The UK was basically taking out an insurance policy,” said Kamal Sharma, chief currency strategist for Bank of America.

“The Government was piling up foreign exchange reserves on the chance the UK would leave the EU without a deal, creating a run on the pound and a current account crisis.”

The purchases were conducted by the Exchange Equalisation Account (EEA), an arm of the Treasury created in 1932 after Britain’s traumatic ejection from the gold standard. It is operated by staff from the Bank of England with a mandate to check “undue fluctuations” in sterling.

The EEA boosted its war chest by $23bn over a matter of weeks in November and December last year. “This pace of accumulation compared to other G10 economies is unprecedented,” said Mr Sharma.

There were big moves by states such as Turkey and Indonesia, but it is highly unusual for developed countries to act in this fashion. An analysis by Bank of America found that most of the intervention was through the swap markets, “repo” or repurchase agreements for securities and bonds bought from banks.

This allowed the EEA to accumulate its safety buffer without leaving a big footprint in the currency markets and to earn a better yield. The repos can be unwound more easily in a crisis to create liquidity and deliver maximum counterpunch.

Mr Sharma said sterling might plunge another 15pc to around $1.10 against the dollar in a full-blown rupture with the EU.

“We have been concerned about the implications of a no-deal on the pound due in large part to its current account deficit position (4pc of GDP), but also because of its reserve currency status: global reserve managers hold $500bn in sterling reserve assets,” he said.

A downgrade could lead to $100bn of gilt sales by central banks and sovereign wealth funds. These big beasts tend to act gradually – though not always, as Russia showed last year with mass sales of US Treasuries – but markets might pre-empt the moves.

The silver lining is that sterling is already undervalued by most measures. The worst accidents happen when a currency has been held up artificially under a fixed peg as occurred during the Exchange Rate Mechanism debacle in 1992, or under gold in 1931.

But floating currencies are no guarantee against a “disorderly” downward spiral that inflicts serious macroeconomic damage. It is hazardous to test that threshold. The Bank of England has run down some of the repo positions since Parliament voted to take no-deal off the table and extensions to Article 50 came into play.

This may have been premature. The spectacular rise of the Brexit Party and the likely emergence of a hard-line Eurosceptic to lead the Tories brings the issue squarely back into focus.

Bank of America says that the EEA may have to start building up its buffer again before the next deadline in October. This intervention will act as a chronic headwind for sterling over coming months even if repos are used

to muffle the impact. Sharma said that there is telltale evidence of Brexit contingency planning in the structure of the repo contracts.

They were largely in the “maturity bucket” of one to three months. This is longer than usual. Most of the repos were in euros and deposited at the European Central Bank.

“It shows they were doing it for a specific purpose,” he said.

The UK has been beefing up gross reserves steadily since the low point of Gordon Brown’s tenure. It was fashionable before the Lehman Brothers crisis to regard foreign reserves as a barbaric relic that no longer served much purpose for open developed economies in a globalised system of floating currencies and free capital flows.

Hard experience has since taught policy-makers that markets can overshoot badly. Stabilisation at the right moment can pay off, but for that you need a war chest.

Sterling is vulnerable on a second front as the decade-long global expansion nears exhaustion and recession fears mount.

Countries with large current account deficits – CADS in trader parlance–- tend to suffer depreciation when trouble starts. So do “highbeta” economies that are leveraged to the global risk cycle. This is both good and bad.

Weaker currencies act as a shock

‘The history of the last 80 years shows that when the pound goes, it really goes. The moves can be dramatic’

absorber but devaluations can also get out of hand.

Britain is famously both high-beta and a CAD at the same time. A hard Brexit could amplify an already volatile effect.

“The history of the last eighty years shows that when the pound goes, it really goes. The moves can be dramatic,” said Simon Derrick from BNY Mellon.

The currency fraternity are on high alert.