International monetary dimension of sterling's decline

5 December 2016

The start of the hearing of the Supreme Court in the U.K. on 5 December on whether the U.K. Parliament’s consent is required to commence official Brexit negotiations, has been accompanied by a recent appreciation of sterling. Sterling’s upward move should not mask the fact that Brexit, assuming the Court will not alter the modalities of Brexit, is set to constitute a permanent significant realignment of sterling. The market expects Britain to be a poorer and less interesting place outside the E.U. Sterling’s decline has a domestic dimension. More importantly is its international impact. Sterling’s decline marks the international monetary dimension of Britain’s decision to leave the E.U. The decline of sterling serves as a reminder that the international monetary system is in urgent need of reform.

The international monetary system represents the monetary side of the international economy. It is based on key international currencies to conduct international transactions and payments and international reserves held by central banks used to manage international liquidity and support orderly international transactions and external adjustments. The system does not work as intended amid repeated bouts of sharp exchange rate volatility and large persistent external imbalances that threaten overall economic stability.

Sterling is a key international currency. It is one of only five currencies in the IMF’s Special Drawing Right (SDR) currency basket. Its decline indicates that the system lacks safeguards against sudden significant exchange rate movements. Its fall also now risks renewed greater currency concentration.

The international economy’s reliance on a small set of key currencies is problematic. While it reduces transaction and information costs, national currencies are ill adapted to deal with international economic situations. The central banks of key currency countries are national institutions and do not subordinate their policy objectives to the needs of the international economy. In times of international liquidity shortages this poses a major problem. More pockets of international liquidity creation is a good thing.

Sterling’s recent depreciation is part of its secular decline that started in earnest after World War II. It followed the great transition from an international economy conducting payments largely in sterling to one using dollars. The increasingly lesser use of sterling accompanied sterling’s fall from representing 60 percent of international reserves in 1950 to 5 percent today. Over the same period, the value of one pound sterling fell from 2.80 dollars, from a pre-war parity of 4.86 dollars, to 1.27 today.

Sterling’s post-war decline was once seen as having systemic implications for the international monetary system. During, the 1960s and 1970s, there was a concern that a disorderly depreciation of sterling would threaten the dollar’s stability. Sterling’s depreciation was therefore supported by coordinated central bank interventions through the G10 and Bank of International Settlements to allow a measured decline. The concern that the unravelling of a key currency could imperil the international monetary system still remains valid.

The challenge is for the system to facilitate the orderly entry and exit of international currencies. The relative increase or decline in the use of a currency naturally has profound implications on its relative value.

The step by the IMF on 1 October to introduce the renminbi in the SDR currency basket is a timid sign that reforming the international monetary system is being taken more seriously. China’s emergence as a major economic power has so far not been reflected in its currency. The adoption of the renminbi in the SDR currency basket shows that there is broad-based consensus that international liquidity should be managed using more rather than fewer international currencies. The renminbi remains marginal in international transactions. It may now change.

The transition towards a multi-currency international monetary system will reduce dependence of the world on and dominance of key international currencies in particular the dollar. Managing well its transition is critical.

Exchange rates in advanced economies have probably not seriously caused popular and market alarm since sterling’s exit from the European Exchange Rate Mechanism in 1992, despite the establishment of the euro or maybe because of it. Exchange rates have been treated with benign neglect. Sterling shows, similar to many emerging markets currencies, that exchange rate realignments amid perceived changing fundamentals can be sudden and severe. Britons have reawaken to an old reality that an important price of policy action is an external one.

Exchange rates need to re-enter the core of economic policy thinking. This requires greater policy coordination. History suggests that transitions in the international monetary system can be tumultuous. Investors better be aware.