RebelEconomist has been surprised by the recent strength of sterling, especially against the euro and the yen, and this short post offers an explanation for this behaviour which, as far as RebelEconomist is aware, has not previously been suggested by forex analysts (at least not when RebelEconomist put the suggestion to Macro Man earlier this week). In brief, RebelEconomist suspects that the Chinese have been buying sterling as part of their efforts to diversify their foreign exchange reserves away from the US dollar. Disclosure: RebelEconomist concurs with Angela Merkel, and holds a significant fraction of his savings in currencies issued by more conservative central banks than the BoE or the Fed).
While sterling did depreciate by about 30% (in terms of the Bank of England effective exchange rate index) from the beginning of the financial crisis (marked by, say, the demise of Northern Rock in September 2007) to the end of March 2009, the almost 10% recovery since March is barely justified by fundamental factors. Rallying share prices, narrowing credit spreads and tentative signs of at least an end to the deterioration in macroeconomic conditions, such as the recent uptick in the UK manufacturing purchasing managers' index, have been offset by increasing concern about the mounting burden of UK public debt and a growing political crisis, while the Bank of England remains in the lead in quantitative easing. Moreover, this sterling appreciation has occurred not just against the dollar, which has had similar fundamentals to sterling and was arguably riding for a fall itself, but also against the euro and the yen.
So what makes RebelEconomist think that China may be driving the recent appreciation of sterling? It is not foreign exchange market reports of Chinese flows; as a former reserves manager who was sometimes amused by erroneous speculation about his own activity and who would have certainly cut off any dealer suspected of such leaks, RebelEconomist is sceptical of anecdotal flows "information" anyway. His reason for pointing to China is that diversification of China's reserves has been advocated by credible Chinese sources and it would make sense for China to diversify into sterling. Of the five reserve currencies separately identified in the IMF Currency Composition of Foreign Exchange Reserves (COFER) reports (the US dollar, euro, sterling, yen and Swiss franc), sterling is probably the only currency whose issuing authority would not resent supportive intervention by foreign central banks at the moment. And if quantitative easing does lead to inflation and renewed depreciation, sterling offers more exit routes (from exposure to further currency losses) than most other major currencies – Britain is one of the most open countries to inward direct and portfolio investment by China's state funds (meaning that China could easily switch from conventional fixed income reserves assets into real investments for protection against inflation) and in the longer term, especially if sterling declines in international importance, sterling may well become part of the euro.