FOLLOWING DEVALUATION THE CONTINUING PROBLEM OF THE STERLING AREA

Press, Volume CVIII, Issue 31596, 6 February 1968, Page 12

FOLLOWING DEVALUATION THE CONTINUING PROBLEM OF THE STERLING AREA

(By

SAMUIL BRITTAN.

economics editor of the "Financial Times”, London)

(Reprinted from the "Financial Times" bp arrangement)

The problem of sterling as it was raised in the Common Market discussions, had two aspects: the sterling exchange rate, and the sterling area. The two problems were linked in many ways because doubts and uncertainties about the value of the pound made the sterling area more vulnerable: and conversely—it was suggested—the existence of the sterling liabilities added to the strains on the rate.

- Now that the rate has been adjusted to a realistic level, the focus of attention has switched to the sterling area. The sterling balances have changed in nature since the end of the War. About threequarters are held by sterling area countries; they are no longer wartime debts but for the most part constitute the reserves and working balances of the countries concerned. Their geographical distribution is shown in the table, from which it can be seen that the biggest group of holders is now in the Far East, including Malaysia and Hong Kong. During the Common Market discussions, the French—with some support from the European Commission—made a great deal of the strains that could be placed on Britain’s reserves by holders outside Europe, and for reasons which might have no real connection with the British balance of payments. The British reply centred on the fact that in spite of the changes in composition there had been no net run-down in the sterling balances since the end of the war.

There had been a cyclical movement, with upward and downward swings lasting anything from two to six years. But taking the sterling area’s own balances, the amplitude from the low to the high point of the cycle had not exceeded about £4oom.

There had, it is true, been a growing desire on the part of the sterling area countries to diversify tfieir holdings; but this had taken the form of holding, new reserves in dollars or gold, rather than making net conversions of existing reserves.

Complacent View Many experts in the Six thought it was unduly complacent to expect this stability to continue in the future. With a large proportion of the balances held by countries whose political future ties with Britain were in any case weakening, a net reduction in the balances is a distinct possibility.

The accelerated British withdrawal from East of Suez, by weakening the ties with Asian sterling area countries, may marginally increase the temptation to diversify reserve holdings. (But this is not itself a sufficient argument for continuing to play a world policeman role which is quite beyond our resources.) Nevertheless, the short-term effect of a properly handled devaluation ought to have been favourable. For the time to withdraw funds from London is before, not after, a devaluation. After the event it is too late.

The expectation of at least some years of stability in the exchange rate, together with the incentive of an 8 per cent Bank Rate, ought to hold funds in London and provide a breathing space, while more permanent arrangements for relieving sterling of its reserve currency role are being worked out. But for this to happen, there needs to be confidence that the exchange rate has gone down as far as it is going to go—which in turn implies confidence that the right internal measures are being taken to make the devaluation work, with a sufficient margin of safety. No Big Withdrawals There have, as far as can be ascertained, been no massive withdrawals of sterling area balances since devaluation, or

since the news of the defence cuts. But there is clearly concern among the British authorities about what may happen. This is one reason why those who are concerned witb the management of sterling in tiie market place are so disturbed that more than two months after devaluation we should still be waiting another two months for the full contents of the domestic passage.

British reserves are protected against the short-term impact of fluctuations in the sterling balances by a special network of “swap arrangements” agreed in Basle in June, 1966, and renewed every year, up to a limit of sl,ooom. These are “specifically designed to counter the Strains to which sterling is subject as a reserve and international trading currency” and exclude movements due to the British balance of payments.

In addition, there is another network of swaps with the United States Federal Reserve going up to $1,500m in Britain’s case, not subject to this proviso. These networks had been largely used up by the time of devaluation. Although there has been some return flow of funds, the amount has been disappointing in relation to the short position previously built up against sterling. In The Locker There is still a good deal of ammunition in the locker. The discussions about the sl4oom International Monetary Fund standby created such a stir, that the special credit facilities of over slsoom—over and above the existing swaps—also announced on November 18 have almost been forgotten. But with perhaps s2ooom already owing in short-term central banking debts and another slBoom owing to the I.M.F. and Bank of International Settlement by 1970, British net reserves are already negative. The authorities would understandably feel reluctant to use the new facilities and pile up even greater shortterm debts; and this adds to the arguments for not leaving eight weeks to go—during which all sorts of unforeseen developments could put pressure on sterling—with the Government’s remaining internal measures still unannounced. There is now pretty general agreement, even among the most orthodox British official circles in London, that once the immediate hurdles are over some long-term solution is required for the sterling balances. There Is no lack of schemes: but they all require international agreement The balances are not—as is sometimes alleged in the Left —burdens imposed by the City for prestige purposes, but British debts. Any solution requires the agreement of both the sterling holders and the main creditor countries in the I.M.F. or Group of Ten.

Technically the solution could take many forms. There could be a long-term loan to Britain either to strengthen the reserves or to enable this country to pay off some of the balances. Alternatively the balances could be funded with the I.M.F. or Group of Ten. This would presumably mean that holders would be given a credit balance, which they could use when necessary to convert Into any currency of their choice. A third approach would be to give extra “Special Drawing Rights,” under the contingency plan agreed last year

at Rio, to Britain as and when the sterling area countries draw on their balances. Common Clause All the schemes have in common a willingness by other leading industrial countries to make available their own resources on demand to sterling area countries—in other words to take over Britain’s debts.

This is the reality of the situation covered by phrases such as “putting the balances into the 1.M.F.” (as if that body were a great all receiving ocean). In any scheme Britain would still have to pay interest to the body that had taken over the debts; and, in practice most Continental opinion is insistent that Britain would have to undertake some repayment obligation

however gradual. This last proviso is the submerged rock which made the British Treasury shy of raising the issue in predevaluation days. It is unlikely that any new arrangements could be negotiated quickly. The Rio scheme for increasing international liquidity generally took several years to negotiate, and there Is still no international agreement on when and how to bring it into force. In the meanwhile, we shall have to rely on the Basle arrangements and the hoped for improvement in the reserves when a payments surplus materialises, to deal with sterling balance movements. Kuwait’s Holdings The areas that will need the most watching will be the Far and Middle East. Overwhelmingly the most important part of the £3B7m of Middle Eastern balances is owed to Kuwait This figure had been up to £47Bm in March, before the Middle Eastern War, and the real figure of Kuwait liabilities would be nearly twice as high, as equity holding on long-term U.K. Government stock held by individuals do not appear in the sterling balance figures. A large proportion of the balances switched out of London by Middle Eastern countries last year were however deposited with Continental banks, who re-deposited tha funds in London; and to that extent the drain on the reserves was limited.

Official sterling balances are only part of the problem. Even If sterling ceased to be a reserve currency, there remain the liabilities to private holders—which account for about one-fifth of the net total, but two-fifths of the gross. (The discrepancy arises because there is a large offset in the private sector, mostly representing British export credits.)

The British economy would be in a much less vulnerable position if our solvency were less dependent on volatile funds placed in London on interest-rat© considerations, and ready to leave at the slightest sign of trouble. But, the only way of dispensing them would be to increase our earned reserves. A Hard Core If we could do this we could eventually afford to reduce our interest rates relative to overseas countries and deter short-term deposits with local authorities and all the other footloose funds on which we have been so dangerously dependent in the past. The funds remaining in London would then be the hard core genuinely required for trading purposes or owned by willing official holders in the sterling areas. Such a policy would involve a real cost in terms of resources; for we would have to run a larger payments surplus than would otherwise be necessary. The British Government would have to discipline itself to use the gains accruing from such surpluses partly to increase reserves and partly to reduce interest rates rather than to relax its restraints on internal and exernal spending. This in fact is the only safe way to reduce the vulnerable ity of Britain to currency crises and overseas confidence movements generally about which Labour members of Parliament complain. But it would be idle to pretend that this prospect is round the corner; confidence movements have still to be taken extremely seriously In deciding on the timing and extent of the next set of domestic restraints.