The World Financial Review

By Catherine Schenk

“The global reserves system is coming under increased scrutiny both as a contributor to the global crisis and as a threat to future stability.”

Critics argue that the dollar’s role as primary international reserve asset combined with the accumulation of substantial reserves in East Asia contributed to America’s ability to accumulate large balance of payments deficits and cheapened government borrowing.  Depressed US interest rates may have fuelled the consumer and mortgage debt boom.  The sustained decline in the value of the dollar from 2002 and fears over the quality of US debt prompt questions about how long it could remain the world’s primary reserve asset and if, when and how it might be overtaken by another currency.  The prospect that more countries will accumulate precautionary reserves in the wake of the current crisis, thereby renewing the cycle, has prompted questions about the costs and benefits of issuing an international currency, how international currencies emerge and how they can be replaced without disrupting the global economic system.  Many reform proposals are similar to the suggestions put forward to resolve the challenges of the late 1960s when the system also appeared to be unsustainable due to persistent American deficits and declining confidence in the dollar.  In the 1960s these problems proved intractable and were in the end resolved for a time by the advent of floating exchange rates and financial innovation, which together reduced the need for national precautionary reserves. In the process sterling retired as the secondary global reserve currency.

“The sustained decline in the value of the dollar from 2002 and fears over the quality of US debt prompt questions about how long it could remain the world’s primary reserve asset and if, when and how it might be overtaken by another currency.”

Although the demand for reserve currencies can be modeled with a range of variables including issuing-country size, share of world trade and return on assets, these exercises have reinforced the importance of institutional rather than economic determinants. The important role of inertia is usually attributed to network externalities (such as convenience) that prolong reserve currency status beyond the time predicted by economic fundamentals.  These externalities also suggest a tipping point or landslide effect should one major creditor begin to switch reserve assets, so that the transition from one reserve currency to another could be catastrophic rather than a gradual retreat.   The case of sterling in the post-war period helps to explore the determinants and timing of shifts from one major reserve currency to another. Like the dollar today, the demise of sterling was widely predicted but the process was more gradual than was anticipated at the time – a dignified retreat rather than a rout.  Does this suggest that we can expect a similarly benign exit for the dollar?

At the end of the Second World War, it was clear that the dollar would be the dominant international currency in any global economic reconfiguration, and this became the core of the Bretton Woods system. Most rich countries pegged their currencies to the dollar, while the dollar alone valued its currency directly in gold.  Nevertheless, there continued to be a role for a secondary international currency to be used as a reserve asset, anchor currency and as a currency of settlement because the supply of USD assets and gold was restricted in the immediate post-war period by US balance of payments surpluses. In the 1950s the sterling area (35 countries and colonies pegged to sterling and holding primarily sterling reserves) accounted for half of world trade and sterling accounted for over half of world foreign exchange reserves. It took ten years after the end of the war (and a 30% devaluation of the pound) before the share of USD reserves exceeded that of sterling. Thereafter, the fall in sterling’s share of global reserves followed a gentle decline rather than a dramatic tumble.  In 1955 40% of global reserves were held in sterling and 15 years later sterling’s share was only 10% lower.  Inflation in the early 1970s and the accumulation of dollars by OPEC sharply reduced sterling’s share thereafter to below 10% by 1972 without prompting a collapse.  This pattern of gradual, if inevitable, decline in sterling’s share might give comfort to those concerned about a disruptive ‘tipping point’ for diversification away from the US dollar in the decades to come.  A closer look at why sterling declined in such an orderly way, however, shows that this was a carefully managed process that required considerable sacrifice and cooperation among key players in the global monetary system.

“It took ten years after the end of the war (and a 30% devaluation of the pound) before the share of USD reserves exceeded that of sterling.”

How do we explain the gradual nature of the decline of sterling?  Was this due to British government efforts to prolong sterling’s role because it increased the capacity to borrow, enhanced international prestige, or because it supported London as a lucrative centre for international finance?  These are the traditional explanations, but new evidence shows that privately many British bureaucrats and politicians recognized that the burdens of sterling’s role in terms of a rising cost of borrowing and vulnerability to external pressure outweighed the benefits of issuing an international currency. Closer examination shows that sterling’s international role was deliberately prolonged by collective global interest in its continuation.

During the early 1950s the UK Treasury devised various plans to discourage the use of sterling as a reserve currency by increasing exchange rate volatility or unilaterally suspending the convertibility of sterling reserves, but these plans were abandoned because they threatened Britain’s political as well as economic relations with creditors, and because the retaliation and disruption to the international monetary system that would ensue threatened domestic priorities of full employment and price stability.  By the early 1960s, the future of sterling as a reserve currency became embroiled in global efforts to reform the international monetary system. As today, critics argued that the use of national currencies as reserve assets delivered ‘exorbitant privilege’ for issuers of reserve currencies since it made it easier for them to borrow.  On the other hand, increases in global reserves required persistent deficits to be run by issuing countries that ultimately undermined confidence in the value of those reserve assets.  It seemed that the system was unsustainable and in the 1960s, as in the G20 today, major reforms were widely debated. The process of global reform was much more prolonged than expected but in the end the outcome (the SDR) was not radical enough to meet the task of retiring sterling, let alone replace the dollar.  Nevertheless, collective belief that national currencies might eventually be replaced as reserve assets coupled with the fear that the collapse of sterling would spread to a collapse in the US dollar (and thereby the entire international system) meant that Britain was able to garner extraordinary support to forestall a crisis.

While elaborate global reforms were debated and rejected, a multilateral support system was quietly developed at the Bank for International Settlements that comprised three successive Group Arrangements in 1966, 1968 and 1977 whereby central banks pledged substantial lines of credit to minimize the impact of a tipping point away from sterling.  These ‘safety net’ schemes ($1 billion in 1966; $2 billion in 1968 and 1977) aimed to forestall a rush away from sterling as a reserve currency by retaining market confidence and reducing the first mover advantage from a flight from sterling.  In 1968 (under pressure from G10 central banks) the UK also built a system of bilateral commitments with holders of sterling to limit diversification in return for a guarantee of the USD value of 90% their reserves. These Sterling Agreements were renewed three times before finally being allowed to expire at the end of 1974. They transformed the nature of sterling as a reserve asset from a voluntary portfolio choice to a formal contractual commitment.

The shift from sterling to the dollar and the elimination of sterling as a major international currency did result in international tensions and conflict over British domestic economic policy.  It was thus not a painless transformation, but it was tempered by the waning attractions of the dollar as a safe haven and by the international commitment to avoid a damaging tipping point for sterling that would undermine confidence in the reserve currency system as a whole.  But the persistence of sterling’s reserve role was not just an artificial one. Many developing countries were willing to accumulate sterling assets during the 1960s because of the denomination of their trade and debt in sterling and because many currencies remained pegged to sterling.  As a result, during the final decades of sterling’s reserve role there was a considerable geographical redistribution of official holdings of sterling assets.  Starting in 1971 most countries shifted their exchange rate anchor to the USD or basket currencies, but the pound remained the primary reserve currency for a range of (mainly developing) countries until the mid-1970s.  Rising international liquidity, inflation, geographical redistribution and international cooperation were the cornerstones that eased the retreat of sterling from global status.

The 1976 sterling crisis marked the first time that sales by central monetary institutions rather than the private market put the primary pressure on the sterling exchange rate.  As confidence in British domestic economic management ebbed, diversification away from sterling prompted a crisis that could only be resolved by a humiliating recourse to the IMF with its attendant conditionality. The crisis also prompted the final multilateral effort to retire sterling as a reserve currency through the Third General Agreement, which provided another $2 billion line of credit from G10 central banks.  This time Britain was forced to sell Yen, DM, $ and Swiss franc bonds to replace sterling reserves. In the end, the crisis was short-lived and sterling quickly recovered. That Britain was still considered deserving of support to defend against the liquidation of overseas sterling reserves despite the decline in sterling as a reserve currency and the advent of floating exchange rates is particularly striking and speaks to the priority given to stable exchange rates even in the environment of de jure floating rates.

The retreat of sterling as a reserve currency has often been misunderstood.  Sterling played a much greater role for a longer period after 1945 than is usually acknowledged and its retreat was carefully managed rather than left to market forces.  Although sterling’s share of global reserves did fall below 50% from the mid-1950s, it remained the dominant reserve asset for a broad range of countries. This was only partly due to inertia related to colonial monetary systems and pre-war commonwealth links.  From the 1950s the persistence of sterling was driven by fresh accumulations among a new group of countries in the Middle East and East Asia as wartime accumulations elsewhere were run down. For these states, the economic fundamentals of the denomination of debt and trade in sterling remained important until the 1960s.  At this point, the pace of the fall in sterling’s share of global foreign exchange reserves slowed because of deliberate action taken by the developed and developing world.  The British were able to convince their G10 partners that postponing the tipping point for sterling was in their common interest and to gather substantial international support to guard against a collapse in the pound that would arise from a rapid switch to the dollar.  This allowed the UK to offer a credible exchange guarantee for existing sterling reserves, in return for an undertaking that these states would retain a minimum proportion of their reserves in sterling. By the time the Agreements expired at the end of 1974 sterling’s reserve role was swamped by the effects of the oil crisis, which concentrated sterling reserves among a few countries, reduced the global share of reserves held in sterling and increased the nominal value of these liabilities. When pressure on sterling finally arose from sales of official reserves in 1976, the value of these liabilities had fallen in real terms, relative to UK GDP and relative to UK reserves.  The 1977 scheme to replace sterling reserves with assets denominated in other currencies merely marked the formal end of sterling’s reserve role.

It is clear that the case of sterling does not provide a blueprint for retiring the dollar, but it does provide some perspective.  For sterling, there was an obvious rival currency that was a genuine threat, but the dollar’s rivals today are weaker.  The strains on the Eurozone arising from the global financial crisis mean the Euro is not an attractive alternative in the current climate, and the internationalisation of the RMB will take time.  It could be argued that by the 1960s the USD was not a strong rival to the pound, but rather the lesser of two evils, and that this was compounded by the depreciation of the USD from 1971.  Nevertheless, the dollar was a viable alternative reserve asset in a way that the Euro or RMB are not today.

As holders of dollars become nervous about the value of their assets (particularly in the current fiscal climate) the prospect that the USA would offer a floor value for the USD to induce major holders like China to refrain from diversifying their reserves seems remote.  In the UK case the exchange risk was underpinned by a substantial multilateral line of credit but the value of sterling reserves then was much smaller than global dollar reserves today.  Britain carefully avoided the interference in domestic economic policy that such large amounts of credit usually attract by negotiating with central banks (who deplored taking political stances) rather then inter-governmental or IMF routes.  However, in the end even central bankers ran out of patience and IMF conditionality was applied to the Third Group Arrangement in 1977.

“Both Britain and the USA recognised that a run on sterling could only be stemmed by Britain’s retreat from the international economy and an acceleration of the retreat of its global military presence.”

However, some more general lessons might be learned.  Firstly, retiring a reserve currency is likely to be easier in a time of inflation (which decreases the real value of outstanding liabilities) and growth in international liquidity, so that the shift is achieved through acquisition of new reserves rather than exchanging or replacing existing assets (flow, rather than stock adjustment).  Secondly, the global political environment is important.  The stability of the international monetary system was closely linked to Cold War interests in the 1960s. Generally, it was believed that a collapse in the global reserve system would destabilise capitalism. More specifically, both Britain and the USA recognised that a run on sterling could only be stemmed by Britain’s retreat from the international economy and an acceleration of the retreat of its global military presence.  Thus, during the Vietnam War US support for sterling was often linked to British strategic commitments in Southeast Asia.  The global context today is much altered and the relatively cosy G10 has been expanded to a much more diverse group of international political interests.  Existing predictions of the timing for any decline in the dollar as the dominant international reserve currency usually set the change well into the future, mainly due to the impact of inertia.  The experience of sterling suggests that extending the tipping point and avoiding a landslide effect may require more deliberate management than the trends predicted by changing economic fundamentals suggest.  The gradual retreat of the pound should not give comfort to those hoping for a smooth transition from the dollar.

About the author

Catherine Schenk is Professor of International Economic History at the University of Glasgow.  She is the author of many articles and several books on international banking and monetary history of the UK, Europe and Asia.  Her recent books include The Decline of Sterling: managing the retreat of an international currency 1945-1992 (Cambridge, 2010) and International Economic Relations since 1945 (Routledge, 2011).  She has been visiting research fellow at the Hong Kong Monetary Authority and the International Monetary Fund.  Her current project is funded by the Economic and Social Research Council; ‘International Financial Regulation 1961-1982′ and she is also engaged on research into the historical precedents of current discussions on the reform of the international monetary system.