W ears pricked up on budget day when George Osborne announced a surprising and potentially expensive plan to rebuild Britain’s foreign currency reserves.
There are two methods of executing this plan. The first is to print sterling to buy foreign currency. This could be regarded as quantitative easing (QE) by another method. Indeed, it might have been an effective way to execute QE in 2009, though it would probably have caused a riot in the Eurozone as other governments – ignorant of the fact that a fall in the exchange rate caused by loosening monetary policy brings no lasting effect – would have accused us of indulging in competitive devaluations.
The second method is that the Debt Management Office (DMO) or possibly the Bank of England (BoE) could issue bonds and use the funds raised to buy foreign exchange reserves for the government. This is expensive. The government pays interest on the bonds and earns no interest on the foreign exchange. It is possible that Osborne is intending that we buy foreign currency bonds rather than cash reserves. In that case, interest would be earned on those bonds but there would then be inter-governmental credit risk: today’s high quality asset is not necessarily tomorrow’s.
One gets the impression from the debt management reports that Osborne proposes the second route – however, it is possible that they were written before he decided to make the announcement.
But this still leaves a big question: why are we rebuilding foreign exchange reserves at all, given that we have been on a floating exchange rate since 1992?
One of the great benefits of floating exchange rates is that Britain no longer needs foreign exchange reserves. Such reserves benefit the foreign currency issuer through seignorage and cost the buyer the interest on the debt issued to finance the purchase. If the government’s intention is to keep the value of sterling down, then issuing bonds to buy foreign currency assets would have a relatively slight effect and a large potential cost.
Apparently the decision was taken after intervening in the market to keep the value of the yen down. It is also motivated by Osborne’s decision to rebuild reserves from historically low levels. But reserves should be at historically low levels – on a floating exchange rate, we do not need them. Has the chancellor taken technical advice from the DMO or the BoE that we need more reserves? The £18bn of reserves he wants to buy might cost £900m a year when interest rates return to normal. Personally, I would prefer another penny off corporation tax.
Perhaps there are ulterior motives. Is the chancellor coming under pressure from the Liberal Democrats to prepare to fix rates against the euro? Is his admiration of low income, manufacturing economies such as China such that he wants to copy their banking and monetary systems too? It is a very strange position to take. Of all the problems the UK faces, a lack of foreign currency assets does not seem to be one of them.
Philip Booth is editorial and programme director for the Institute of Economic Affairs