The Sterling Crisis: Defence of sterling may have cost pounds 1bn: Bank of England

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The Independent Online
BRITONS alarmed at the apparently stunning cost of defending the pound this week can take some comfort. Contrary to some reports, the Government, the Bank of England and the nation did not lose pounds 10bn or more this week amid the vain attempts to restore sterling's value.

Far from simply dumping sterling in an imaginary bin as it tries to hold the fort, the Bank of England is no different from any other trader or speculator when it steps into the currency markets.

When sterling needs help the Bank usually sells dollars or marks from its foreign currency reserves in exchange for pounds. So for every dollar and mark that it sells, it acquires the equivalent amount of pounds at the exchange rate prevailing.

The loss to the Bank - and the country - would depend on how far the pound then fell on the foreign exchanges after it bought. The pound has dropped between 5 and 10 per cent against major currencies this week. So the Bank's trading loss may be as high as pounds 1bn - high enough, but far below the pounds 10bn referred to in some quarters.

Nonetheless the Bank has more pounds than it wants. At the same time, its reserves of foreign currency for future intervention have been severely depleted. Only two weeks ago, Norman Lamont, the Chancellor, stoked up the Bank's war chest by borrowing pounds 7.25bn in foreign currency.

But market sentiment can change direction with astounding speed. If, for instance, the French on Sunday vote in favour of the Maastricht treaty on European Union it is possible that the pound could see a modest restoration of its fortunes. If this persisted for some time the Bank would be able quietly to sell its stock of pounds on the markets and rebuild the depleted reserves.

Of course the Bank must be certain that there is sufficient demand for pounds on the markets. And it must also be sure that its operations are conducted secretly, so that very few people on the markets are aware of its activity. A more open attempt to rebuild reserves could set off a new sterling crisis.

There are precedents for this. After experiencing severe pressure on the pound in the early 1980s the Treasury, in 1987, pursued a policy of shadowing the mark with the ultimate aim of joining the European exchange rate mechanism.

At the time, demand for sterling was growing strongly, helped by Britain's then rosy economic propsects. In a few months, the Bank of England sold sterling and bought the equivalent of about dollars 20bn, making Britain's stock of foreign reserves one of the largest in the world.

While a repetition of this would seem to be remote, it is impossible to predict how and when sentiment towards sterling might change.

Diary, page 21