Last week was the worst for the pound for a year as holders of sterling sold it following the collapse of the talks between the Conservatives and Labour on how to proceed with Brexit. On the foreign exchange markets, the price of a currency is determined by supply and demand and, if holders of sterling wish to sell it to buy euros or dollars, then the supply of sterling increases and the price falls. Simultaneously, given the state of political uncertainty, demand for sterling on the foreign exchange market fell, further weakening the value of the pound against other currencies. As a result, sterling dropped to $1.27, losing 1.85% of its value during the week.
Most forex transactions are made using the U.S. dollar, euro, pound and Japanese yen; although one might think that currency is mainly traded on the FOREX market to buy foreign goods and services, this is not the case. On average $5.5 trillion is traded each day but less than 5% of this is to buy goods and services. The majority is to purchase financial assets (e.g. foreign shares and government bonds and to place money into an overseas bank account) or to speculate about the likely movements of currencies to make a profit. Therefore, confidence in an economy is crucial in determining its value.
The UK’s reserves of foreign currency, currently standing at $137bn, are used by the Bank of England to protect the value of the pound on the foreign exchange market. The reserves, at their highest level for at least 21 years, are held mainly in US dollars and can be used to buy pounds on the foreign exchange market, thus increasing the demand for pounds and hence increasing the price, or rate of exchange of the pound against other countries.
According to the IMF, they grew 19% in the last quarter of 2018 because the government wanted to have them available in case they were needed after the originally-planned Brexit date. However if one compares the value of our reserves against the £420 billion of sterling traded daily by UK financial institutions one can see that, while the UK authorities might be able to nudge the value of sterling and slow down its fall, we do not have the resources to withstand a major fall in its value unless the government decides to borrow heavily overseas from foreign governments, banks and the IMF.
Economics Department Blog 