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87/98

2 June 1998

QUARTERLY REPORT ON UK OFFICIAL HOLDINGS OF FOREIGN CURRENCY AND GOLD: JANUARY - APRIL 1998

The Treasury and the Bank of England published today the third edition of the Quarterly Report on UK official holdings of foreign currency and gold. The report gives details of the forward foreign exchange position, the currency composition of foreign currency assets, the size and currency composition of foreign currency liabilities for the Exchange Equalisation Account (EEA) and the Bank of England's holdings of foreign currency and gold.

The report shows that the level of the Government's reserves, including the forward book was $37.9 billion at end-March, an underlying fall of $10 million on end December 1997. Net forward holdings of foreign currency were $1.29 billion at end- March. After the annual revaluation the reserves stood at $35.5 billion.

The level of the Bank of England's holdings of foreign currency and gold was $1.78 billion at end-March.

No intervention operations were undertaken during the quarter to end March with either the Government's reserves or the Bank of England's holdings. Should intervention in the foreign exchange market be undertaken the quarterly report will provide details of the amount and date of intervention and an explanation of why it was undertaken.

Notes to Editors

1. Media copies of the quarterly report are available from the Treasury Press Office on 0171 270 5185 or from the Bank of England Press Office on 0171 601 4411.

2. Non-media copies of the report are available from the Treasury Public Enquiry Unit on 0171 270 4558 or from the Bank of England on 0171 601 4878.

3. The quarterly report covering January - March 1998 will be published on 2 September 1998.

QUARTERLY REPORT ON THE UNITED KINGDOM OFFICIAL HOLDINGS OF FOREIGN CURRENCY AND GOLD JANUARY - MARCH 1998

This report contains a commentary on foreign exchange market developments during the three months January - March 1998 and details changes in the level and composition of UK official holdings of foreign currency and gold over that period.

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I: FOREIGN EXCHANGE MARKET DEVELOPMENTS

Summary

Compared with the volatility seen in the final quarter of 1997, financial markets were more stable in the first quarter of 1998. Concerns lessened about the effects of the Asian crisis as currency and equity markets in the region showed signs of recovery. In the UK, official interest rates were unchanged at 7 1/4% during the first quarter, although short-term market rates rose slightly early in the period.

In the foreign exchange markets, sterling rose by over 4% on a trade-weighted basis and was stronger against all the major currencies. The US dollar appreciated against the European currencies. The yen weakened slightly over the period amidst considerable volatility, affected principally by the prospects for Japanese fiscal policy and the stock market in the context of a persistently weak economy.

Sterling developments

Table A overleaf shows that sterling strengthened during the first quarter of 1998, rising more against the Deutsche Mark than the US dollar. Sterling reached its highest level against the Deutsche Mark since May 1989 during trading on 31 March when it reached DM 3.1088. This helped lift the Effective Exchange Rate Index (ERI) to 109.2 intra-day, its highest level since January 1986. Gains against the dollar were more modest. The pound moved briefly above $1.68 1/2 in late March but remained below levels seen in the previous quarter. The pound firmed against the Japanese yen, reaching a new five hear high at 224 yen in March.

Table A: Exchange Rates and effective Rate Indices (Bank of England Calculation)

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In part sterling's strength during the quarter can be attributed to views on the prospects for UK interest rates. Attention focused particularly on the decisions of the Bank's Monetary Policy Committee (MPC) and publication of its minutes. While rates remained unchanged the announcement of the decision of each meeting sometimes occasioned adjustment in the balance of market expectations. The publication of the minutes of the January and February MPC meetings, which revealed a division of votes in the Committee, attracted particular attention.

The market impact of the release on 11 February of the minutes from January's MPC was clouded by the simultaneous release of weaker-than-expected UK data (for unemployment and average earnings). Overall, sterling strengthened slightly, and it rose further later in the day, after the Bank's quarterly Inflation Report was published. Sterling closed up by 1.0% on the exchange rate index at ERI 104.4 on 11 February. During the next four weeks, sterling remained steady against the US dollar between $1.63-$1.65, but rose with the US dollar against the Deutsche Mark from DM2.93 to DM3.00. At times, sterling strengthened independently, against both the US dollar and Deutsche Mark, for example following the release of the February MPC minutes on 11 March. Following the Budget on 17 March, the release of strong RPIX data boosted the exchange rate. Sterling rose by 0.8% on the ERI, to ERI 107.5 between the start of trading on 17 March and the close on 18 March. Sterling peaked at ERI 109.2 during trading on 31 March, its highest since January 1986.

International developments

The Japanese yen was at the centre of foreign exchange market developments for much of the first quarter, reflecting news about the depressed state of the Japanese economy, prospects for fiscal policy and the weakness of the stock market. As Table A shows, the yen weakened only marginally over the period, but it traded in a wide range against the dollar, from Y123 to Y135. Within the ERM the Irish punt's central rate was raised by 3% against the Deutsche Mark. East Asian currencies recovered some ground following the substantial falls of late 1997. The US dollar and the Deutsche Mark each traded in a relatively narrow range during the period.

The yen strengthened against the dollar in January, underpinned by market reports of
intervention by the Bank of Japan and by the greater stability of the East Asian currencies. Expectations of an income tax cut strengthened the yen, which ended the month at Y126, up Y8 from its weakest point. However, sentiment changed on 12 February on concerns about Japanese policy ahead of the announcement of a new fiscal package on 20 February. Over this period the yen weakened sharply: from Y122 1/2 to over Y128 against the dollar and from Y67 1/2 to Y71 1/2 against the Deutsche Mark. During March a similar pattern was evident. Expectations that Japanese fiscal policy would be relaxed before the end of the financial year supported the yen for a period. But as these expectations were not met, the yen weakened, ending the month at Y133 1/4.

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The US dollar traded in a relatively narrow range against the Deutsche Mark, between DM 1.79 DM 1.84 for most of the quarter. Periodically, the market rate was influenced by heightened political risk (such as tensions between the US and Iraq in the Gulf, and US domestic politics). In late March the US dollar briefly broke out of this range, reaching DM 1.85. In the ERM spot and forward exchange rates continued to converge on their central rates, assisted by a re-alignment in the case of Ireland. The punt's central rate against the Deutsche Mark was raised by 3% from DM 2.44105 to DM 2.48338 with effect from 16 March, bringing the central rate more closely into line with the prevailing market rate. At the same time the Greek drachma joined the ERM. Its ECU central rate was set at 357 drachma. East Asian currencies strengthened during the first quarter. As structural reforms formulated by the IMF were implemented the currencies began to recover, though uncertainties continued periodically to effect the markets.

II: THE LEVEL AND COMPOSITION OF UK OFFICIAL HOLDINGS OF FOREIGN CURRENCY AND GOLD

The accompanying tables show the size and composition of the foreign currency and gold holdings of the Exchange Equalisation Account (EEA) and of the Bank of England. Due to differences in accounting methodology that are explained in the footnotes to the tables, no overall total for the EEA and Bank holdings is shown.
EEA Holdings

The non-US dollar assets of the EEA are translated to US dollars at exchange rates (termed 'parity rates') that are set at the end of March each year and which apply for the subsequent twelve months. The method of calculation of parity rates, and the level of the major rates, is set out in Note 3 to the EEA Tables. The effect of the revaluation of the EEA holdings in US dollar terms that took place at the end of March 1998 is set out in Tables 1 and 2, which show figures on both a pre- and a post-revaluation basis. Table 1 shows that the total of foreign currency and gold reserves in the EEA after the revaluation at new parity rates at end-March was $ 35,508mn, as compared with $ 37,871mn on a pre-revaluation basis. The currency breakdown of the EEA holdings in Table 2 shows that the main reasons for this fall were the lower valuation in dollar terms of the EEA's holdings of EU currencies and of gold. If translation to US dollars had been carried out at prevailing market rates rather than at parity rates, the total of gold and foreign currency reserves in the EEA would have been $ 38.6bn at end-December and $ 37.3bn at end-March compared to $ 39.7bn and $ 37.9bn respectively at (pre-revaluation) Parity Rates. The difference between the total at prevailing market rates and at post-revaluation parity rates is primarily due to the 25% discount applied to the value of gold for the latter.

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As shown in Table 1, during the quarter to end-March the total of foreign currency and gold reserves in the EEA on a pre-revaluation basis fell by $ 1,798mn. The reduction was almost entirely accounted for by the reduction in Capital and Other Items totalling $1,788 mn. The most significant factor was the maturity of the UK's ECU 2 bn 1998 Note ($ 2,152mn equivalent), only partly offset by the issue of h 500mn ($ 538mn equivalent) of a new Euro Note (see below for further details). The underlying change in the reserves, that is the change net of capital items, was a fall of $ 10mn. Interest payments exceeded interest receipts during the quarter: as explained in the notes to the tables, interest receipts are accounted for on a cash basis and the net total is therefore subject to considerable variation. This was offset by small net purchases of foreign currency.

As set out in the Chancellor's letter of 6 May 1997 to the Governor, if the government so instructs then the Bank, acting as its agent, may intervene in the foreign exchange market by buying or selling the government's foreign exchange reserves. If intervention is undertaken the quarterly reports will provide details of the amount and date of intervention and an explanation of why it was undertaken. No intervention operations were undertaken during the quarter to end-March.

Foreign currency liabilities, which formally are liabilities of the National Loans Fund rather than of the EEA, are set out in Table 2. Footnote 2 to the EEA tables gives more detail on these liabilities.

The UK Government issued the first Note in January under its new Euro Note programme, which replaced the previous ECU Note programme. h 500 mn of the 4.25% 2001 Euro Note was sold by tender, and it was announced that sales of further tranches by quarterly tender were contemplated in April, July and October. Meanwhile, the ECU 2 bn 8% 1998 Note, issued in 1995, was repaid in January. The total outstanding of Euro and ECU Notes and bonds thus fell from ECU 8.5 bn to ECU 7 bn during the quarter. In addition, the regular programme of tenders totalling ECU 1 bn of ECU Treasury bills was held each month, comprising ECU 200 mn of one-month, ECU 500 mn of three-month and ECU 300 mn of six- month bills, and these maintained the total Bills outstanding with the public at ECU 3.5 bn. Non-marketable debt repayments are shown in footnote 7 to the EEA tables.

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Bank of England Holdings

The Bank of England's holdings of foreign currency and gold during the quarter arose partly from foreign currency and gold deposits placed with the Bank by overseas central banks and other customers in the course of their banking relationship with the Bank, and partly from foreign exchange swaps conducted as part of the Bank's domestic sterling money market operations. These foreign exchange swaps were undertaken as a supplement to the Bank's usual money market techniques to provide sterling liquidity to the market. The operations are purely technical in nature and have no monetary policy significance. Under the Bank's accounting methodology holdings of foreign currency and gold are translated to US dollars at prevailing market exchange rates. The change in the Bank of England's holdings of foreign currency and gold during the quarter to end-March was an increase of $ 26mn. This includes changes in foreign currency and gold deposits placed with the Bank by overseas central banks and other customers and the change in valuation over the quarter. Table 1 also shows spot purchases of foreign currency by the Bank of $ 1,180mn and a corresponding forward liability. These represent the foreign exchange swap operations described above.

As set out in the Chancellor's letter of 6 May 1997 to the Governor, the Bank may also undertake foreign exchange operations to intervene in support of its monetary policy objective. If intervention is undertaken the quarterly reports will provide details of the amount and date of intervention and an explanation of why it was undertaken. No intervention operations were undertaken during the quarter to end-March.

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Table 1: Exchange rates and effective exchange rate indices (Bank of England calculation)

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TABLE 2: BREAKDOWN OF ASSETS AND LIABILITIES AT END MARCH 1998

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Notes to the EEA Tables

1. The EEA's foreign exchange reserves are held in assets of high liquidity and credit quality, for the most part government securities issued by the US, EU countries and Japan. In the management of the EEA the Bank of England also makes use of other financial instruments including interest rate and currency swaps, bond and interest rate futures and sale and repurchase agreements.

2. The bulk of the government's foreign currency liabilities consist of marketable international bonds which generally trade as benchmarks in their sector. At end-March, these comprised three US dollar bonds (two fixed-rate and one floating-rate) totalling $ 7bn, a Euro Note totalling h 0.5 bn ($ 538mn equivalent), two ECU Notes totalling ECU 4.0bn ($ 4303mn equivalent), an ECU bond totalling ECU 2.5 bn ($ 2690mn equivalent) and ECU 3.5 bn ($ 3765mn equivalent) of ECU Bills. The rest of the liabilities consist of remaining non-marketable long-term debt arising from loans made by the US and Canadian governments during World War II, and liabilities arising from the Exchange Cover Scheme, under which HM Treasury undertakes to sell foreign currency to repay local authority and public corporation borrowing from the European Investment Bank and European Coal and Steel Community. There has been no new non-marketable borrowing since the 1980s, and the debt is being gradually repaid under fixed amortisation schedules.

3. The EEA tables have been compiled according to EEA accounting methodology:

• Transactions are accounted for on a cash basis, ie on settlement.
• Assets are valued on an historic cost basis.
• Liabilities are shown at their nominal value.
• Non-US$ foreign currencies are translated to US$ using the average of the relevant dollar exchange rates in the three months up to the end of March each year or using the actual exchange rates on the last day in March, whichever calculation gives the lower US$ value. The translation rates ("Parity Rates") set for the year beginning 31 March 1998 are shown below, with the rates used during the year beginning 31 March 1997 shown for comparison. It should be noted that the official reserves figures in the UK Balance of Payments statistics (The Pink Book) are expressed in sterling, with translations done at current market exchange rates.

• Gold is valued at the average of the London fixing price for the three months to end- March, less 25%; or at 75% of its final fixing price on the last working day in March, whichever is the lower. The gold price in use during the year beginning 31 March 1998 is US$ 220.66 per troy ounce, as compared with US$ 261.11 per troy ounce during the year beginning 31 March 1997.

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4. Included within liabilities is the UK's allocation of IMF Special Drawing Rights (SDRs). In the event of the winding up of the IMF SDR Department, or in other circumstances, the UK could be obliged to repurchase SDRs to the extent of its allocation. It should be noted that the treatment of the UK SDR allocation in the Pink Book differs. The SDR allocation is shown therein as a memorandum item.

5. Investment income is net income derived from ownership of foreign financial assets, including any capital gain or loss realised on sale. As noted above, income is in general recognised only when it is realised. The exception to this rule in the table is that interest on deposits maturing beyond the quarter date and the accrued interest bought or sold in the forward leg of a repo agreement are shown as forward investment income. As a result of this income recognition policy the published figure may fluctuate considerably from quarter to quarter. It should be noted that this is not the same treatment as in the Pink Book.

6. Due to the inclusion of the forward book in this quarterly report, the Total Overall and Underlying Change figures are not the sum of the respective published monthly changes.

7. The underlying change in the spot reserves excludes a number of items, identified as Capital and Other Items, which are included in the overall change:

• Repayments on HMG ECU Treasury Notes maturing exceeded receipts from those issued by $1,769 million.
• Revaluation arising from EMI swap of $99 million. Due to the mechanics of the swap this appears as a negative figure in the spot reserves, balanced by a positive entry in the forward book.
• There were repayments of $21 million of public sector borrowing for which HMG has provided an exchange rate guarantee under the Exchange Cover Scheme (ECS).
• Receipts from HMG ECU Treasury Bills issued exceeded repayments on those maturing by $2 million.
• 8. The underlying change is the result of a variety of transactions, both debits and credits, including, for example, transactions for Government departments, transactions with other central banks, and interest receipts and payments. For these reasons, the underlying change should not be taken as an indication of market intervention.
• 9. Due to there being a two day settlement period in the foreign exchange market, the March end-quarter figures include some transactions for the last two working days of December and exclude some operations in the last two working days of March.

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Notes to the Bank of England Tables

1. These tables have been compiled on the basis of the Bank of England's accounting policies. In particular the following should be noted:

• Assets and liabilities in currencies other than US$ are translated to US$ at the exchange rates ruling at the end of the quarter.
• Gold is valued at current market rates on the basis of the London fixing price, without discount.
• Investment income is recognised on an accruals basis, and is displayed here net of interest paid on liabilities. Income accrued in foreign currency that has been exchanged for sterling is excluded from the table.

2. The Bank's foreign currency and gold assets and liabilities are published annually in the Bank's Report and Accounts.

3. The Bank's contribution to the European Monetary Institute (EMI) of ECU 95mn (US$ 102mn at the end-March exchange rate) is largely funded by a deposit from the EEA of ECU 93mn. This deposit therefore appears both as a foreign currency liability of the Bank and as an asset of the EEA.

Data contained in this report and in previous Quarterly Reports is published in The Bank of England's Monetary and Financial Statistics, copies of which may be obtained from the Bank.

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Press Notices 1998 (January to June) index