Why would anyone want to buy Sterling?

Everyone wants a piece of the UK today. Bill Bryson just got himself an honorary gong. Monty Python's 'Spamalot' musical will soon hit Las Vegas (it's a hoot, by the way). And half-a-million Polish citizens are now living in Britain to earn Sterling, not Zloty.

Should US investors hail a black cab to Britain? They should hold the Pound up to the light before they hedge their Dollars this New Year.

Check the watermark. Make sure the metallic strip is intact. Then read the 'promise to pay' signed by Mervyn King, Governor of the Bank of England. It's just as empty as the promise on US Treasury notes. Nothing but more fiat promises back it up which will work fine so long as everyone accepts Sterling in payment of debt.

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Why the Pound is set to fall

But the Pound is set to fall hard, according to two big US investment banks. Goldman Sachs says the Pound is 13% over-valued on a trade-weighted basis. Lehman Brothers are gloomier still. 'I'm not saying that things will be terrible, but they will feel much worse,' warns their chief UK economist, Alan Castle. He sees Sterling falling to $1.82 next year, before sinking to $1.68 by Christmas 2008.

Wall Street's reasons are simple. They might give US investors dja vu, too. For Great Britain and the United States have much more in common than merely the mess in Iraq.

Just like America, Britain is currently running a huge trade deficit with the rest of the world. The largest shortfall in Western Europe, it reached a near 18-year record this fall. And just like America, Britain also has a mountain of government debt.

Officially, public sector net debt stands at £486.7bn. That's equal to US$953.9bn and represents a little under 38% of annual GDP. Add the state's 'off balancesheet' debt, however including its pension promises to state- paid employees and the total shoots nearly three times higher. Research by the Centre for Policy Studies in London says it would put UK government deficits at a staggering 103% of GDP. The debt burden per household would be over $103,880.

Then there's consumer debt only here, Britain is way ahead of the States. Total consumer liabilities now run to an entire year's worth of GDP, thanks to house prices tripling since 1996. That's when the last wipeout troughed. It started in late '89 and knocked average home prices, adjusted for inflation, down by 35% and beyond. Fast forward to Dec.'06, and the British now owe$2 trillion in housing debt, much of it held as a naked call otherwise known as interest-only home loans with no money down.

Now add unsecured debt per household of $16,840 on average...plus personal bankruptcies doubling to an all- time record since 2004...and 'the surprise is that the Pound has been so strong,' gasp Lehman Brothers.

'Current account deficits matter over time,' the suits in the City remind us, 'and we're worried that Britain's [trade] deficit could widen to 4% of GDP in 2008.'

But c'mon! What took Lehmans so long? None of this trouble is new. And other US investment banks have called the Pound lower before. Trouble is, they were wrong.

'As a top trade for 2005, we recommend going short AUD, GBP and NZD,' said Morgan Stanley in January last year. By their expert math, these three Anglo-Saxon currencies were all 'overvalued [and] no longer trading on fundamentals.' That bit was right, but the trading idea was not. If you had sold the Aussie, Kiwi and Sterling against Euros and Dollars in 2005 it would have cost you dear long before now. As 2006 draws to a close, the trade's barely back in the money.

And all this while, the Pound has grown weaker on all fundamentals. Britain's broad money supply has exploded 25% since the start of '05. That's the fastest growth by far amongst the G7 economies, and nearly twice the rate of world money growth judging by the Bank of England's own data. Worse still, in early April this year, Dollar interest rates overtook Pound rates for the first time since 2001. This didn't bode well for Sterling, as a research note from HSBC said.

During the previous three decades, the GBP/USD pairing known as 'cable' by traders had lost 12% per year on average whenever Dollar rates were higher. Yet this time the Pound shot higher against the Greenback as the yield-premium went Stateside. In fact, it leapt 15 cents higher to $1.90 within only five weeks!

Who's buying the Pound now?

So who's been filling their boots? It's a good job that Sterling broad money has risen so fast. Because the Pound has become the 'anti-Dollar' of choice for the world's central bankers.

'There are not many places to go once you decide to get out of the Dollar,' shrugged an official from the Banca d'Italia in August. Italy's monetary wonks had just said that Sterling accounted for 24% of their foreign currency reserves. They didn't hold any in 2004.

'Japan is always a question mark,' he shrugged again.

'At least the British economy is humming along okay and UK bonds offer a decent yield...'

In other words, Sterling is better than a poke in the eye. And it's thanks to that logic, says a report from the Bank for International Settlement (BIS), that the Pound now accounts for 12% of all foreign reserves held by governments worldwide. In fact, the UK currency underpinned by record inflation of the money supply...record house-price inflation...and near-record trade deficits is now the world's third reserve currency, second only to the Dollar and Euro.

What's to love about Sterling in this beauty contest of misshapen half-wits? Put simply, it isn't the Dollar or Euro. Nor are buttons or whale's teeth, of course. But a government vault full of cowrie shells would be tough to explain next time the wonks met for dinner in Paris. And the same sorry logic is at work on Wall Street, remember.

Lehman Brothers say Sterling will drop to $1.68. Goldman Sachs forecast a 13% drop or more versus the Dollar. Morgan Stanley this summer set 'fair value' at $1.63. But what if the Dollar keeps falling...and Sterling falls too? Where will central banks turn next as they try to spread their currency risk from one fiat money to another?

How the Pound became the world's third reserve currency

'In the 1980s,' the BIS says, 'the Yen had begun to erode the US Dollar's share [of central bank currency reserves]. At its peak the Yen accounted for over 10% of reserves. By 2006, it accounted for less than 5%. The decline in Japanese asset prices and the subsequent long period of low relative returns on yen assets appear to have contributed to the shift out of Yen reserves...The pound sterling has replaced the yen as the third largest currency in reserve portfolios. According to the BIS data, the share of sterling doubled between 1995 and 2006.'

Funny, but the UK economy looks uncannily like late '80s Japan Inc today...only in miniature and minus the trade surplus. Yet central bankers have piled in regardless. Even the Swiss have bought Sterling, pushing it to 10% of their foreign exchange reserves! The BIS can't be sure what China, Japan and Russia have done. The three largest owners of foreign exchange reserves now deal secretly through private bank transfers to avoid telling the market what they're selling or buying. But Russia collects some $12bn per month thanks to its oil and gas sales. Sterling's strength in the currency market says it can't all have been destined for Dollars or Euros.

All central bankers now share this headache. The BIS puts total worldwide currency reserves at $4.8 trillion...a full 11% of world GDP. When the Pound hits the skids which even Wall Street knows it must, soon the stampede out of Sterling will send the next-best- thing soaring. In fact, the glut of central bank Pound buying may in fact have already ended.

In October, the official data report, the largest buyers of British government bonds were private foreign investors rather than central banks. Okay, furtive officials in Beijing, Tokyo or the Kremlin may have placed those orders 'off book'. But if they have chosen to stop buying Sterling, they'll find the four other major currencies in a race to the bottom.

Japanese inter-bank lending pays less than 0.4% today.

Eurozone bankers have got all the Euros they want; the 'Esperanto Experiment' now yields two percentage points less than the Dollar. The Swiss France pays even less, and the Dollar itself...well, you already know how ugly the Dollar now looks.

What about the commodity currencies, Korean Won, or the newly convertible Russian Rouble? 'The BIS data suggest,' says the Bank's September Review, 'that at the margin [central bank] reserve managers have increased their holdings of Australian and Hong Kong dollars, Danish kroner and other currencies in recent years. The share of currencies other than the major five rose to 4% of deposits in 200506.'

But there's a snag. For while cash deposits of non-major currencies are easy enough to snap up, there aren't enough non-major bonds to go round. The Dollar, Euro, Yen, Sterling and Swiss Franc account for 83% of the world's debt issuance in total. Most likely that leaves non-major securities too tight. The big central banks can't seriously increase their holdings without freaking the market, most of all at the long-dated end where supply is tightest.

Alternative currencies

Finally, of course, there's gold. Since it pays no interest in a world always seeking out yield, it now accounts for just 0.5% of all government reserves by value. But now the 5 major currencies all look as bad as each other, then who knows? Gold might just find favor...most especially in Asia.

'It is unfortunate how much [India] has lost by...holding on to the antiquated belief that gold transactions in the market by the Reserve Bank of India are bad, while frequent transactions in USD, Euro, Yen and Sterling are good,' said former RBI Deputy Governor S.S.Tarapore late in November. 'Gold is unique, in the sense it is both a commodity and a store of value...

'More importantly,' he went on, 'gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum. Thus, there are strong reasons for holding a reasonable proportion of Indian foreign reserve exchange reserves in gold.'

Central bankers in gold buying shock? 'The week ended the 22nd December saw one of the signatories of the Central Bank Gold Agreement sell and another BUY gold leaving a net sale of 2.7 tonnes of gold,' gasps Julian D. W. Phillips at GoldForecaster.com. 'It seems that we are seeing a change in policy by European Central Banks...The information is huge...It is deeply significant that a European Central Bank (not just one of the Arab or Asian banks) should actually buy gold.'

Further east, and the Russian central bank raised its gold holdings by 2.2% to more than 394 tons in the third quarter, according to the World Gold Council. China should also increase its gold holdings, according to an article published in the state-run newspaper The People's Daily at the start of December. Gold makes up 1.3% of China's vast foreign currency reserves. That's lower than the 3% benchmark used by other nations, says Gao Jie, a professor at the University of International Business and Economics.

Trouble is, China can't switch much of the $1 trillion it holds into gold without squeezing the market so tightly, the price would explode.

Doesn't mean it won't try though. Who knows what 2007 might bring in the race to flee the US Dollar...?

By Adrian Ash for The Daily Reckoning. You can read more from Adrian and many others at www.dailyreckoning.co.uk

Editor's Note: City correspondent for The Daily Reckoning in London, Adrian Ash is head of research at BullionVault.com - giving you direct access to

investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.