When FX reserve is politicized
ON March 16, Russia made a $117-million coupon payment on two sovereign Eurobonds. The move averted the first default of external Russian sovereign bonds since 1918 during the Bolshevik Revolution. The near default is unimaginable when one looks at the fundamentals of the Russian economy. The country runs a current account surplus of $120 billion in 2021, outstanding foreign currency debt is only $40 billion, and it holds $643 billion foreign exchange (FX) reserve at the end of February 2022, the fourth largest in the world.
The unexpected freezing of the Russian FX reserve caused this near-meltdown of Russian international credit. It caught the Central Bank of the Russian Federation (CBRF) off-guard. It is reported that nearly $300 billion of the Russian reserve is being frozen now in the sanctioning countries. Only its reserve in the Chinese renminbi of $95 billion, funds kept in other developing countries and gold are still available for use to CBRF.
Unprecedented politicization of FX reserve
A series of financial sanctions were imposed on Russia after the outbreak of the Ukraine War. First, a dramatic expansion of sanctions against key Russian government officials and prominent businesspeople perceived supporting Putin. Second, a series of sanctions against seven individual Russian banks representing about a quarter of the Russian banking system, including the disconnection from the international interbank messaging system SWIFT. Third, freeze CBRF international reserves in the US, the EU, Japan, Australia and Switzerland. These sanctioning jurisdictions cover all the core reserve countries in the World, sans China. Fourth, the Bank for International Settlements (BIS), based in Switzerland, known as the central bank for central banks, has suspended Russia from using its services. In addition to these governmental decisions, some key financial firms such as VISA and Mastercard are restricting their Russian services and adding to the disruption to the Russian economy.
Of all the measures implemented thus far, the CBRF-targeted sanction is the most unexpected; its effect is systemic and likely caused the most harm to the Russian economy. In response to the freeze of foreign exchange reserves, CBRF raised the benchmark interest rate to an unprecedented 20 percent from 9.5 percent before the war and closed the Moscow Stock Exchange from February 24 to March 20. The market reopened on March 21, but the trading is limited to government bonds. The ruble exchange rate dropped from RUB80.42 to $1 before the war broke out on February 24 to RUB107.50 on March 19. CBRF Governor Elvira Nabiullina said the economy is entering a large-scale structural transformation. All companies are experiencing disruptions in production and logistic chains in their settlement with foreign counterparts.
In the past, the United States sanctioned other central banks such as Venezuela and Iran in 2019. Still, coordinated action by all Group of Seven (G7) jurisdictions against a central bank, let alone one as large and internationally active as the CBRF, never happened. None of the 63 central banks members of the BIS in Basel has ever been the target of financial sanctions. The CBRF is not only a member of the BIS club but also of its more exclusive subsets, the Financial Stability Board and the Basel Committee Banking Supervision. The BIS sanction has no precedent since its establishment in 1931, even during World War 2.
Purpose of FX reserve
FX reserves generally refer to readily safe external assets holdings of a country. They composed mainly foreign currency deposits overseas, gold, IMF Special Drawing Rights (SDR). The reserve is one of the most important macro policy toolkits of any country.
The FX reserves are generally held for traditional operational purposes and precautionary policy objectives. Traditional operational purposes include facilitating regular international debt and import-related payments, serving as collateral to relax external borrowing constraints, or underpinning monetary policy for liquidity operations. From a precautionary perspective, countries hold reserves as a self-insurance against the balance of payment (BOP) shocks, including sudden stops in international capital flows, providing foreign currency liquidity to banks in stressed situations, and mitigating volatility in foreign exchange markets.
Global economic crises often trigger new thinking on FX reserves. For example, the 1998 Asian Financial Crisis prompted many developing countries to build their reserves as the key to self-insured against BOP shock. As a result, total FX reserves held globally increased to over $11 trillion at the end of 2018, a tenfold increase from 30 years ago. The latest IMF figure shows a total foreign exchange reserve of more than $ 12.25 trillion at the end of 2021. Around two-thirds of global FX reserves are held by emerging and developing economies.
The Russian freeze quickly prompted questions about whether targeting reserve holdings as an act of ‘economic warfare’ may prompt a rethink by reserve managers across the globe — not least in countries that may be at loggerheads or face a potential conflict with the US or the EU governments — over where to place their national reserve.
Even the Chinese government bond is the natural destination of any funds shifting out of the West; it is not as large or liquid — or as free from market or credit risk — as the US Treasury or core EU sovereign debt markets. More importantly, Beijing is deliberately slow to liberalize its financial markets to attract foreign funds. It has only taken about a quarter of the 10 percent share of world reserves ceded by the US dollar since 2000, with most of the diversification going to the euro.
But the lack of short term choice does not mean to say there will be no long term impact. Recent anecdotal and research-based evidence suggests that geopolitical considerations may already impact reserve management decisions even though the market has not witnessed any shift thus far. The current dollar-centric reserve system stays on from a lack of alternatives, and to keep it requires a sound US economy with a strong external position in the long run. Unfortunately, the current trillion dollar size current account and the federal deficit are running against what a global anchor currency needs.
Noted Berkeley reserve management expert, Barry Eichengreen, reckons that of the two imperatives behind reserve stockpiling — traditional operational purposes and precautionary policy objectives, the latter may now be in question. He posited that the main effect on the geopolitical intrusion into reserve management is to cut demand for reserves and cause higher volatility in the exchange rate.
Eichengreen recommends that countries strengthen their financial systems and economies against exchange rate-related disruptions by discouraging corporations from borrowing foreign currency. That could profoundly impact world markets and the financing model for emerging markets and developing economies. The cutting of reserves will also hurt the demand of the US dollar and cut its “exorbitant privilege.”
Sanctions on FX reserves carry many unforeseen consequences to the global economy, and they are still playing out; all governments worldwide must stay alert to, and start adjusting to it.
Dr. Henry Chan is an internationally recognized development economist based in Singapore. He is also a senior visiting research fellow at the Cambodia Institute for Cooperation and Peace and adjunct research fellow at the Integrated Development Studies Institute (IDSI). His primary research interest includes global economic development, Asean-China relations and the Fourth Industrial Revolution.
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