On March 16, Russia made a US$117 million coupon payment on two sovereign Eurobonds. The move avoided the historic default of external Russian sovereign bonds since 1918 during the Bolshevik Revolution. However, the near default is unimaginable a month ago when one looks at the foreign currency debt of Russia is only US$ 40 billion, and the country holds the fourth largest foreign exchange (FX) reserve in the world, amounting to more than US$ 643 billion at the end of February 2022 (China, Japan & Switzerland are the three largest foreign exchange holders in the world, with the latest reserve figure at US$ 3.40 trillion, US$ 1.41 trillion and 1.11 trillion respectively).
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 US$ 300 billion of the Russian reserve is being frozen now in the sanctioning countries. Only the reserves in the Chinese Renminbi of US$ 95 billion and elsewhere are still available for use to CBRF.
Ukraine War sanctions:
A series of financial sanctions were imposed on Russia after the outbreak of the Ukraine War. First, freezing the assets in sanctioning countries against hundreds of senior Russian officials, legislators and business people perceived close to Putin. Second, a series of sanctions against seven individual Russian banks representing about a quarter of the Russian banking system, including the disconnection from SWIFT, the international interbank messaging system based in Belgium under E.U. jurisdiction. Third, freeze CBRF FX reserve in the U.S., E.U., 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 the past, the United States sanctioned Venezuela and Iran central banks 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 Bank for International Settlements (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 II.
Purpose of FX reserve:
FX reserves generally refer to readily available safe external assets of the country’s central bank or finance ministry. They composed mainly foreign currency deposits overseas, gold, IMF Special Drawing Rights (SDR).
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. The reserve is one of the most important macro-policy toolkits of any country.
Global economic crises often trigger new thinking on foreign exchange 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 USD 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 US$ 12.25 trillion at the end of 2021. Around two-thirds of global foreign currency reserves are held by emerging and developing economies. The FX buildup helped to cushion the inflationary impact of the Quantitative Easing (QE) following the 2008 Global Financial Crisis (GFC).
Freeze impact on Russian economy:
In response to the freeze of foreign exchange reserves, CBRF raised the benchmark interest rate to an unprecedented 20% from 9.5% earlier. The ruble exchange rate dropped from 80.42 to one US dollar before the war broke out on February 24 to 107.50 on March 19. The freeze is a huge blow to Russia’s economy, and inflation rises to a seven-year high of more than 12.5% by March 11. Governor Nabiullina of CBRF said the economy is entering a large-scale structural transformation. All companies are experiencing disruptions in production & logistic chains in their settlement with foreign counterparts.
An uncertain world on FX reserve management after Ukrainian war:
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 U.S. or EU governments – over where to place their national reserve.
Recent anecdotal and research-based evidence suggests that geopolitical considerations may already impact reserve management decisions even the market has not witnessed any shift thus far.
Most experts agreed there’s simply no real alternative at the moment for most countries. The G7 bond markets are stable to the talk of reserve management shifting away from the G7 capital market thus far. Even though 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 U.S. Treasury or core EU sovereign debt markets. More important, Beijing is deliberately slow to liberalize its financial markets and attract foreign funds. The country intervenes to support its economic priorities frequently and has only taken about a quarter of the 10% share of world reserves ceded by the U.S. dollar since 2000. Most of the shift out of dollar went to euro.
But lack of short-term choice does not mean to say there will be no long term impact. The current dollar-centric FX system stays on lack of alternatives, and to keep it stable in the long run requires a sound U.S. economy with a strong external payment position. Unfortunately, the current trillion-dollar size current account deficit and the federal budget deficit are running against what a stable global anchor currency needs.
Noted Berkeley expert on world reserve management, 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.
Cutting foreign exchange buildup when countries perceive that FX reserve is less useful will result in a more volatile exchange rates environment. Therefore, countries must strengthen their financial systems and economies against exchange rate-related disruptions by discouraging corporates from borrowing foreign currency. That could profoundly impact world markets and the financing model for emerging markets and developing economies.
Former Goldman Sachs global economist Jim O’Neill said it could ultimately lead to a major reform of the global system when countries see less need to accumulate FX reserves and force some of the bigger emerging markets to reform, focus on domestic growth and move away from the U.S-centric system.
Most economists agree that FX reserve changes will inevitably come, and the consequences are hard to predict. The big question is when the reserve managers will start their FX reserve changes and how the moves will affect the world’s financial markets. Any disorderly change of the global FX reserve system will significantly hurt the world economy.
Dr Henry Chan
Senior Visiting Research Fellow
Cambodia Institute for Cooperation and Peace, Cambodia
Mar 2022