Author: Editorial Board, ANU
Policymakers have spent decades trying to stop financial crises. After Russia’s invasion of Ukraine, those in the United States, Europe and their partners have been trying their best to start one. Starting a financial crisis is a bit like starting a house fire. It involves four basic steps: take away the fire extinguishers, douse the place in petrol, light a match and retreat to a safe distance.
Removing the fire extinguishers is the logical first step. There’s not much point starting a fire if it can be put out before it gets going. In the context of a financial crisis, this means removing Russia’s access to its foreign exchange reserves and stopping them from acquiring more.
Foreign exchange reserves are vital for stopping a financial crisis. If investors start fleeing a country, its currency falls in value. This makes it much more expensive to import not just consumer goods but also vital materials for production and, more importantly, it increases the amount of domestic currency required to repay foreign currency-denominated debt. This can cause the banks, businesses or households which hold foreign debt to default, triggering rolling crises across the economy.
Russia had amassed more than US$630 billion in foreign exchange reserves to try to ensure that in the event of shocks like Western sanctions it could continue to trade freely and defend the value of the ruble. Russian authorities, however, mistook the difference between ‘ownership’ and ‘control’ of these international assets
Even though Russia owned US$630 billion of foreign exchange reserves prior to the onset of the war, it only controlled a fraction of them. Much of the stockpile was held in international assets controlled by the United States which promptly froze them. Russia’s available foreign exchange reserves plummeted by at least 60 per cent, severely limiting its ability to protect its currency and ward off a financial crisis.
Russia’s primary source of foreign exchange is its exports of oil, gas and other resources. It can access emergency foreign exchange reserves through the IMF, through a currency swap arrangement with China, through a US$100 billion bailout fund with the ‘BRIC’ countries (Brazil, Russia, India and China) and by selling its 2300 tonnes of gold or other state-owned assets.
These sources of foreign exchange need to be cut off if the West is to create maximum pressure on Russia’s financial system. The US Government effectively controls the IMF, and its measures to block purchases of gas and resources, freeze assets and block sales have made it hard for Russia to sell goods, services and assets.
The biggest challenge has been China, followed by India, who could provide Russia with foreign exchange through the BRIC bailout fund, through a bilateral currency swap line, or by buying Russian exports and assets. European dependence on Russian energy supplies has also provided Moscow with substantial breathing space.
The West is doing better in triggering if not a full-blown banking crisis, at least a situation of grave difficulty. It has blocked access for many Russian banks to the SWIFT system — the system used for effecting international payments. This makes it difficult for these banks to borrow internationally to build their buffers should Russians start withdrawing their savings. Moscow has been forced to respond by merging several state-owned banks, among other measures. Tellingly, the quarterly report on the banking sector from the central bank omitted its usual statistics on banking sector profitability.
Blocking access to foreign exchange has triggered higher interest rates in Russia. This is a key trigger to a debt crisis as it becomes increasingly difficult for banks, businesses, and households to service their debts.
Putin’s actions have themselves contributed to plummeting confidence in the Russian economy. Threats of nuclear war, breaches of cease fires, incoherent media appearances, and threats of long-term consequences for the West are ways to throw a match onto the pile of financial fuel. Any lingering doubts about whether Putin is a sage geopolitical strategist should have now been dashed.
Having the ability to trigger a financial crisis in Russia does not necessarily mean it’s a good idea. Is there such a thing as a ‘safe distance’ in a globally interconnected world? What will be the consequences of the west’s attempts to trigger a financial crisis?
These are the questions explored by Barry Eichengreen in our lead essay this week. What will be the reaction of China and of other countries worried about similarly being on the out with the United States? Will they shift their foreign exchange reserves away from US Treasury bonds? Will they reduce their reliance on the dollar and US banks? Will they curtail their commercial and technological dependence on the United States, cutting supply chains and reshoring production? Will the global economy be reconfigured into rival blocs?
‘The answer to these questions is no’, says Eichengreen. Eichengreen argues that Russia and China have been moving some way in the direction of decoupling from the West, but there is little evidence that this will accelerate following the sanctions against Russia.
The dominance of the US dollar has indeed fallen. As Eichengreen shows, the share of the dollar in foreign exchange reserves has fallen from around 70 per cent of the global total at the turn of the century to less than 60 per cent today.
But most of this movement has been toward the currencies of small, open economies with strong policies, such as the Canadian and Australian dollars, South Korean won and the Swedish krone — countries which are also sanctioning Russia. ‘This means that Russia and other countries contemplating a scenario in which they find themselves in the same position’ warns Eichengreen ‘cannot hedge against sanctions risk by shifting from the dollar into other Western currencies’. Gold and the renminbi aren’t substitutes, either, and don’t expect alternative payment systems to be readily available, warns Eichengreen.
What does this mean for Taiwan? ‘If sanctions on Russia will not break the world economy into Western and Eastern blocs, a Chinese incursion into Taiwan most certainly would’ says Eichengreen. Sanctions, frozen reserves and the exclusion from the SWIFT payments system ‘would be an economic catastrophe for China and the world economy’ warns Eichengreen ‘and Chinese officials know it’. ‘Taiwan can derive at least some comfort from the fact that President Xi Jinping evidently cares more about the health of his economy than does President Putin’.
If China starts trimming its US dollar reserves, it could be an indication that it is preparing for sanctions, or it could be an unrelated attempt to better diversify those assets. ‘Either way’ suggests Eichengreen, ‘it is important to keep a watchful eye’. There is every sign that China’s assessment of these international trade and financial circumstances is carefully calculating the risks.
The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.
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