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Towards a new monetary order?

The economic sanctions imposed on Russia by the West in retaliation for the invasion of Ukraine could prompt central banks to rethink their foreign reserve policy.

On February 14, the government of Justin Trudeau decided to impose financial sanctions on certain activists of the freedom convoy, a popular movement which blocked Ottawa to protest against the obligation to vaccinate against Covid-19. A few days later, Canadian police announced that more than 200 bank accounts linked to the protest movement had been frozen. This is an unprecedented event in a developed country with an unequivocal message: if the government does not like the way you use your money, they can decide overnight that you no longer have control. on your assets.

Two weeks later, a confiscatory decision of a completely different dimension was born: in retaliation for the invasion of Ukraine, the West decided to block the assets of the Russian Central Bank. Indeed, the United States, Canada, France, Italy, Germany and the United Kingdom want “to prevent the Russian Central Bank from deploying its international reserves in a way that undermines the impact of the sanctions. “. Half of the 630 billion dollars in reserves that could have been used by the Russians to defend the ruble (in free fall) and to recapitalize the local banks (cut off from SWIFT) are not accessible today in Moscow.

This is the first time that a G20 central bank has been sanctioned in this way. Russia is now a pariah of the international financial system, just like Iran, Venezuela or North Korea.

The Russian central bank holds more gold than US dollars.

The international monetary system

This extraordinary decision is likely to call into question the international monetary system which has been in place for more than 50 years now. As recently recalled by Gavekal, the financial order as we know it rests on the following foundations:

  • Energy prices and most world trade are denominated in US dollars;
  • The United States faces a structural current account deficit, which allows the rest of the planet to have access to the dollars needed for international trade;
  • Countries with a current account surplus invest their surplus dollars in US Treasury bonds as a reserve (a boon for the US budget which is also in structural deficit and therefore needs to be financed);
  • If necessary, the US Federal Reserve stands ready to inject dollars into the global system via currency swaps or directly into the US economy (which de facto benefits the global economy).

The hoarding of international currency reserves is a cornerstone of the current monetary system. World currency reserves have literally exploded over the past twenty years, from 1.8 trillion in the early 2000s to 12.8 trillion at the end of last year. These reserves are mainly held in the form of US and European government bills and bonds, with the US dollar still accounting for almost 60% of these reserves and the euro around 20%. As the chart below shows, global reserves stand at almost 15 trillion, as central banks also hold other assets such as gold – we’ll get to that.

Even if this system has created many excesses and disparities, it has worked rather well since the end of Bretton Woods, and in particular for Americans who have thus found a way to finance their twin deficits.

Chart: Official reserves held by central banks

(source: IMF)

Towards a new paradigm?

But for many observers, the fact that the West has chosen to freeze reserves in dollars (and in euros) will encourage some central bank governors to rethink the logic of building up reserves but also the merits of investing part of the balance sheet in US Treasuries. With negative real yields (-5% for the 10-year), US bonds have no other reason for being than the security they offer their holders. But if Washington can decide overnight to freeze dollars that a sovereign country thought were its own, the central bank governors of China, Pakistan, India, Turkey, Kazakhstan or Saudi Arabia aren’t they going to be incentivized to sell some or all of their dollars and diversify their holdings into other assets? Of course, the circumstances linked to this unprecedented decision by Western countries are quite exceptional and are not supposed to be repeated (at least we hope so…). However, this freezing of the assets of the Russian central bank could have the following consequences.

  1. Building up foreign currency reserves will lose some of its usefulness
    Two imperatives underlie the building of reserves: to intervene or stabilize national markets or to serve as a war chest in the event of an economic shock, natural disaster or balance of payments crisis. For Barry Eichengreen, professor at Berkeley and expert in the management of world reserves, it is the second which could be called into question with the effect of a drop in demand for reserves. With an important consequence: if sovereign states consider that reserves are less useful and/or less available, they will then have to accept the inevitability of a greater variation in their exchange rates.
  2. The urgency of reforms in emerging countries
    For Professor Eichengreen, the lessening of the role played by reserves will push States to strengthen their financial systems and make their economies less sensitive to disturbances linked to exchange rates, for example by discouraging companies from borrowing in foreign currencies. This in itself could have a profound impact on global markets and the pattern of emerging markets and developing economies.
    An opinion partly shared by Jim O’Neill, economist at Goldman Sachs. For him, this paradigm shift will push emerging countries to implement more reforms, open their domestic markets, liberalize their economies and somehow free themselves from their dependence on the American model.
  3. The decline of the dollar as a reserve currency
    This is a hypothesis put forward by Zoltan Poszar, a specialist in the monetary markets at Credit Suisse and a former employee of the Federal Reserve of New York. Historically, wars have often been a turning point for the forex market. Russia’s invasion of Ukraine and the sanctions that followed could indeed act as an electroshock. For Poszar, the accumulation of dollar reserves by central banks makes less and less sense. The Russian asset freeze will cause many central banks to diversify away from the dollar and re-anchor their local currencies to assets that are less likely to be influenced (or confiscated) by Western governments.
  4. A new monetary order
    Still according to Poszar, we could witness the emergence of a new monetary order where States would be much less interconnected via international bank accounts and reserves.
    To date, most reserves are made up of debts of states to others. This is the case, for example, for a central bank that holds US treasury bills or dollars deposited with JP Morgan. It is this type of asset that can indeed be seized or sanctioned.
    In the future, many states could be tempted to hold assets over which they can keep control in all circumstances – this is the case, for example, of gold held in a safe deposit box at a domestic bank.
    The temptation is therefore great for Russia, China and other emerging countries to peg their currencies to the gold standard, which would constitute a sort of return to Bretton-Woods. A 180 degree turn that would reduce the possibility for the West to use the dollar or the euro as an economic weapon.
    Note also that this dedollarization movement was initiated by Russia several years ago (cf. Allnews article “The world has changed”). Since the annexation of Crimea in 2014, Russia has gradually shed its US treasury bonds and reinvested its assets in euros, yuan, sterling and also gold. Moreover, the Russian central bank holds more gold than US dollars.

Chart: Breakdown of Russian central bank holdings by asset type and geography

(source: Bloomberg).

Which asset(s) to replace the dollar?

While many countries are probably tempted to reduce their dependence on the dollar and the euro, they nevertheless face a major problem: how and in what asset to reinvest the trillions of dollars currently held as a reserve?

Until the Ukrainian crisis, the euro was the main alternative to the dollar. But the alignment of the Europeans with the Americans during this conflict is not likely to reinforce the attraction of the euro for the States which want to free themselves from the type of risk discussed above.

The yuan is also one of the alternatives, and all the more so as China weighs ever more heavily in trade (see Allnews article “Chinese debt, a safe haven?”).

Gold is of course a natural candidate. Central banks have also accumulated an additional 463 tonnes of gold in 2021, bringing global gold reserves to around 35,600 tonnes, their highest level in nearly 30 years…

But gold as a reserve asset has its limits. First of all at the level of its market value, which today is approximately 12 trillion dollars, a small amount compared to the approximately 29 trillion dollars of annual commercial exchanges.

Another limitation of gold: it is not so simple to store and transfer it.

These limitations are all elements that lead some central banks to consider cryptocurrencies such as bitcoin as a possible reserve currency: limited supply (see Allnews article “What is rare is expensive”), decentralization, ease of storage and transferability are all elements that make bitcoin a candidate as a reserve asset for central banks. But this asset also has limits: market value even lower than that of gold, legal risk, high volatility, etc.

Even if the reserve diversification movement is underway, dedollarization cannot take place overnight. But it is very likely that the composition of central bank balance sheets will now be scrutinized even more closely by economists and governments alike, as the macroeconomic and financial consequences of a reallocation of assets could be considerable.

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