Editors' note: This column is part of the Vox debate on the economic consequences of war.
Following the invasion of Ukraine, the sanctions taken against Russia have been unprecedented in scale and, above all, in scope. For the first time in recent history, the foreign exchange reserves held by a major central bank have been frozen. Reactions by Russian authorities show that this was totally unexpected on their part (Berner et al. 2022). This column presents some preliminary thoughts on the potential long-term and systemic consequences in a context of geopolitical rivalry and increasing ‘deglobalisation’, at least in respect to financial transactions.
Sanctions and the dollar
A first question to consider is whether the status of the dollar as the dominant international currency could be put in doubt or risk. Our answer is negative for three reasons.
- The freeze is taking place in a situation that may be perceived as truly exceptional: an armed conflict triggered by the invasion carried out by a major country. No one would expect standard financial relations and arrangements to hold in those circumstances. In comparable situations, such as Japan’s war in Asia from 1937, cross-border payments were eventually blocked. Gold owned by countries occupied or in war was not handed over to the aggressor by the central banks that held it. Thus, France and Britain refused to hand over the reserves of the Baltic countries annexed by the Soviet Union in 1940. These are extreme and rare circumstances.
- All actions taken by the US authorities over the last decades demonstrate their commitment to promote and preserve the dollar as a safe asset. Numerous facilities have been deployed by the Federal Reserve to ensure the liquidity of the Treasury market – some of them specially designed for official foreign holders. The implicit government guarantee benefitting Fanny Mae and Freddie Mac (which serve as a major instrument of foreign exchange reserves) has been reaffirmed when necessary. With the possible exception of the Trump administration, successive US Treasury secretaries have been adamant that “a strong dollar is in the interest of the United States”.
- Finally, attractive alternatives to the US dollar do not exist and hence no realistic diversification instrument is available. The power of the US to impose sanctions derives directly from the central role of the dollar. For any international corporation or financial institution, life without the dollar is currently impossible. Therefore, any of their operation falls potentially under US jurisdiction. All will remain under the reach of sanctions so long as the dollar remains essential. Avoiding and resisting sanctions means finding alternatives to the dollar. We are therefore drawn back to an old, and still very acute question: are there such alternatives?
International money, old and new
Money is about scale and externalities. They come in two forms: network externalities – the more people accept a currency the better it is as a medium of exchange; and liquidity externalities – a true store of value remains tradable and valuable in times of need (Brunnermeier et al. 2022). In the current world economy, a crucial question concerns the causality between those two functions.
The dominant currency paradigm (Gopinath and Stein 2021) mainly attributes the essentiality of the dollar to its role in global payments and finance – emphasising the medium of exchange role and its function as a vehicle currency for international financial flows. In the same vein, Eichengreen (2010), based on his analysis of history of the interwar period, sees a logical sequencing in the emergence of a global currency: (1) invoicing and settling trade, (2) use in private financial transactions (vehicle currency), (3) use by central banks as reserves.
If that sequence is still valid, there are real prospects of alternative reserve currencies emerging. China is the world’s major trading power. It has leverage to push for the use of its currency as a medium of exchange and unit of account. It could exploit its advance in the development of digital currencies. A possible scenario would see both Alipay and Tencent expand their international operations, progressively shifting their denomination from local currencies to the renminbi. China is the most advanced in developing a central bank digital currency. The introduction of the e-yuan, already past its pilot phase, is often interpreted as an offensive move to promote the RMB internationalisation.
Another, somehow opposite, approach attributes the dollar dominance to its unique role as a store of value, being the ultimate safe asset. There is nowhere else to park several hundred billion with almost total security and liquidity. That function is central in a financially globalised world where both private and public entities must protect their liquidity. From that role as a store of value, other functions derive, reversing the causality that may have prevailed in other periods. Because it is a reserve asset, it is convenient to also use the dollar for invoicing and payments. It serves as a global unit of account. Significantly, even China overseas lending by official entities is still 70% denominated in dollars and only 10% in renminbi.
If, as we think, that second approach is correct, no other money is positioned to dislodge the dollar in the foreseeable future. Being a reserve currency certainly brings privileges and power. It is also very demanding. Two major requirements must be met, which no other country can do: a large and liquid Treasury bond market (which Europe does not currently have) and a fully and unconditionally open capital account (which China will not have). Localised swap and barter agreements, such as developed by China, can help but will not dispense of those two basic requirements. (A columnist recently remarked that a credit line in renminbi is financially equivalent to being fluent in Esperanto).
A quick look at other possible mentioned alternatives confirms that diagnosis:
- Currencies such as the Australian dollar are mentioned as possible reserve instruments.1 While fully open and accessible, the size of the Australian Treasury Bond market is only 2.5% of the US.
- There have been recurrent attempts to make the Special Drawing Rights into a genuine alternative to reserves – a course actively promoted by China in the aftermath of the Global Crisis (Zhou 2009). They have largely stalled, for reasons of size and accessibility (the possible use of Special Drawing Rights is closely restricted by design).
- Some observers stress the potentialities of cryptocurrencies, pointing to their role to channel funds to Ukraine after the Russian invasion (Danielsson 2022). However, they have no ability to process transactions on a large scale (daily amounts mentioned in relation with Ukraine are in the tens of millions of dollars). Despite some fascinating technological features, cryptocurrencies are even further from having any significant role as reserves. Managers are aware of the peculiarities of these money systems. Their day-to-day functioning relies on the initiatives and incentives of private operators, whose activity is purely voluntary and profit-motivated. It is doubtful that they would entrust public reserves to groups of ‘miners’ scattered all over the world, with a non-negligible proportion having migrated to Kazakhstan after having been prohibited to operate in China.
Globalisation and the demand for reserves
Sanctions may still have significant longer-term effects – not on the composition, but on the demand for reserves. The international monetary system may ultimately adjust by moving to a new architecture, where financial integration is reduced and, consequently, the need for reserves is smaller.
Leaving aside the reciprocal relation between the US and China – famously qualified by Larry Summers as a “financial balance of terror” – it is useful to consider the situation
of other emerging countries. Around twenty countries have foreign exchange reserves above $100 billion, most of them emerging economies. Borrowing from the finance and climate literature, those countries clearly face a new ‘tail risk’ of sanctions, with a very low probability but very high impact. The same climate literature tells us that one cannot diversify against those risks. The only way to buy insurance is to reduce one’s exposure. In climate, it means bringing down CO2 emissions and concentrations to low levels. For emerging economies, it means reducing the need for (and dependence upon) foreign exchange reserves.
There has been a constant increase in foreign exchange reserves until 2015 and a plateauing since then. That evolution almost mirrors (with a lag of a few years) the trends in gross cross-border capital flows and international exposures, which expanded until 2010 and then stabilised as a consequence of the Global Crisis.
a) Foreign exchange reserves
Source: ECB Economic Bulletin issue 7/2019.
b) Gross international assets and liabilities
Source: Adler and Garcia-Macia (2018).
This is not a coincidence. With the exception of China, countries’ demand for reserves is a direct result of their financial integration with the world. Reserves are traditionally viewed as a tool for exchange rate management. But they play a broader role. In many emerging economies, the productive and financial sector is partially ‘dollarised’. As a consequence of capital account liberalisation, both corporate and financial institutions are able to borrow and lend in foreign currency. Consequently, they may be facing maturity and liquidity mismatch in dollars. Foreign reserves allow central banks in those countries to act as lenders of last resort in foreign currency and protect domestic, as well as external, financial stability. This is the fundamental reason why reserves have, over the two last decades, expanded to levels that are impossible to explain and rationalise by traditional metrics of trade and financial openness.
Those policy choices may well be reversed if and when reserves are carrying new risks. Financial globalisation had essentially come to a halt well before the invasion of Ukraine.
New forms of sanctions, even if very rare, may lead to a further retreat and segmentation of the world financial system (Harding 2022).
Ultimately, sanctions, and their implications, reveal a basic, and forgotten, truth: the movement towards greater financial globalisation has been underpinned by a long-term commonality of purposes, standards and understanding between countries. By supplying a reserve currency (and benefiting from it), by augmenting it in crisis moments such as 2008 or 2020 by swap lines, the US has provided the world with a global public good (Wolf 2022): widespread access to a safe asset, which can be used as a buffer against financial shocks. Whether that equilibrium can be preserved in a geopolitically divided world is a major question for the future.
Adler, G and D Garcia-Macia (2018), “The Stabilizing Role of Net Foreign Asset Returns”, IMF Working Paper WP/18/79.
Berner, R, S Cecchetti and K Schoenholtz (2022), “Russian sanctions: Some questions and answers”, VoxEU.org, 21 March.
Brunnermeier, M, S Merkel and Y Sannikov (2021), “Debt as Safe Asset”, NBER Working Paper 29626.
Danielsson, J (2022), “Crypto currencies and the war in Ukraine”, VoxEU.org, 11 March.
Eichengreen, B (2010), “The renminbi as an international currency”, policy paper.
Gopinath, G and J C Stein (2021), “Banking, Trade, and the Making of a Dominant Currency”, The Quarterly Journal of Economics 136(2): 783-830.
Harding, R (2022) “Toppling the dollar as reserve currency risks harmful fragmentation”, Financial Times, 10 March.
Landau, J P (2021), “International Currency Competition: the Digital Dimension”, Markus Academy.
Wheatley, J and C Smith (2022), “Russia sanctions threaten to erode dominance of US dollar, says IMF”, Financial Times, 31 March.
Wolf, M (2022), “A new world of currency disorder looms”, Financial Times, 29 March.
Zhou, X (2009), “Reform the international monetary system”, BIS Review 41/2009.
1 Gita Gopinath quoted in the Financial Times (2022).