Author: Editorial board, ANU
Policymakers have spent decades trying to stop financial crises. After Russia invaded Ukraine, those in the United States, Europe and their partners did their best to create one. Triggering a financial crisis is like starting a fire. This involves four basic steps: removing fire extinguishers, douse the area with gasoline, strike a match, and retreat to a safe distance.
Removing fire extinguishers is the logical first step. There is no point in starting a fire if it can be put out before it starts. In the context of a financial crisis, this means removing Russia’s access to its foreign exchange reserves and preventing it from acquiring more.
Foreign exchange reserves are vital to stem a financial crisis. If investors start fleeing a country, its currency will lose value. This makes it much more expensive to import not only consumer goods but also materials vital for production and, more importantly, it increases the amount of national currency needed to repay debt denominated in foreign currency. This can cause the banks, companies or households that hold the external debt to default, triggering continuous crises throughout the economy.
Russia had amassed more than $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. However, Russian authorities have confused the difference between “ownership” and “control” of these international assets.
Although Russia had $630 billion in foreign exchange reserves before the war began, it only controlled a fraction of it. Much of the stock was held in international assets controlled by the United States, which quickly froze them. Russia’s available foreign exchange reserves have fallen by at least 60%, severely limiting its ability to protect its currency and avoid a financial crisis.
Russia’s main source of foreign currency is its exports of oil, gas and other resources. It can access emergency foreign exchange reserves through the IMF, through a currency swap deal with China, through a US$100 billion bailout fund with the “BRIC” countries (Brazil, Russia, India and China) and selling its 2,300 tonnes of gold or other state-owned assets.
These sources of currency must be cut off if the West is to exert maximum pressure on the Russian financial system. The US government effectively controls the IMF, and its measures to block gas and resource purchases, freeze assets, and block sales have made it difficult for Russia to sell goods, services, and assets.
The biggest challenge has been China, followed by India, which could provide foreign currency to Russia 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 respite.
The West is doing better by triggering if not a generalized banking crisis, at least a situation of great difficulty. It blocked many Russian banks from accessing the SWIFT system – the system used to make international payments. It is therefore difficult for these banks to borrow internationally to build up their reserves if the Russians start withdrawing their savings. Moscow was forced to respond by merging several state-owned banks, among other measures. Tellingly, the central bank’s quarterly banking sector report omitted its usual statistics on banking sector profitability.
The blocking of access to foreign currencies has led to higher interest rates in Russia. This is a key trigger for a debt crisis, as it becomes increasingly difficult for banks, businesses and households to service their debts.
Putin’s actions themselves contributed to the fall in confidence in the Russian economy. Threats of nuclear war, ceasefire violations, inconsistent media appearances, and threats of long-term consequences for the West are ways to throw a match into the pile of financial fuel. Any lingering doubts about whether Putin is a wise geopolitical strategist should have now been dispelled.
Having the ability to trigger a financial crisis in Russia doesn’t necessarily mean it’s a good idea. Is there a “safe distance” in a globally interconnected world? What will be the consequences of Western attempts to trigger a financial crisis?
These are the questions Barry Eichengreen explores in our main essay this week. What will be the reaction of China and other countries worried about also being on the sidelines with the United States? Will they divert their foreign exchange reserves from US Treasuries? Will they reduce their dependence on the dollar and on American banks? Will they reduce their commercial and technological dependence on the United States, cutting supply chains and relocating production? Will the global economy reconfigure into rival blocs?
“The answer to these questions is no,” says Eichengreen. Eichengreen argues that Russia and China have moved in the direction of decoupling from the West, but there is little evidence that this will accelerate after sanctions on Russia.
The dominance of the US dollar has indeed fallen. As Eichengreen shows, the dollar’s share of foreign exchange reserves has fallen from about 70% of the world total at the turn of the century to less than 60% today.
But most of that movement has been to currencies from smaller open economies with strong policies, like the Canadian and Australian dollars, the South Korean won and the Swedish krona — countries that also sanction Russia. “This means that Russia and other countries considering a scenario in which they find themselves in the same position” warns Eichengreen “cannot protect themselves against the risk of sanctions by switching from the dollar to other Western currencies”. Gold and the renminbi are also not substitutes, and don’t expect alternative payment systems to be readily available, warns Eichengreen.
What does this mean for Taiwan? “If sanctions against Russia don’t divide the global economy into Western and Eastern blocs, a Chinese incursion into Taiwan most certainly would,” Eichengreen says. Sanctions, frozen reserves and exclusion from the SWIFT payment system “would spell economic disaster for China and the global economy,” Eichengreen warns, “and Chinese officials know it.” “Taiwan can take at least some comfort from the fact that President Xi Jinping clearly cares more about the health of his economy than President Putin.”
If China begins to reduce its US dollar reserves, it could be an indication that it is preparing for sanctions, or it could be an independent attempt to better diversify these assets. “Anyway,” Eichengreen suggests, “it’s important to keep a watchful eye.” Everything indicates that China’s assessment of these international trade and financial circumstances carefully calculates the risks.
The EAF Editorial Board is located at the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.