Russia’s invasion of Ukraine has exposed some deep fault-lines in the global economic system. By freezing half of Russia’s foreign exchange, or forex, reserves, the West has declared economic war with central bank assets as the target. Russia had amassed $640 billion in forex reserves but now finds itself left with only gold and assets in other denominations, such as the Chinese renminbi.
Twelve years back, economist Raghuram Rajan had warned about this in his book Fault Lines: How Hidden Fractures Still Threaten the World Economy. One of the issues Rajan flagged was developing countries building up huge foreign exchange reserves that are invested in US assets. This was made possible by the debt-financed consumption model of the US and the US dollar being a safe-haven currency.
The US dollar emerged as the global currency after the Second World War due to the country’s economic and military might. Because the US dollar is the global currency, all prudent central banks of the world keep a significant portion of their forex reserves in US dollar-denominated instruments (for example, treasury bills, government bonds or simply deposits). Many people are unaware that these forex reserves of various central banks are actually held with the banking system of the US and not in the respective central banks’ own vaults. Apparently, the Reserve Bank of India does the same but does not publicly disclose the details of its holdings. Most other ‘safe’ alternatives also lie in the West.
Also read: SWIFT restrictions on Russia likely to help boost China’s digital yuan, weaken dollar clout
The risk to developing countries
Besides US dollar, forex reserves would invariably include euro, pound, franc and yen-denominated instruments issued by advanced economies. All these countries are at the heart of the global financial system.
After the Second World War, these countries had espoused democratic values and relentlessly fought Communism. Together, we may call them the West (or OECD countries), even if they include countries that are far apart (Japan, Australia and New Zealand). Some of these countries have even colluded to manipulate the value of the US dollar in the past (the Plaza Accord of 1985 and the Louvre Accord of 1987) to benefit themselves without giving a hoot about its consequences for developing countries.
The Ukraine war has exposed the imbalance in the global financial system run primarily by the West. When the West decides the course of a currency, others must take it as given. When the West imposes sanctions, others must follow the diktat even to the detriment of their interests. And sanction means all of one’s accumulated assets can be frozen by the West, as Russia has experienced and others are realising can happen to them too.
From the perspectives of the developing countries, it is time to ask the question: How safe are the developed countries as investment destinations for foreign currency earned through export earnings, inward foreign investments or remittances? If one falls out of favour with the West, is there a risk of forex assets getting frozen at a moment’s notice? War and internal strife are not uncommon in today’s world. The West often takes sides in civil wars and domestic discords. History suggests that the West may not always prefer a democratic leader in other countries even though they espouse the values of democracy at home. The future is uncertain and assessing political risk of central bank assets is extremely important.
Why do central banks hold forex assets at all? It is necessary for facilitating international economic transactions such as imports, overseas travel or outward investments. Second, the forex assets can be deployed in times of crisis when there is a sudden outflow of foreign currency due to economic crisis, war or other shocks. Third, keeping a war chest of forex reserves sends out a signal of strength that prevents speculative attacks on the domestic currency. But all this comes to nought if the forex reserves get ‘demonetised’ by the West as has happened to Russia.
Also read: Do sanctions work? Lessons from Russia, Iran and US ‘War on Terror’
Indian rupee has an opportunity
The Ukraine war has exponentially raised the risk for central banks holding massive forex assets. A golden rule of risk management is portfolio diversification. This means almost inevitably, many developing countries will silently move away from the assets held in the West and invest in other countries, especially friendly economies. The change may not be immediate, but a slow and calibrated one. This is precisely what Russia did by increasing its investments in Chinese renminbi and gold because they correctly anticipated the West’s actions. Media reports suggest that Israel and India have also reduced the share of US dollars and euros in their forex portfolio over the last six months.
What could be the implications of these movements? If there is reduced demand for US dollar, euro, and other ‘global’ currencies, either the interest rates of these developed countries have to rise to make the currencies more attractive (but will cause an economic slowdown) or there will be a depreciation of these currencies in the international market, yielding more purchasing power to the developing countries. A lot depends on which way some influential emerging market economies like China would go.
Also, we could see the emergence of more regional trade and investment blocks. Within these blocks, trade may happen in the currency of the most influential member country. For example, within SAARC, India and its rupee could be a natural choice. Globally too, countries may choose different currencies as mediums of exchange. Already Saudi Arabia is contemplating a yuan-based trade with China. India has recently entered into an agreement to buy oil from Russia in rupees and allow Russia to invest that money in Indian bonds. In the long run, there is a strong possibility that there will be more trade through other currencies. Chinese renminbi could be a big gainer. Even the Indian rupee could benefit if India highlights its soft power and remains committed to peace and stability, both internally and with the external world.
Also read: India shouldn’t fall for Putin’s rupees-for-rubles deal despite tempting discount on oil
Dislodging US dollar
Among other options, we may see central banks holding higher gold reserves as it is the only physical asset that is universally accepted. Though it seems unlikely today, we may also see the emergence of innovative assets like oil and metals (like copper or aluminium) in central bank portfolios. Cryptocurrencies being highly volatile at the moment do not seem like an option, but could be chosen in the distant future if they stabilise and gain acceptance. The International Monetary Fund’s Special Drawing Rights could also become a favoured option as long as it does not get captured by US political priorities. Either way, the demand for US dollars will decline.
Whether the Ukraine war has the potential to dislodge the US dollar as the global currency or not, only the future can tell. However, the war can give a big jolt to the US dollar exposing the fault lines in the global economy, perhaps leading to a crack this time. In a war, nobody wins. Even those who are far apart and are actively encouraging one of the fighters may not. This applies to the West as well. If the West wants to espouse the spirit of democracy, its own power to influence the global system must come down. Democracy is about sharing power. Any large power asymmetry in the world and articulation of democracy without concomitant action does not go together.
In Meditations XVII, John Donne famously said, “No man is an island, entire of itself.” What applies in the case of a man, applies more in the case of a nation. In the globalised world, any war in any part of the world has implications for all nation-states. The war in Ukraine will be no exception.
Kaushik Bhattacharya and Rudra Sensarma are Professors of Economics at Indian Institute of Management Lucknow and Indian Institute of Management Kozhikode, respectively. Views are personal.