20 May,2022.
Imagine you went to your friendly neighbourhood bank one day and asked to withdraw your savings and the bank manager said, “Savings? What Savings?” and simply refused to honour a bank’s commitment to provide you with your savings on demand. Apart from being justifiably pissed off with your banker you would also inform your neighbourhood about your banker’s antics. This is the classic example of what economists call a “bank run”. Neighbour after neighbour would then rush to the bank to redeem their own savings before it was too late thus driving the bank into bankruptcy and collapse.
Nations just like individuals need savings in their piggy banks to be able to manage the proverbial rainy day. These savings are called foreign exchange reserves and since they have to be maintained in foreign currencies, the piggy banks must be in the respective foreign countries that issue those currencies. In today’s world, 88 percent of international transactions are settled in US dollars, so common sense tells us that the preponderant foreign currency in which nations maintain reserves must be the US dollar and that national piggy banks are therefore situated in US treasury markets controlled by your friendly neighbourhood banker called Uncle Sam along with his trusty lieutenant, the Federal Reserve Bank of the United States of America.
Nations need these reserves mainly to balance payments of the country, control exchange rates of its currency in forex markets and maintain speculator confidence in its financial situation.
Asian Currency Crisis
The Asian Currency Crisis was a currency crisis that affected many countries in East and South East Asia in 1997 and was so severe that it threated a worldwide economic collapse resulting from financial contagion. Suddenly, what was until then famous as the Asian Economic Miracle turned into an Asian Economic Debacle and the until then roaring Asian Tiger Economies suddenly metamorphosed into the whimpering Asian Kitten Economies when these economies were unable to defend their currencies in foreign exchange markets as a result of inadequate foreign exchange reserves to provide the requisite financial fire power for credible intervention by their central banks in foreign exchange markets.
The resulting chaos and political churn forced most countries in the world to reassess the adequacy of their reserves and prompted a sharp generalized increase in worldwide reserves to the US$13 trillion or 15% of world GDP that it is today. Nations hoped that bloated reserves would convince the foreign exchange markets that they had sufficient financial fire power to bring foreign exchange markets to heel in the event of any crisis. This of course is a pipe dream considering that daily turnover in world foreign exchange markets is in the region of US$7 trillion per day and any sovereign reserve is puny in comparison – but central banks with bigger guns however inadequate do command additional respect in financial markets.
Russia-Ukraine War
But then a nation’s piggy bank is only as good as its piggy banker and in this case that banker mostly happens to be the US government. This is because about 88 percent of international transactions are denominated in US dollars which is the de facto world reserve currency.
The US government has an illustrious history of wielding the sanctions bazooka to force other governments all over the world to do its bidding against their will. The sanctions bazooka has generally proved to be an effective but ineffective weapon because it succeeds in inflicting pain on the victim nation and its citizens but has generally failed to force the victim nation into what the US government would consider good behaviour. Think Iran, Venezuela, et al.
If 88 percent of international transactions are denominated in US dollars, it is reasonable to expect that 88 percent of worldwide reserves should also be denominated in US dollars. However, only about 60% of these reserves are actually in US dollars. Perhaps, nations considered it prudent to limit their exposure to US dollars considering Uncle Sam’s propensity to use the sanctions bazooka.
But in its sanctions against Russia as a result of the Russia-Ukraine war the US government has transformed its erstwhile relatively humble sanctions bazooka into the financial equivalent of a nuclear tipped intercontinental ballistic missile. The US government has cut off Russia’s access to its entire reserves amounting to about US$ 630 billion. Furthermore, the US government has pressured all other nations to prevent Russia from accessing its reserves in any other currency. In other words, the US government has effectively nationalized Russia’s reserves.
Nervous reserve managers all over the world must surely take note of these developments. It is clear that when a nation needs its reserves, it may not have them depending on the whims and fancies of the US government. It is also clear that, diversification of these reserves into several currencies will not save them. Also, paradoxically, greater the reserves, greater the risk.
Financially MAD?
One reason why the Cold War never became a Hot War was the doctrine of Mutually Assured Destruction (MAD) – the military doctrine that asserts that use of nuclear weapons by any side in a conflict would guarantee annihilation of both the attacker and the attacked because of the certainty of retaliatory strikes. In other words, nuclear weapons are strictly for show and can never be used in actual combat because of MAD. Could MAD apply in the case of the financial equivalent of nuclear war?
One nation’s reserves are the other nation’s debt and in this case that other nation is the United States of America. Out of the US$13 trillion in worldwide sovereign reserves US$ 7 trillion are in US dollars and therefore represents 26% of the US government debt of US$ 27 trillion which is 130% of US GDP.
The US government has now bared its fangs and let the world know that sovereign reserves are reserves only at the pleasure of the US government and that sovereign reserves are therefore a gun in the US government’s hands pointed at the sovereign’s head. That gun grows bigger and bigger with the addition of every dollar into sovereign reserves. Nations are playing Russian roulette with bigger and bigger guns by continuing to deposit their hard earned savings in US treasury markets.
What if those other nations come to the inescapable conclusion that Russian roulette does not suit their risk appetite and decide to wind down their reserves in US treasuries? That would lead to a severe spike in US interest rates and send an already stressed US economy into a tailspin from which it is unlikely to recover any time soon – unless the US government clamped down on the sale of US treasuries by foreign entities. That kind of haircut would have the effect of reducing US government debt by 26% and bring it down to around 95% of US GDP. In other worlds, Uncle Sam will be literally laughing all the way to the bank.
But surely the days of unlimited credit from the rest of the world to the US government may be grinding to a permanent halt with grave consequences for the US economy. In retrospect, the US decision to usurp Russia’s reserves might just turn out to be financially MAD.
