In The Economic Weapon: The Rise of Sanctions as a Tool of Modern War, historian Nicholas Mulder reminds us that even when Britain and Russia were savagely battling each other during the 1853-56 Crimean War, they continued to service their debts to each other. Likewise, when hedge funds launched predatory attacks on Asian currencies during the 1990s Asian financial crisis, they ultimately still played by the rules (even though their unethical behavior brought some East Asian countries’ economic progress to a halt).
The United States’ February 28 decision to freeze around half of Russia’s foreign-exchange reserves would seem to fall into a different category. Though the US has taken similar actions against Iran, Venezuela, and Afghanistan, Chinese economists thought those were exceptional situations and find it shocking that the US would carry out such measures against Russia.
The international financial system is based on the trust that all participants will play by the rules, and honouring debt obligations is one of the most important rules there is. Whatever the justification, freezing a country’s foreign-exchange reserves is a blatant breach of that trust. The US, which issues the main global reserve currency, is jeopardising its financial credibility for the sake of some elusive short-term tactical advantages. That is a big mistake.
For many years, China’s ability to amass foreign-exchange reserves was a symbol of its burgeoning economic success. But this has been a controversial issue since the mid-1990s (when China’s reserves reached $100 billion), because the purpose of trade is not to earn ever-greater foreign-exchange reserves, but rather to to participate in the international division of labor in a way that improves resource allocation across borders.
The Asian financial crisis in 1997 seemed to vindicate the argument that China needed large foreign-exchange reserves with which to fend off predatory attacks by international speculators. By 2003, China’s reserves had quadrupled to $400 billion, and there was growing international pressure on Chinese authorities to allow the renminbi to appreciate. But they were reluctant to do so, because they didn’t want to cause a slowdown in export growth. China’s vast foreign-exchange holdings thus continued to increase at an accelerated pace.
Then came the 2008 global financial crisis, which compelled China to recognise that its foreign-exchange reserves might be in jeopardy. The prime minister at the time, Wen Jiabao, expressed these concerns publicly in March 2009: “We have lent a huge amount of money to the US, so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries.” He then urged the US government to “maintain its credibility, honour its commitments, and guarantee the security of Chinese assets.”
The US government did honour its commitments, and China carried on accumulating foreign-exchange reserves, which peaked at $3.8 trillion in 2014, before falling by $800 billion in the following two years as the Chinese central bank intervened heavily in the foreign-exchange market to stabilise the renminbi in the face of large capital outflows. Since 2016, China’s reserves have fluctuated around $3 trillion under a more flexible exchange-rate regime, even though it has continued to run a current-account surplus. Today, they stand at around $3.2 trillion.
Whatever the causes, there is no denying that China has accumulated an excessive volume of foreign-exchange reserves. As I have been arguing for decades, there are two big reasons why it should reduce these holdings. First, with more than $2 trillion of net international assets, China’s net investment income has been negative for almost 20 years, because its holdings are disproportionately in low-yield US treasuries. This is a grotesque misallocation of resources.
Second, the US dollar eventually may fall significantly, because America has been running huge net foreign and national debts for decades, and this shows no signs of changing. Moreover, the US Federal Reserve’s expansionary monetary policy (in the form of quantitative easing) may continue to create inflationary pressure in the future.
To be sure, with many countries, especially China, holding such large quantities of dollar-denominated foreign-exchange reserves, the US dollar can remain strong for quite some time. But at some point, the greenback’s value will fall, and the second largest foreign holder of US treasuries – China – will face huge losses.
Given this possibility, I have long advocated a floating exchange-rate regime for the renminbi; a cautious approach toward capital-account liberalisation; diversification of foreign-exchange reserves; patient, market-driven internationalisation of the renminbi; and more balanced trade with the US. But all these suggestions assume that the US will play by the rules. Now that it has unilaterally frozen the Russian central bank’s foreign-exchange reserves, the foundation for my policy recommendations has crumbled.
If all foreign assets – public as well as private – can be frozen in a split second by reserve-currency countries, policymakers should not even waste their time with hedging measures like diversification. Now that the US has proved its willingness to stop playing by the rules, what can China do to safeguard its foreign assets? I don’t know. But I am sure that Chinese policymakers, and perhaps those in other countries as well, will be thinking very hard about solutions.
Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006. Copyright: Project Syndicate, 2022, and published here with permission.
34 Comments
Interesting article, I suppose all savers feel the the way the author does at some point . When can savings be secure even in our local banks there is no depositors guarantee. China is also guilty of not playing by the rules , witness the militarization of the south sea islands despite assurances from China that would not occur. Also the breaking of trust with countries by stealing commercial technology. The weaponization of finance is not new just the scale of it has changed and now threatens rogue players in ways they hadn't counted on.
The two largest communist experiments failed fantastically when forced to compete with market democracies. Russia and China got invited into the global market in an attempt to bridge the East West divide, but at the end of the day it's a game made and ruled by America and if you don't play nice, it's back to famines and the poverty line for you, which Russia will soon find out.
Even if China wants to find a new way to store reserve wealth it can't escape the fact that its existence and prosperity is dependent on foreign trade, and importing a large amount of its energy and nutritional requirements. They're boxed in a corner and should they decide to try and assert themselves militarily, losing their USD reserves will be the least of their economic woes, Russia actually has more leverage, being a net exporter of energy and food.
Great article We're all so busy feeling smug about thumbing our collective noses at Russia, that we don't realise we're about to cut it off to spite our face.
The behaviour of the Americans here is pathetic. It's like a soccer player intentionally tripping over their opponent to try and force a penalty. Just saying "oh, but Putin doesn't like it so it must be good" is myopic and narrow-minded. This will have far-reaching implications beyond what's happening in Ukraine.
'and honouring debt obligations is one of the most important rules there is'.
The problem is, the US can't. And has been in that situation for some time. So yes, China did all that work for an IOU with no backing.
Who calls?
And the bigger play is the removal of the USD from energy. Whatever emerges, we who satellite upon the US will be the losers. Unless China self-implodes, concurrently, of course.
Interesting times.
This is literally what crypto is for. Private citizens and countries wanting to secure assets that can't be frozen like this are going to quietly start stacking btc if they haven't already been doing it. States have to setup mining operations to back up their investment security as well. No one is talking about it yet especially on boomer sites like this but this is the next step
I disagree on that one J.C. That is exactly what Bitcoin is designed to be. A non-soverign store of welath that allows parties to interact trustlessly. And no one can change the rules like America has just done.
Bitocin is the only asset in the world you can store and transport around the world with no one being able to stop you or confiscate it.
All investments boil down to people. That is, relationships between people, and specifically trust in that relationship.
Whether that is money in the bank, stocks and shares, property, business, farms, forestry, a product or store with a good reputation, or your training that made you a doctor, banker, teacher or whatever. If the trust others have in that relationship with your investment, that is with you, is lost, then your investment is lost.
Any time that society goes all armageddon (war, etc) it is gold that people use to store wealth. It can be carried, it can be hidden, it dosen't require banks or electricity.
Not saying that we are heading for that scenario. But it shows the utility of gold, silver.
Was reading a few months ago, that if the US did this, based upon financial assets in comparison to when they broke away from the gold standard, the gold price would need to be in vicinity of $24,000 USD/oz.
Peter Thiel at the recent Miami Bitcoin conference showed that back in 1980, the total value of gold was equivalent to the total value of all stocks (1:1 ratio and approx USD2.5 trillion). That ration is now closer to 1:10, but actually much higher because of derivaties.
Bang on ibas. It is trust & trust alone that underwrites pretty much all human transactions. We deal with people we trust, not with those we don't. That's how our business works. When someone let's us down (as they inevitably do) we don't invite them back. I know that a lot of global trade is set up on trust. That's one of the reason's everyone is so pissed at Putin. He's f......... up the trust factor which will have long term consequences. Germany in particular has been screwed by Putin. Sure, Merkle made some dumb decisions, but essentially, Putin has lost Germany's trust. To rebuild that back will have to be post Putin. He is no longer tenable. And it has to be a Russian that deals with him, otherwise it will be WWIII. What has this got to do with foreign exchange? Everything.
Slightly odd article - might have been worth mentioning, for example, that Russia rebalanced its foreign reserves away from the US dollar over recent years (mainly to Euros and some gold) - probably because they anticipated exactly this kind of move. Russia also have the strongest currency in the world right now because they will only sell their oil and gas in Rubles, which are therefore in hot demand! The idea that the US could bring destroy their currency by making a fuss was short-lived.
What people often don't realise is that reserves in a foreign currency are held at the central bank associated with the sovereign currency. China sell loads of stuff to the US in USD so they have trillions of dollar reserves at the US Federal bank. Obviously they buy US bonds with these dollars - better to get a few points in interest on their excess reserves; however, they remain beholden to the Fed. That's the price you pay for sending all of your stuff there in exchange for some credit at the Fed.
The idea that the greenback is about to fallover is fashionable at the moment but it is a fantasy - at least in the medium-term. The Fed is the only bank that is able and willing to step in during an international crisis - offering swaplines in dollars to other banks etc. The prize for being the superhero is an overly-inflated dollar that makes imports cheap.
I agree with freezing Russia's foreign exchange reserves. It is a "blatant breech of trust" for Russia to have invaded the Ukraine, so it's disingenuous for China to point to the freezing of half of Russia's foreign exchange reserve as a "breech of trust" when Russia acted the way it did.
Russia is only getting back what it asked for. Unfortunately Russia did not get back in equal measure, and not fast enough.
Speaking of Trust just what trust is there in a China whose ascendency has been built on stealing Intellectual Property from every western business that does business on their shores--and plenty that chose not to but got hacked none the less. Thomas Edisons, Henry Fords, Steve Jobbs builders and inventors all who built from the ground up, whereas China simply stole. Like the Russians their day of reckoning will come and that is what the writer fears most.
China does not share any of our basic values such as free elections, democracy, freedom of speech, freedom of assembly, freedom of association, a free press, the separation of powers, an independent judiciary etc...
China is engaging in an influence campaign to cultivate distrust within the western democratic alliance, and especially in the minds of kiwis with respect to our allies such as the United States.
These influence campaigns, which have been well researched by Professor Anne-Marie Brady from the University of Canterbury, have become smarter and more subtle over the years.
China's one party dictatorship is particularly worried about the sudden and effective western coalition against the Russian regime after Putin's invasion of the Ukraine. This strong and coordinated western response to Russias actions poses an existential threat to China's undemocratic one-party regime.
It is important to always remember that China's political system (a one party dictatorship) and it's predatory economic system are not aligned with out basic values.
The response to Russias barbaric actions by a unified western democratic alliance is absolutely necessary. It is not just a response by the United States, which Mr Yu Yongding tries to single out here, it is a response by a United democratic alliance. China's attempt to create distrust within the western alliance is a simple "divide and conquer" strategy.
If we wish to live in a world where the kiwi way of life is a distant memory, and where basic human freedoms and democracy are not our paramount goal we can side with China.
If we want to fight for our liberties (which haven't fallen into our lap overnight, and which had to be paid for by our ancestors sacrifices) and stand up to authoritarianism we have to side with our allies.
The United States is not perfect, but it shares our basic human values. China doesn't.
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