A note to Russian leaders: Do not fight with a country whose currency you use as a reserve currency to maintain your own. It can ruin you in hours without firing a shot. In today’s electronic world, your foreign exchange (FX) reserves do not exist in physical form. They are electronic book entries in your Central Bank’s accounts with the Federal Reserve System and other Western central banks. Your access can be denied by sanctions, and you won’t be able to use your FX reserves. Your currency will fall, your banks will fail, the supply chain will break down, and the economy will implode. A note to U.S. policymakers: Explain it to them, slowly and patiently, bullet by bullet (no pun intended). This will help to de-escalate the new Cold War.
Russia is not the Soviet Union, let alone Cuba or North Korea. The Soviet Union was less vulnerable to economic measures. It had a controlled economy in which the dollar value of exports matched that of imports and a non-convertible currency. Russia has an open economy and a convertible currency. Economic stability depends heavily on the exchange rate which depends on export revenues and foreign exchange reserves. Openness and convertibility are strengths in peace and vulnerabilities in conflict.
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Bullet 1. The Bank of Russia, its central bank, owns FX reserves to the tune of $397 billion. It sells them when it wants to support the national currency, the ruble; sells or lends to the government to help service foreign debt; and bails out domestic commercial banks when they need to pay foreign creditors and domestic depositors but cannot obtain FX on the market. Although never stated by law, any of today’s central bank holding FX reserves is the lender of last resort in foreign currencies to the government and the home banking system.
Yet, in today’s electronic international finance, these reserves in foreign currencies are available only as long as their governments and central banks say so. Of the roughly $397 billion of FX reserves, $257 billion are in Western government securities, $66 billion in monetary gold, $64 billion in deposits and banknotes with Western central and commercial banks, and $10 billion with the IMF. Almost all of these holdings exist in electronic form only, in New York and other banking centers, under control of the U.S. and other Western central banks and governments. They can close access to these FX reserves at will.
Bullet 2. Consider the $257 billion of Russian FX reserves in government securities such as U.S. Treasuries. These are dematerialized securities without certificates. They are entries in the Russian Central Bank accounts with Western central banks. $88 billion worth of U.S. Treasuries are in the custodial service of the Federal Reserve Bank of New York where 250 foreign central banks and governments hold accounts. Another $25 billion or so of U.S. Treasuries Russia keeps on accounts with the hedge funds in the Cayman Islands. Still, these securities actually end up on the computer of the Depository Trust and Clearing Corporation in New York affiliated with the New York Fed. No matter what the intermediary, all proceeds from selling U.S. securities credit only Russia’s account with the New York Fed. The Bank of Russia can receive electronic funds only via the Federal Reserve’s Funds Transfer System, FedWire and receive dollar banknotes only via shipments by the New York Fed. Similar centralized electronic holding and payments apply to the rest of Russia’s Western government bonds in its FX reserves in Euros, British Pounds, Canadian Dollars, Australian Dollars and the Yen.
Bullet 3. The Bank of Russia owns $66 billion worth of monetary gold. Some is in the gold bars in the New York Fed’s vault and elsewhere. The bulk is in the unallocated gold bullion of which Russia has electronic gold depository receipts on the account with the New York Fed and other Western central banks. These holdings are quite liquid, can be marketed expeditiously, but the proceeds must go through the New York Fed and similar central bank accounts and the FedWire and similar transfer services.
Bullet 4. Russian FX reserves have roughly $64 billion in deposits and banknotes. $26 billion are deposited with Western central banks and $38 billion are deposits with foreign commercial banks, including their branches in Moscow, and cash. Apart from the cash stored on the Russian Central Bank premises, the rest is electronic book entries, available on demand or not. Western banks in Moscow do not have billions of dollars of banknotes in their vaults. They manage minimal necessary liquidity and request delivery of cash from their home offices when needed.
Bullet 5. At a time of an international crisis, access to Russian FX reserves in the U.S. and other Western countries as well as in Moscow branches of Western banks can be shut by Western sanctions. There is nothing Russia could do to gain access. Whatever foreign cash the Russian Central Bank has and could purchase from Russian oil and natural gas exporters will be insufficient. The Central Bank will be unable to uphold the exchange rate. Panic will sink in. There will be a run on the dollar and a flight from the ruble. The ruble will be in a free fall. Devaluation will be catastrophic and inflation high. The black market in foreign exchange will emerge. Russian enterprises will demand foreign currency in payments from their buyers or resort to barter. Input-output disruptions will spread. The supply chain will break down. The current mild recession will degenerate into one of the greatest contractions on record.
Bullet 6. Of the $397 billion of Russian FX reserves, over $88 billion represent stabilization funds of the Ministry of Finance. These funds, which used to be twice as great before the Western sanctions imposed in 2014 on Russian borrowing abroad, have been used by the government to finance the budget deficit of about three percent of GDP. This source of budget deficit financing will become unavailable if sanctions are extended to the Central Bank at a time of conflict. The government will have to cut pensions and other domestic spending or military expenditures or raise taxes in a recession, or all of the above. Powerful interests will clash in dividing the shrinking pie.
Bullet 7. Russian commercial banks hold $279 billion of foreign currency deposits of Russian businesses and households. Against these short-term foreign exchange liabilities they own foreign exchange assets, primarily long-term loans to businesses and mortgage borrowers. As is natural in banking, this is the maturity mismatch. It is eminently manageable until there is a banking panic and a run on foreign exchange. Come such run, the Central Bank without FX reserves will not be able to provide liquidity to commercial banks in foreign exchange and even the perfectly solvent banks will fail. The entire Russian commercial banking system will fall down like a domino.
Bullet 8. Russia may try to preempt this unraveling, to no avail. It can unwind FX holdings, sell bonds and gold, withdraw deposits, cash everything and ship the cash (plane loads of it) home to the Central Bank vaults. Let them. The amounts are too small to affect Western financial markets. But this will be an early warning to the West that Russia prepares for an escalation of the Cold War. This will also be a warning to Russian foreign currency depositors in Russian banks that Russia cuts-off its financial ties with the West. They could not be sure that the ruble will remain convertible. There will be a run on their $279 billion in foreign currency deposits with Russian banks, to withdraw the cash the banks do not have. The Russian Central Bank will have to bail out Russian banks and provide foreign exchange liquidity buying their worthless assets until it nearly exhausts its FX reserves shipped from the West. Russian households will stash dollars and Euros under the mattresses. The story will end up about the same: The ruble will fall because it will be backed only by worthless Russian bonds, not by FX reserves; the banks will be dysfunctional; the supply chain will break down; and the economy will shrink. No matter what the Russians do, in the world of today’s electronic international finance they just cannot win the Cold War.
This is the best news since the end of the old Cold War: In the case of a revanchist Russia, mutual assured destruction is no longer the only last resort. The U.S. and its allies have a non-military option that the Russian leaders need to be warned about in order to de-escalate the new Cold War. They need to be reminded of their vulnerabilities and warned of the cost of miscalculations. This is just a warning. It is safer than a military response and cheaper than the arms race. If the Russian leaders do not want an all-out war, they have to choose between ruin and retreat. They have not been delivered the message yet. They think that they can survive any crisis with impunity, surrounded by glorifying subjects and loyal generals. But so did Ceausescu.
This article was written by Capital Flows from Forbes and was legally licensed through the NewsCred publisher network.
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