As US limits Russia’s forex reserves use, central banks may aim for diversification​

Central banks and governments across geographies have relied on their foreign exchange reserves to serve as a cushion during times of crisis. That forex reserves also carry a risk during unprecedented geopolitical crisis has been now realized by central banks.

The US along with its European allies has indicated that they would prevent the Russian central bank from using its forex reserves in a way that undermines the blow of the sanctions they have put on the country. In essence, this means that the Russian central bank cannot use at least a part of its reserves to protect the rouble from sinking or even pay for imports. No wonder the rouble has sunk more than 25 percent since Russia invaded Ukraine on February 24.

Indeed, the Russian central bank may not be able to sell US treasury bonds to get dollars and sell the same in the market to prop up the rouble. That said, the duress is only on the extent that the forex reserves are held in dollar-denominated treasury bonds. About 22 percent of Russia’s forex reserves are held in physical gold lying inside the vaults within the country. Russia can sell these or even ship gold physically to friendly countries in exchange for dollars. Note that shipping gold has been done before by India during the Asian currency crisis.

This brings a crucial aspect of diversifying forex reserves into multiple asset classes by a central bank. Concentration of investments in assets denominated in a single currency is a risky proposition akin to putting all eggs on one basket. The part-freeze on Russia’s forex reserves could prompt other central banks across economies to pursue diversification of their forex assets more vigorously.

The Russian central bank has been diversifying its forex reserves over the past decade even as it has built a formidable pile. The share of physical gold is 22 percent, or $133 billion. To that extent, Russia may not feel the pinch of the freeze on its central bank’s forex assets. Even so, the US dollar, euro and pound sterling account for more than half of the reserve assets, enough to hurt the central bank and by extension the economy. An assault on the central bank’s assets would wreck its liability side too, which is essentially currency notes issued to the public. This explains reports of banks in Russia facing unprecedented queues of people for withdrawal of their money even as the rouble sank. So considerable damage has been done already.

Another major central bank, the People’s Bank of China, has also diversified its reserves to a large extent. However, the share of US treasury bonds in Chinese reserves still remains sizeable.

Global foreign exchange reserves have grown exponentially over the past decade. Even now, 60 percent of global reserves are held in dollar assets although the share of the dollar has come down over time. The Chinese yuan has just 2.7 percent share in global reserves. China’s push for yuan as a reserve currency has been persistent too. Economists believe that the assault on the Russian central bank would give China enough reason to push further.

Central banks, especially from countries that are at loggerheads with the US and European nations could look at alternatives to invest their forex reserves in. “There could be a block of central banks, perhaps led by China that could give more weightage to other currencies including the CNY (yuan) for holding forex reserves. China may benefit in a big way from this fallout,” said Abheek Barua, chief economist at HDFC Bank Ltd. Barua believes that some central banks could also look at securities linked to commodities to invest in as part of diversification.

Be that as it may, the dollar is unlikely to be replaceable as a reserve currency. Indeed, central banks stress on safety and liquidity of an asset in deciding the investment vehicle for their forex reserves. US treasury bonds have been the most popular assets and widely purchased by central banks as they are the most liquid. Securities, even sovereign, denominated in currencies other than the dollar do not match the liquidity of the latter.

To be sure, the dollar’s share has declined in overall global reserves and could continue to do so if central banks feel strongly the need for diversification. The sanctions on Russian central bank would surely increase this inclination going ahead.