The reversal of the dollar as a reserve currency risks harmful fragmentation


During the Crimean War, from 1854 to 1856, Great Britain, France and Russia fought fierce battles on the territory of modern Ukraine. Hundreds of thousands of people died of injuries or disease. Yet throughout it all, the British Treasury continued to pay its debts to the Tsarist government, and Russia continued to pay interest to the British owners of its sovereign debt. According to Nicholas Mulder’s New History of Sanctions, The economic weapona British minister said that it was obvious to “civilized nations” that public debts had to be paid to an enemy during war.

The times have changed. In response to Vladimir Putin’s invasion of Ukraine, the United States and its allies banned relations with the Russian government, expelled some Russian banks from the Swift payment system, and froze Russian central bank assets. Rather than paying debts to the enemy, today’s standard response is to cripple the aggressor’s economy, even if you’re not involved in the fighting.

Freezing the reserves of the Central Bank of Russia was a particularly unexpected, ruthless and effective act. He deprived Moscow of the means to stabilize its currency. The ruble collapsed. But the use of such a powerful sanction has raised fears of unintended consequences for the international financial system. If your central bank dollar reserves can be frozen when you need them most, then what’s the point of holding them?

This in turn has reignited an old debate: is the US dollar in danger of losing its place as the world’s reserve currency? But while Russia’s freeze will spur those who would provide an alternative – notably China, through the internationalization of its currency, the renminbi – they are unlikely to supplant the dollar. The greatest threat is that of fragmentation in a financial system which, although imperfect, allows everyone to prosper together.

Credit Suisse‘s Zoltan Pozsar argues that the central bank freeze marks the death of the post-Bretton Woods system, born after Richard Nixon took the United States off the gold standard in 1971, and the start of a new one. “commodity-centric” monetary order. currencies in the East”. If your dollars can disappear at the whim of the issuer, logic runs, then a reserve must exist outside of the dollar-based financial system.

China’s $3.2 trillion in foreign exchange reserves, the largest stockpile in the world, suddenly looks more like weakness than strength. It is only by becoming an issuer rather than a holder of reserves that Beijing will be able to appropriate some of the American financial power. The way to do this is to persuade others to hold the renminbi.

The dollar, however, will be hard to defeat. The might of the world’s preeminent economic and military power guarantees the stability of US Treasuries in times of crisis; the US Federal Reserve assures that they are liquid. During any type of economic turbulence, they are the asset that a central bank wants to hold. Indeed, if Russia were to suffer a natural disaster or an unexpected collapse in exports, the dollar reserves would also be exactly what it wants.

Other alternatives have their own flaws. Russia has a lot of gold. The problem is liquidity: what bank today will lend foreign currency against the security of bullion in a Moscow vault? In time, Russia may be able to sell gold to friendly countries, but in reality the market has already passed judgment: it does not believe that Russia’s gold reserves can support the rouble.

Cryptocurrency could be valuable for individual Russians right now. As a way to get money out of the country, it is anonymous and portable. But for reserves, crypto is of little use: it trades like a risky asset, falling in times of stress, and almost all the liquidity is on the exchanges, where the penalties will be as harsh as with the dollars.

That leaves the possibility of a rival currency, most obviously the renminbi – which would be attractive to China-friendly countries, such as Russia, or to those fearful of US censorship. But Beijing could use sanctions as easily as Washington. For many other countries, including large reserve holders in Asia, being at the financial mercy of China would be even less appealing than that of the United States.

The risk is therefore that of fragmentation. In his book, Mulder describes how the rise of economic sanctions and blockade during the interwar period, as a tool to enforce peace, drove the autarkic policies of Nazi Germany and Imperial Japan, destabilizing ultimately the international system rather than strengthening it. The world has been drifting for several years towards the formation of rival economic blocs. One way to avoid this is to keep the dollar at the heart of the international financial system.

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