Seizure of foreign exchange reserves will not weaken the role of the dollar as an influential reserve currency.
The sanctions imposed on Russia by the United States have created a lively debate about the ability of the dollar to maintain its position as an influential reserve currency.1 Surprisingly strong sanctions restricting the use of the Russian dollar reserves suggest that, for at least some countries, the accumulation of dollar assets on rainy days would be less attractive. But from the point of view of consensus, it seems that the dollar will prevail if there is no better alternative (Brunnermeier et al. 2022).
The current debate is driven by the notion that governments keep reserves to smooth international payments in the face of trade or capital account problems. We do not disagree with this thinking, but have argued since 2003 that it provides a severely incomplete framework for understanding the dollar and the modern role of the United States in the international monetary system (Dooley et al. 2008).2 Experimental research suggests that the traditional story is incomplete in the face of huge reserves by China and other emerging markets since 2002 (Levy Yeyati 2010, Calvo et al. 2012). Instead of expanding the traditional story to suit the truth, we offer an additional reason to keep stock. In our framework, the optimal reserve holdings for poor countries should be significantly higher than the amount suggested by the conventional model pursued for economic development. Moreover, there is good reason for the United States and the dollar to continue to play an influential role in the system, despite having a record of previous freezing or even foreclosure.
In our framework, the desire and ability to seize massive financial assets is part of the job description for modern reserve currency. Such potential seizures were the parallel basis for the massive expansion of net and gross capital inflows between rich and poor countries for at least the last 25 years. Moreover, for good reason, the United States was the most trusted country and the most likely to fulfill this responsibility. It has a long track record of seizing foreign assets without diminishing its role as the main reserve currency.3 It follows that the United States and its allies are willing to impose sanctions on even the most militarily powerful country, strengthening the dominance of the dollar up front.
The most important historical example of the demand for reserves to reassure private foreign investors is China since 2002. China had to convince foreign industrial capital that the Chinese government, still a fierce enemy of private capital, would not eventually seize their investments. China’s policy of managing exchange rates, namely sterile foreign exchange intervention, also promises the necessary reserve savings to support the flow of private foreign capital. The deposit may have been made inadvertently, but it did not make it less effective.
This net export of Chinese capital for collateral is so large and sustainable that long-term real interest rates in industrialized countries have declined over the past 20 years. An influential academic theory for the persistently depressing real interest rates at the center is that the United States provides ‘safe resources’ to the rest of the world (Caballero et al. 2017). Just part of this story. The United States also creates assets that are unsafe for those who misbehave, and they are in high demand. The Center must provide security for good behavior and punishment for bad behavior.
A key difference between the demand for a transaction for a reserve and the parallel demand for a reserve is that the parallel demand is much larger. The parallel that was provided through reserve savings was comparable to that required in China among private investors with relatively different credit risks. We have calculated the parallel requirements for a hypothetical total return of reserves as opposed to direct investment. To our surprise, Chinese direct investors learned about the need for trade swaps. Over the years, updates to our calculations have reaffirmed our results (Dooley et al. 2014).
The analogy with the personal parallel system is useful but should not be taken literally. Personal collateral is a strong incentive for risky agents to make personal loans because it is both a deterrent to default and an almost risk-free guarantee to pay off creditors. Furthermore, the circumstances under which the collateral is forfeited are well-defined and enforced by the legal system where the credit agreement is negotiated. Public collateral, in the form of international reserves, is a strong deterrent to default, but it is much less clear that all or private international investors will be compensated. Note, however, that by increasing the cost of misconduct, the threat of U.S. sanctions benefits all private investors in risky countries, not just U.S.-based private investors.
What has changed?
Over the past few months, an astonishing array of Russian private sector assets – from banks to boats – have been shown to be at risk of being confiscated by central governments. This includes the financial and even real assets of the Russian government, government officials and the government’s powerful and ultra-rich private sector allies. Furthermore, blocking access to Western financing systems and insurance contracts puts many personal assets at risk, even within the country itself.
What is the reaction to this huge de facto expansion of asset stocks consisting of public parallel pools of enclave countries? For individuals in a country at risk with foreign assets, this would result in a transfer to foreign assets that is less risky and of course less visible, although in previously uninvited places that are quite risky.
But while governments in high-risk countries are still participating in the dollar system, the effects are less obvious. Stocks of their existing foreign assets, suddenly much more obviously risky hostages due to the published teeth of the United States and its partners, would actually support the flow of more gross capital from investors in rich countries as their doubts about such an application are dispelled. If the peripheral government wants to encourage private foreign investment, creating a stock of foreign reserves is now a stronger incentive for foreign capital.
Ahead, a key challenge for economic analysis is how a country’s total foreign assets and liability framework will adapt to new data on how risky it is for government sanctions on adversaries. The explosion of gross international capital flows in recent decades has been identified as an important source of global growth. The level of parallelism would not have been possible in these decades without the liberalization of the domestic financial system and the corresponding expansion of the gross international capital flows. The scale and structure of gross flows are much more important for development than the conventional academic analysis of net savings flows across the country. High-risk countries that exit the dollar block will have very limited ability to reassure foreign investors. The result will be excluded from the growth strategy so that the participation of the capital of the central country is involved.
A small part of this financial intermediation will be reduced because Russia will be excluded from the system (Bekkers and Góes 2022). If China also leaves, or perhaps begins to prepare for the exit, it will be a much more significant change in the international system (Horn et al. 2022). But if that exit is an unfavorable and abrupt process, China will face the cost of seizing similar assets from Russia. Our main conclusion, however, is that the dollar will remain the central reserve currency of the remaining dollar-based system and the role of the dollar and the demand for the dollar will increase within that block.
Bekkers, E and C Góes (2022), “The Impact of Geopolitical Conflict on Trade, Growth and Innovation: An Illustrated Simulation Study”, VoxEU.org, 29 March.
Bretel, K. (2022), “Analysis: Sanctions ‘Armament’ the US Dollar, Some Treasury Buyers May Reach Out”, Reuters, 29 March.
Brunnermeier, MK, H James and JP Landau (2022), “Sanctions and the International Monetary System”, VoxEU.org, 5 April.
Caballero, RJ, E Farhi and PO Gourinchas (2017), “Secure Resource Deficit Problems”, Journal of Economic Prospects 31 (3): 29-46.
Calvo, GA, A Izquierdo and R Loo-Kung (2012), “The Best Holding of the International Reserve: Self-Insurance Against Sudden Closures”, NBER Working Paper 18219.
Dooley, M, D Folkerts-Landau and P Garber (2008), “Asia, Interest Rates, and the Dollar”, Doutsche Bank Research.
Dooley, MP, D Folkerts-Landau and PM Garber (2014), “The revived Bretton Woods system’s first decade”, NBER Working Paper 20454.
Eichengreen, B (2022), “Ukraine war accelerates stealth erosion of dollar dominance”, FT.com, 28 March.
Horn, S, C Reinhart and C Trebesch (2022), “China’s Foreign Lending and the War in Ukraine”, VoxEU.org, 8 April.
Kessler, A. (2022), “Is the Dollar in Danger?”, WSJ.com, 13 March.
Levy Yeyati (2010), “What is the reserve deposit (and at what cost)?”, VoxEU.org, 30 September.
Lutz, E (2022), “Russia’s Sanctions: New Incentives for Chinese Yuan to Rise to Reserve Currency Scale?”, ConversationMarch 22.
Poser, Z (2022), “Breton Woods III”, Credit Suisse, 7 March.
Wigglesworth, R, P Ivanova, C Smith (2022), “Financial War: Will there be a reaction against the dollar?”, FT.com, 7 April.
See Eichengreen (2022), Pozar (2022), Bretell (2022), Loots (2022), Kessler (2022), and Wigglesworth et al. (2022).
2 A compilation of this series can be downloaded here. Specifically, we are drawing here from chapters 1, 2, 3, 4, and 6, “An Assess on the Revived Breton Woods System”, “The US Current Account Deficit and Economic Development: Parallel to the Total Return Swap”, “The Respectively The two crises of the international macroeconomy “,” the religion of those old times: good enough for me “, and” direct investment, real wage growth and exploitation of excess labor in the area “.
3 See Chapter 4 of Dooley et al. (2008), “That Old Time Religion: It’s Good Enough for Me”, pages 68-69 for a History Through 2005. The pace of such convulsions has intensified since then.