Analysis: Sanctions on Russia’s economy could destabilize financial market

During the Crimean War from 1854 to 1856, Great Britain, France and Russia fought savage battles on the territory of present-day Ukraine.

Hundreds of thousands of people died from injuries or disease. However, throughout all of this, the British Treasury continued to pay its debts to the Tsarist government, and Russia continued to pay interest to British holders of its sovereign debt.

According to Nicholas Mulder’s new sanctions story, “The Economic Weapon” [A arma econômica]a British minister declared it obvious to “civilized nations” that public debts must be paid to an enemy during war.

Times have changed. In response to Vladimir Putin’s invasion of Ukraine, the United States and its allies banned negotiations with the Russian government, expelled selected Russian banks from the Swift payments system and froze the assets of Russia’s central bank.

Instead of paying debts to the enemy, the standard response today is to cripple the aggressor’s economy — even if you’re not involved in the fight.

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

This, in turn, reignited an old argument: is the US dollar in danger of losing its place as the world’s reserve currency? While the Russian freeze spurs those who would like to offer an alternative — notably China, through the internationalization of its currency, the renminbi — they are unlikely to supplant the dollar. The biggest threat is the fragmentation of a financial system that, while imperfect, allows everyone to thrive 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 pulled the US off the gold standard in 1971, and the beginning of a new monetary order “centered on around commodity-based currencies in the east”. If your dollars can disappear at the whim of the issuer, logically, a reserve needs to exist outside the dollar-based financial system.

China’s $3.2 trillion in foreign exchange reserves, the world’s biggest stockpile, suddenly looks more like a weakness than a strength. Only by becoming an issuer rather than a holder of reserves can Beijing claim some of the financial power of the United States. The way to do this is to persuade others to hold renminbi.

The dollar will be hard to beat, however. The power of the world’s leading economic and military power ensures that US Treasuries remain stable in a crisis; the Federal Reserve guarantees that they are liquid. During any kind of economic turmoil, they are the asset a central bank wants to hold. Indeed, if Russia were suffering a natural disaster or an unexpected collapse in exports, dollar reserves would also be exactly what it would want.

The alternatives have their own flaws. Russia has a lot of gold. The problem is liquidity: which bank today will lend foreign currency against the safety of gold in a Moscow bank vault? In time, Russia will be able to sell some gold to friendly countries, but in fact, the market has already made its judgment: it does not believe that Russia’s gold reserves can support the ruble.

Cryptocurrency can be valuable to Russian individuals right now. As a way to get money out of the country, it’s anonymous and portable. But for reserves the cryptocurrency is of little use: it is traded as a risky asset, falling during periods of stress, and almost all the liquidity is on exchanges, where the effect of sanctions will be as harsh as with dollars.

That leaves the possibility of a rival currency, most obviously the renminbi, that would be of interest to countries friendly to China, such as Russia, or to those fearing American censorship. But Beijing could use sanctions as easily as Washington. For many other countries, including large holders of reserves in Asia, being at the financial mercy of China would be even less interesting than the US.

The risk, then, is one of fragmentation. In his book, Mulder shows that the increase in economic sanctions and blockade during the interwar years as a tool to enforce peace boosted autarkic policies in Nazi Germany and Imperial Japan, eventually destabilizing the international system rather than strengthening it. it. The world has been floating for several years towards the formation of rival economic blocs. One way to avoid this is to keep the dollar at the center of the international financial system.

_{Translated by Luiz Roberto M. Gonçalves}