Sanctions against Russia highlight the dollar’s exorbitant privilege

Sanctions imposed by the United States and the European Union on Russian banks have made Russian business entities a global pariah, much like North Korea. Importers, exporters and banks in many countries are stuck with receivables, payables and exposures and there is a small fear of large defaults. But in financial and academic circles, the seizure of Russian central bank reserves is seen as far more drastic.

The sanctions against the central bank of such a large country with 630 billion dollars in reserves, half of which in dollars and euros, are unprecedented. It would be interesting to consider the psyche of a PBOC (People’s Bank of China) which has over $2 trillion in reserves or the RBI which also has over $630 billion in reserves. Will their rulers encourage them to look for options beyond hard currencies? Above all, are there such options?

“The management of our reserves is guided by safety, liquidity and yield in that order,” Dr. D Subbarao, former RBI Governor, told me, adding that currently only the dollar and , to some extent, the other G3 currencies satisfy these qualities. He said a key lesson for governments from the Russian case will be that “US sanctions bite” and “it’s too costly to be on the wrong side of the United States.”

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The dollar’s role as an international currency began in 1944 when the United States brokered an agreement at Bretton Woods that pegged other currencies to the dollar and the dollar was loosely pegged to gold. This new arrangement was needed to replace the gold standard that had collapsed during the Great Depression. War-torn Europe was too dependent on the United States to complain. But in the late 1950s, as Europe recovered, some European nations felt the same righteous angst that can currently prevail in the central banks of Russia and China over dollar hegemony. French Finance Minister Valéry Giscard D’Estaing raged against the move from gold to the dollar, calling it an “exorbitant privilege” of the United States.

Economist Barry Eichengreen explains in his book, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, that when trillions of dollar banknotes circulate around the world, seigniorage gains for United States can be substantial. (Seigniorage gain here means for the United States that the cost to earn a dollar is simply the expense incurred to print that bill, but other countries must produce a dollar of goods or services to earn that dollar. ) Also, the fact that central banks around the world hold trillions of dollar bonds means that the US government can raise debt very cheaply. This position of the dollar allows the United States (even requires it) to run current account deficits without worrying about external challenges. Even European countries resent American privilege, economist Kenneth Rogoff said speaking to CNBCTV18.

In the 1960s, European countries starting with France reacted by demanding that the United States pay them gold in exchange for their dollar reserves, which the United States did. But this caused the United States’ gold reserves to dwindle and eventually President Richard Nixon changed the law and broke the dollar’s gold backing. Since then, the world has accepted the dollar as an international reserve currency, and the search for an alternative has remained in academic circles. With the sanctions against Russia, the question of the exorbitant privilege of the dollar is coming back to the fore.

An RBI veteran said the scale of the sanctions against Russia’s central bank and its other banks is so unprecedented that it may be hard to repeat as countries and their central banks will begin to prepare for such eventualities, but we do not know how they will do it. to prepare. What options do they have?

Some pundits have toyed with the idea that as a hedge, central banks like RBI must hold some of their reserves in the form of crude. Subbarao and other central bankers disagree that these are squarely in the domain of governments and private companies. Central bankers have neither the expertise nor the bandwidth to manage these commodity reserves. They can only manage financial reserves, which must necessarily be safe and liquid, in order to be able to use them to intervene in the event of a run on their own currency.

Is it possible that the Chinese central bank with that of Russia tries to develop bilateral payment systems that facilitate the settlement of bilateral exchanges without entering the dollar zone, even if the exchange between the two currencies is done by the dollar? India attempted to do so when sanctions were imposed on Iran. India had a crude oil purchase agreement with Iran, which it wanted to honour. The Reserve Bank used UCO Bank to pay Iran, after isolating the bank from any exposure to US dollar settlements. At present, Indian banks or the RBI are making no such effort towards Russian parties, for fear of secondary sanctions from the United States, according to banking sources. Perhaps when the dust settles, China will likely develop renminbi-denominated trade with more partners, and even with Russia as insurance against possible dollar blackmail by the United States.

“Alternatives could emerge, as appropriate, as a unit of account or a means of payment,” Subbarao agreed, “but as a store of value, the dollar will remain unmatched,” he said.

The trump card in favor of the United States and the European Union is global confidence in their legal system. Even if Russia and China develop bilateral payment systems, they are unlikely to inspire global business confidence due to their opaque legal systems. As Churchill once said: Democracy is the worst form of government except all others. Despite all its flaws, businesses and governments still trust the Western legal system and this is where a rival Chinese alternative can falter.

Central bank digital currencies (or CBDCs) can offer a route. mBridge, which is a prototype of multiple Central Bank Digital Currencies (mCBDC) developed by the Bank for International Settlements Innovation Center and four central banks – Hong Kong, Bank of Thailand PBOC and Central Bank of the United Arab Emirates united – recently demonstrated the potential of using digital currencies and distributed ledger technology (DLT) to provide real-time, cheaper and more secure cross-border payments and settlements. The RBI has also signed with the Monetary Authority of Singapore to link India’s UPI with Singapore’s PayNow to work on cross-border payments.

However, even these are based on dollar exchange rates and therefore are not an alternative to the current international financial regime. In short, to use what Dr. Subbarao said, “there is currently no alternative to the dollar”. But the angst against the greenback is great, from Russia to India to China and even Europe until recently. Whether geopolitics combined with technologies like blockchain will succeed in finding an alternative to the dollar as an international currency remains to be seen.

(Edited by : Bivekananda Biswas)

First post: STI

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