By Gene Frieda, Global Strategist at PIMCO
Freezing a central bank’s currency reserves is not new, but Russia is the first globally integrated economy to suffer this fate. Thus far, we have seen dramatic ramifications for Russia, with potential implications for the status of the U.S. dollar as the world’s main reserve currency and strength of China’s renminbi.
The potency of sanctions on Russian central bank reserves has stemmed from coordinated actions of the U.S., Europe, the U.K., Canada, and Japan, among other jurisdictions. That unity created de facto near unanimity, as Chinese banks became reluctant to deal with Russia for fear of secondary sanctions. However, for most countries outside China, sanctions risk should remain low.
A big question is to what extent will existing foreign exchange (FX) reserve allocations and indeed the portfolio allocations of international investors be adjusted out of fear of future sanctions, as foreign investors seek to avoid risks of capital lost or trapped onshore? If these reserves cannot be shifted to safe locations, then their insurance value may be deemed limited and, accordingly, the extent of sustainable foreign liabilities may be less than previously assumed.
Our view is that reserves will shift to currencies of countries deemed as sanctions-remote. A corollary is that a sanctions-risk premium on FX reserves realistically applies only to countries where the risk of globally coordinated sanctions is high.
Ultimately, we believe the U.S. dollar will come out at least as strong as before, while the picture for the renminbi is more clouded.
From China’s perspective, sanctions could be disruptive given ongoing tensions with the U.S. China lacks obvious alternatives for its $3.2 trillion in FX reserves to traditional reserve currencies and gold. While China could sell down its FX reserves, this seems highly implausible given its large gross foreign liabilities and its desire for currency stability. Total foreign liabilities have risen to $3.6 trillion as of end-2021.
If China concludes its reserves no longer provide much insurance, a logical conclusion would be to allow the exchange rate to fluctuate more. The People’s Bank of China (PBOC) continues to tightly manage renminbi (CNY) volatility. Convergence toward realized volatility levels in line with G-10 and Asian peers would imply a 100%–125% increase in realized CNY volatility. Carry could still be attractive relative to regional peers, but its status as a top carry trade would be undermined.
Coupled with ongoing trade tensions between China and the West, the freeze of Russia’s reserves have again raised fears of an exodus from the U.S. dollar (USD), but to where?
While the CNY should continue to benefit from China’s strong trade linkages, its status as a potential challenger to the USD is likely to suffer from greater uncertainty around rule of law and sanctions-risk premium. Larger central banks may be more reluctant to hold CNY due to potential Western sanctions risk and the corresponding need for China to re-impose capital controls on foreigners. The CNY should continue to attract reserve flows from smaller countries that China dominates as a trade partner and to some extent from commodity exporters, but it should remain a fractional share of global reserves.
The euro’s (EUR) share of global reserves should rebound if yields return to positive territory. Recent progress in reducing eurozone break-up risk is the precondition for both higher rates and a larger EUR share in global reserves, currently about 20%.
We believe the USD’s anchor status has arguably been reaffirmed by the freezing of Russia’s reserves, if not buoyed at the margin. At last count the dollar’s share of global reserves was 59%, little changed from a decade ago. We do not see much immediate spillover risk from Russia to other countries, including to China.
However, we foresee lingering consequences through three channels: China’s efforts to insulate its existing reserves from potential sanctioning; commodity exporters’ consideration of how to invest freshly minted FX reserves stemming from the current commodity boom; and foreign investors’, both public and private, consideration of collateral damage from financial sanctions that might affect the convertibility of CNY assets onshore.
Sanctions risk to China and indeed China’s increasingly conservative economic policies work against the CNY’s rise as a reserve currency. The lesson from Russia is that sanctions on FX reserves can be potent, effectively forcing currency non-convertibility on the country. The share of CNY’s weight in global reserves, while still set to rise, will likely be capped in mid-single digits.
For countries fearful of being sanctioned, reserves may be less of an insurance buffer than previously assumed. If diversification is not an option, then reduced external borrowing – another form of secular deglobalization – is the logical consequence.
Finally, if global reserve growth accelerates again (for example, due to the persistence of high commodity prices favoring commodity exporters), developed market government bonds would likely benefit more than any individual currency as reserves are recycled back into traditional safe assets.