The empty threat of dumping western assets

Greetings. The debate on how to make Russia pay for its devastation in Ukraine — specifically, whether to transfer about €300bn of its foreign exchange reserves forcibly to Kyiv — is heating up inside the G7 group of large western economies. At a roundtable hosted in Brussels this week by the International Institute for Strategic Studies, a new development weighing on governments’ minds was discussed: what IISS senior fellow Nigel Gould-Davies called the first instance of financial weaponisation against western countries.

It was a reference to reports that large emerging market economies — including China, Saudi Arabia and Indonesia — have warned the west not to seize Russia’s reserves. Politico has them “begging” western governments not to do so. My own colleagues describe them as “lobbying”. Behind the scenes, the sense is of something darker, a version of “nice currency you’ve got there, would be a shame if something happened to it”.

In other words, veiled or not-so-veiled threats from large non-western surplus nations to pull out their reserves altogether should the west dare to seize Russia’s. As someone who advocates doing precisely that, I often encounter worries about financial instability and the future of the euro. But I have never been presented with a fully articulated explanation of what actually would happen. So below, I offer my own — and conclude that once you understand the mechanics of “dumping western reserve assets”, it turns out the threats are empty. Am I missing something? Write to me!

What are these reserves? I have previously talked about the “treasure chest fallacy” that sees central bank reserves as a physical trove that can be dug up and moved, and where the central question is who has the key to the chest. While they do own some amounts of gold, where this description is correct, central banks largely “hold” their reserves in the form of claims on other governments. That is what US, UK, German and French sovereign bonds are — promises to pay by those governments — and it is ultimately what deposit accounts in their central banks are. (And in the case of Russia, these promises to pay have mostly been fulfilled by being turned into a €159bn bank deposit, in other words, a gargantuan promise to pay by a private sector Belgian financial institution, Euroclear Bank.)

According to the IMF, governments have about $12tn of accumulated foreign exchange reserves. Since 2015 the fund no longer breaks down this total between advanced and emerging/developing economies. But if we assume the emerging economies’ share has at least not fallen since then, they account for $8tn if not more. And out of the full $12tn, at least $10.5tn is in western currencies, mostly the dollar and the euro, and most of the rest unspecified.

So in terms of the numbers, for emerging countries to move their reserves out of the west would involve shifting out upwards of about $7tn. Since these are claims on western governments, an exit involves finding new owners to hold those claims. It also means finding alternative investments for the reserve managers to swap their previous assets into. As we’re about to see, both are easier said than done.

As a first step, emerging market reserve managers would sell all their holdings. That is the nightmare of western finance ministries, but suspend judgment on the possible financial chaos for a moment and just focus on how the sale would actually proceed. At first, $7tn in government securities and deposits in western central banks would turn into $7tn in cash, which means deposits in western financial institutions or their central banks.

That is clearly not a likely end destination for EM foreign exchange reserves. Deposits in the west are as politically exposed to freezing and confiscation as government securities, and keeping your money in private banks is less safe because banks can go bust. (Could they hold western currency cash with non-western financial institutions? Not in those amounts, they couldn’t. There is no way an institution without access to the western central banks’ deposit facilities or swap lines could safely offer such deposits.)

Reserve managers could not simply convert it into non-western currencies, because they are the issuers of those currencies, so they would just be exchanging with themselves. To get rid of the western cash, EM reserve managers would have to convert their cash into something else. What something else would that be? Surely not private sector investments in western countries. Again, there would be no point in this, because it would be less safe and just as politically exposed as government securities. (And western countries would surely celebrate a flood of capital into their companies.)

So the reserve managers’ task would be to find $7tn worth of investments inside EMs themselves. They cannot buy one another’s government bonds, because any net seller of new public debt would be a net acquirer of more of the western cash they are trying to get rid of. So they have to find private sector assets.

Good luck with that. No doubt they can be found, but can they be found in the scale and quality needed for central bank reserves? For comparison, China had taken a decade to invest $1tn in its massive Belt and Road infrastructure programme, with decidedly mixed results.

But suppose these governments do find good private sector assets, big investments that contribute to their economic development. You could see a promising narrative: instead of lending to dastardly western governments that will just seize our reserves if we do something they don’t like, we will invest in our own future. (Leave alone that it’s hard to liquidate roads and bridges at home in a balance of payments crisis, which is the original purpose of central bank reserves. The idea here would be to give up that benefit for political reasons.)

A further question remains: who would be the sellers of these investments — ie, who would the reserve managers be sending their dollars and euros to, in exchange for these alternative EM assets? Again, they could not be non-western governments themselves (because they would collectively end up holding the same western cash they were trying to get rid of). So it would have to be private investors. If it’s EM private sector investors, some political risk presumably remains — it would still be a situation where non-western investors have huge claims on western governments that could in theory be frozen or seized. The only definitive exit, then, would be where non-western governments buy non-western assets off western investors. That would be a true financial decoupling — a reduction in claims of non-western economies on western ones but also an identical reduction in claims the other way.

Is this even possible? Is $7tn of EM assets readily available for sale from western private investors? I’ll just observe that the countries with large reserve assets in the west accumulated those because they have been running large surpluses — that is to say, they have long been investing more in the west than they have received western funding for investments at home. In other words, there may simply not be enough of the right assets for “exiting” to be possible.

And even if such a massive shift in financial asset ownership could be engineered, in what way would this be bad for western governments? Their bonds would now be owned by private sector investors, probably domestic ones. Those domestic investors would, in turn, be less exposed to political risk in newly hostile non-western jurisdictions, having sold their assets there. And as portfolios were reallocated, private funds repatriated to the west would seek other investments than cash, lowering the financing costs of western businesses. It’s not at all clear what there is to fear.

Now for some caveats. In this process of asset ownership changing hands, relative prices would change: the relative price of non-western assets over western ones would rise, and the relative price of government bonds over private sector assets may rise. A different way of saying this is that the spread of private borrowing costs over government ones within western economies would shrink, but the benchmark government cost of borrowing would rise.

Those are perfectly manageable consequences. Central banks steer financial conditions to where they think is right for the economy. Be in no doubt that if US Treasury yields suddenly shot towards 10 per cent, say, the Federal Reserve would loosen policy. And western government bonds will remain the benchmark safe assets for western investors: there is only so much their price can fall before the interest they offer is irresistibly better than the zero-interest cash that the EM reserve managers would be shedding in this thought experiment.

A second caveat is that this argument has all been about a large move by non-western reserve managers to pull out of the west. It suggests that this is nigh-on impossible to achieve. What could be realistic is something more modest — a single EM central bank selling a partial share of its dollar and euro assets. But the impact would be correspondingly more marginal, so nothing to worry about — unless it was targeted in a way that would cause maximum pain for a single victim.

Beijing could, for example, let it be known in Paris that if a move were made on Russia’s foreign exchange reserves, it would promptly dump its entire holding of French government bonds (without aiming for an impossible general exit from western assets). A French establishment still suffering post-traumatic stress disorder from the scary days in 2011 when it looked like French bond prices may go the way of Italian and Spanish ones, may well conclude it’s best not to risk anything — strategic autonomy and support for Ukraine be damned.

A better approach would be to buttress the instruments the Eurozone has to neutralise any such targeted financial attack. The European Central Bank has a dedicated, unrestricted bond-buying programme for “jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals”. It would be opportune for the Eurogroup of finance ministers to note that it fully expects the ECB to use the instrument in case of an unwarranted attack, and to express a commitment of solidarity between Eurozone governments, and for the ECB to state that, of course, it would do so, “and believe me, it will be enough”.

Third, the difficulty of pulling a $7tn-plus stock of reserves out of the west does not mean EM governments need to continue to accumulate. They could also let them gradually decline over time. That, of course, is a different proposition. It would not threaten any kind of short-term financial instability. (There was a time when large reserve accumulation was universally seen as a threat to stability, after all.) Such decumulation may over time raise real borrowing costs for economies, such as the US, that run structural external deficits. But the Eurozone does not; in fact, it has recently realised how perverse it is to send about €300bn worth of capital out of the bloc every year.

In any case, recall again that the accumulation of reserves reflects the large export surpluses of the countries we are talking about. Decumulation would require reversing these flows, and that is only possible by changing domestic economic models away from external surpluses. That is a much, much bigger political and policy commitment than a mere financial reallocation choice. It is completely unlikely that China or Saudi Arabia will soon turn into external deficit economies that import much, much more from the west. And even if they did, isn’t that something the west says it wants, rather than something it should fear?

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