In The Economic Weapon: The Rise of Sanctions as a Tool of Modern War, historian Nicholas Mulder reminds us that even when Britain and Russia fought fiercely in the Crimean War of 1853-1856, they continued to fight each other. pay each other their debts. Similarly, when hedge funds launched predatory attacks on Asian currencies during the Asian Financial Crisis of the 1990s, they ultimately continued to play by the rules (even as their unethical behavior halted economic progress for some). East Asian countries).
The US decision on February 28 to freeze about half of Russia’s foreign exchange reserves seems to fall into another category. Although the United States has taken similar measures against Iran, Venezuela and Afghanistan, Chinese economists believed that these were exceptional situations and find it shocking that the United States takes such measures against the Russia.
The international financial system is built on trust that all participants will play by the rules, and honoring debts is one of the most important rules there is. Whatever the justification, freezing a country’s foreign exchange reserves is a gross breach of that trust. The United States, which issues the world’s main reserve currency, is jeopardizing its financial credibility in the name of some elusive short-term tactical advantage. It’s a big mistake.
For many years, China’s ability to accumulate foreign exchange reserves was a symbol of its budding economic success. But this has been a contentious issue since the mid-1990s (when China’s reserves reached $100 billion), because the purpose of trade is not to gain ever larger foreign exchange reserves, but rather to participate in the international division of labor in a way that improves the allocation of resources across borders.
The Asian financial crisis of 1997 seemed to justify the argument that China needed large foreign exchange reserves to fend off predatory attacks from international speculators. By 2003, China’s reserves had quadrupled to $400 billion, and international pressure was on the Chinese authorities to allow the renminbi to appreciate. But they were reluctant to do so, as they did not want to cause a slowdown in export growth. China’s vast foreign currency holdings thus continued to grow at an accelerated pace.
Then came the global financial crisis of 2008, which forced China to recognize that its foreign exchange reserves could be threatened. Then-Prime Minister Wen Jiabao expressed these concerns publicly in March 2009: “We have lent a huge amount of money to the United States, so of course we are concerned about the safety of our assets. Frankly, I have some concerns. He then urged the US government to “maintain credibility, honor commitments, and ensure the safety of Chinese assets.”
The US government honored its commitments and China continued to accumulate foreign exchange reserves, which peaked at $3.8 billion in 2014 before dropping $800 billion over the next two years, the central bank said. China having intervened massively on the foreign exchange market to stabilize the renminbi in the face of major capital outflows. Since 2016, China’s reserves have fluctuated around $3 billion under a more flexible exchange rate regime, although it has continued to post a current account surplus. Today, they are around $3.2 billion.
Whatever the causes, it is clear that China has accumulated an excessive volume of foreign exchange reserves. As I’ve been saying for decades, there are two big reasons he should cut those holdings. First, with more than $2 trillion in net international assets, China’s net investment income has been negative for nearly 20 years, as its holdings are disproportionately in low-yielding US Treasuries. This is a grotesque misallocation of resources.
Second, the US dollar could eventually drop significantly, as America has accumulated huge net foreign and domestic debt for decades, and it shows no signs of changing. Additionally, the US Federal Reserve’s expansionary monetary policy (in the form of quantitative easing) may continue to create inflationary pressures going forward.
Certainly, with many countries, especially China, holding such large amounts of dollar-denominated foreign exchange reserves, the US dollar may remain strong for some time. But at some point, the value of the greenback will plummet and the second-largest foreign holder of US Treasuries – China – will face huge losses.
Given this possibility, I have long advocated a floating exchange rate regime for the renminbi; a cautious approach to capital account liberalisation; diversification of foreign exchange reserves; the patient and market-driven internationalization of the renminbi; and more balanced trade with the United States. But all of these suggestions assume that the United States will play by the rules. Now that he has unilaterally frozen the foreign exchange reserves of the Russian central bank, the basis for my policy recommendations has crumbled.
If all foreign assets – public and private – can be frozen in a split second by reserve currency countries, policymakers shouldn’t even waste time on hedging measures like diversification. Now that the United States has proven its willingness to stop following the rules, what can China do to protect its foreign assets? I do not know. But I am sure that Chinese policymakers, and perhaps those in other countries as well, will think very seriously about solutions. — Project syndicate
* Yu Yongding, former president of the Chinese Society for World Economics and director of the Institute of Global Economics and Politics of the Chinese Academy of Social Sciences, served member of the monetary policy committee of the People’s Bank of China from 2004 to 2006.
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