28 08 2022

Playing with fire

The English Economist Keynes, sitting in the middle, once said: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at yours.” China, Russia and many other countries seem to have forgotten that simple truth. The English Economist Keynes, sitting in the middle, once said: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at yours.” China, Russia and many other countries seem to have forgotten that simple truth. Ottoline Morrell (1873-1938), Public domain, via Wikimedia Commons.

Many countries build up reserves of gold and foreign exchange to hedge against sudden adverse events. As the currencies such as the US dollar and the Euro are not linked to any physical asset (as e.g., gold), their value is based on trust (called fiat money). However, the increasing politicization of the international financial system is eroding this trust. This may have far-reaching repercussions as some countries are now looking for alternatives.

The idea was originally that IMF should be the lender of last resort to provide emergency loans to central banks when needed, but most countries would very much prefer not to have to deal with IMF, as this implies that the country loses the right to decide its own economic policy. Particularly the Asian Crisis 1997-1998 and the humiliating and crippling conditions IMF set for providing support, convinced many countries to build up reserves so that they never again would have to ask for IMF support. Among these were China, Russia, Korea, Malaysia, Vietnam and many other countries, particularly in Asia. The reserves can be accumulated through running a surplus in foreign trade, by the Central Bank taking out foreign loans, or by attracting foreign capital by offering good investment opportunities (e.g., high interest rates on Government bonds). The latter is considered less secure as it is often footloose money, and national or international investors may pull their money out of the country at the first sign of troubles. To avoid this and to avoid excessive fluctuations of the exchange rates, countries may put restrictions on the movement of capital in and out of the country (e.g., China and now also Russia).

As all foreign trade has ultimately to sum up to zero (one country’s import is necessarily another country’s export), some countries must run a trade deficit to mirror the surplus countries. One of the big surplus countries is historically Germany and with it the whole Euro Area. The other big surplus countries during the last decade are principally China and Russia, but several minor countries, particularly in South-East Asia also run substantial surplus. To mirror this, the main deficitary country has during the last two decades been the US.

So for the present system to work, the US has to run a huge trade deficit to provide assets (cash dollars, treasury bills, shares and bonds in US companies etc.) to the countries that are building up reserves. This is obviously not a sustainable solution in the long run. It is of course convenient for the US that it can borrow cheaply or for free and hence does not have to balance its public finances or its foreign trade, as other countries have to. But it also has downsides, as it encourages recklessness (public expenditures can be increased without need to increase taxes, e.g., to finance a bloated military), leads to an overvalued dollar which makes the country increasingly uncompetitive, etc.

If a country wants to avoid IMF, considering it to be a political instrument of the rich countries (let us call them NATO+) (1), and hence wants to build up its reserves, it faces the dilemma that foreign exchange reserves in dollar, Euro, etc. are at risk of being frozen or confiscated, if it is considered not to be behaving well (Iran, Venezuela, Cuba, Afghanistan, and Russia are examples, and even China is now starting to sense the risk). What alternatives does a country have to build up reserve buffers for the eventuality of adverse events?


ASEAN +3 countries have set up the Chiang Mai currency swap system. By rdb

The first is diversification, and in particular to avoid building up reserves of currencies from countries that have a track record for seizing other countries’ assets (particularly US dollar, Euro, and British Pounds). In 2002, after the Asian financial crisis, the Southeast Asian countries in ASEAN set up a multilateral currency reserve pool, which in 2010 was expanded to include China, Japan, and the Republic of Korea (called ASEAN +3), a sort of regional IMF which permits them in principle to trade in their own currencies. It provides emergency lines of credits to the members when needed, without the involvement of IMF, to avoid a repetition of the 1997-1998 financial crisis. This experience could be replicated in other regions as e.g., South America or Central Asia. A more cumbersome way is to set up a series of bilateral swap agreements, so that e.g., the Indian Central Bank opens a bank account in the Russian Central Bank in roubles, and vice versa. Companies in the two countries can then buy and sell against these bank accounts without involving currencies of third countries. A more simple mechanism is to just include currencies from the most important trade partners in the reserves – however, that may require some assurance for the stability of the value of the local currency by indexing against e.g., a basket of commodities traded between them.

Another possibility is to create a new virtual currency constituted as a basket of the local currencies of the participants, a bit like the IMF special drawing rights (SDR) (2). The currency could also instead be indexed to a basket of commodities (e.g., gold and other metals, oil, grains). However, this requires a long period of negotiations and the building of new institutions. The Russians have proposed the BRICS countries (Brazil, Russia, India, China and South Africa) to do that, but it is unlikely to prosper, at least in the short term.

There is also the possibility to simply build up inventories of products that can be stocked without deteriorating. The most traditional one is gold, but for supply security reasons countries also traditionally build stocks of other strategic products such as oil, gas, rice, corn, and wheat. This list can be expanded by other products with common use as say silver, copper, nickel, iron, sugar and so on. In the light of the present shortages, some companies have been stockpiling semiconductors, but they run the risk of becoming obsolete and hence lose value. The drawback with building up inventories, apart from the cost of maintaining them, is that this is what could be called “dead capital”, resources that could have been used to create more useful things. However, the same is the case for foreign exchange reserves that tend to generate insignificant returns, so in reality they constitute a free loan to the country of the reserve currency (mainly the US and EU) with no conditions regarding ever paying back the loan.

Another possibility is to push forward infrastructure investments, so that there is less need for investments in the near future. The drawback is again that this is in some sense also “dead capital” as the infrastructure is not needed at the moment – even if it will be needed in the future. However, it provides some security as investment plans can be reduced in the future to free resources to meet an emergency, without causing problems with bottlenecks in the country.

It is surprising how often countries, which know they are at odds with NATO+, are sub-estimating the risk of their foreign currency reserves. Libya and Iran got their reserves frozen, with little chance of ever getting them back. Venezuela got its gold deposited in Bank of England and its considerable assets in the US, not only frozen but put at disposition of the Zombie President Juan Guaidó. Russia, stupidly thinking that its reserves in Euro were secure, found out they have been frozen too, and there is scant chance they will ever get them back. China has an enormous foreign exchange reserve valued at 3.1 trillion US dollar, of which a considerable part is in US treasury bonds (the composition of it is now a State secret). Former US President Donald Trump hinted at the possibility of not paying that debt to China, makng the Chinese suddenly aware of how vulnerable they are. Even if China has brought down the share of US assets in its reserves, it is still at enormous risk, and it is not easy for them to find a secure place to park this enormous amount of money.

The English Economist Keynes once said: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at yours.” The morale is that in the relationship between a lender and a borrower, it is not always the lender that holds the strongest hand. It is not a good idea to lend too much money to one client, because you may never get it back, and he knows that. China, Russia and other countries accumulating foreign currency reserves in US dollar, Euro and Yen seem to have forgotten this simple truth.

On the other hand, the Governments and Central Bankers in the US and the EU seem to have forgotten another truth: their money has no intrinsic value, so its value depends on trust. It takes a very long time to build up trust, but you can destroy that trust overnight. So they are playing with fire. The result is a likely a fragmentation of the international financial system.


1 It is common in mainstream media to refer to the US, its European allies, Japan, Canada and New Zealand as theInternational Community”. The Chinese foreign ministry mockingly published the map below on twitter. It does not really do justice to the argument, as it is a map “seen from the North” where Greenland appears as the size of South America when it is in reality 8 times smaller, but it gives an idea. So instead of “International Communitya more correct term would be NATO+.

The IMF SDR is constituted as 43 percent U.S. dollar, 29 percent euro, 12 percent Chinese renminbi, 8 percent Japanese yen, and 7 percent pound sterling.



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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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