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Russian Frozen Reserves

Posted:June 27, 2024

Categories: Central Bank, US Treasuries, Geopolitics, Gold, Bonds

Paul Hancock, CFP®    June 27, 2024

Two days following Russia’s invasion of Ukraine on February 24, 2022, the United States ordered several sanctions against Russia. One sanction was to freeze $300 billion of sovereign Russian assets in the West to put pressure on the monetary system in Moscow. The fallout from this decision by the United States will likely go down as a major geopolitical mistake. In this article, I argue the largest consequence of this decision is a loss of confidence in global central banks willingness to hold dollar-denominated reserves. A likely destination for some of this liquidity has been gold. No, this does not mean the end of the dollar. But this is a major shift in the global monetary system unfolding in front of our eyes.

What are Central Bank Reserves?

Every nation runs either a trade surplus or deficit. When a country runs a trade surplus, it must choose how to invest the excess dollars, euros, yen, etc. People are no different. If we spend less than we make, we must choose how to invest our savings. We can invest in cash, stocks, bonds, real estate, etc. A central bank “reserve” is akin to the savings account of a nation’s central bank. Thus, central banks tend to keep much of their foreign reserves in very liquid instruments such as fiat-denominated bank accounts (dollars, euros, yen, etc.), sovereign debt such as US Treasuries, European government bonds, and gold bullion. 

Jan Nieuwenhuijs recently published an article detailing the makeup of global international reserves among central banks. See the figure below, From 1900 through the early 1980s, more than 50% of reserves were held in gold. Since the early 1980s, most reserves have been recycled from fiat dollars into US Treasury bonds. A smaller amount has gone into the Eurozone following the creation of the Euro in 1999. He notes:

“Gold's percentage of total reserves reached 18% in 2023, up from 11% in 2008. Gold has currently surpassed the euro, which got stuck at 16%.” 

Figure 1: Global International Reserves

Source: Gainesville Coins

Using Gold as a Neutral Reserve Asset

Some analysts argue that central banks are loading up on gold as a way to “de-dollarize”. The argument is that countries will exchange goods and services using their currencies and then net settle their accounts in gold. While this sounds good, in reality, the world works on dollars. This type of activity is picking up speed with the BRICS organization growing, but economic systems take time to develop. I believe central banks are buying gold to diversify their portfolio, hedge against monetary inflation, and hold a liquid, neutral reserve asset without counterparty risk.

Figure 2: Central Bank Gold Purchases

Source: Incrementum AG

Where’s the Money?

As of June 20, 2024, Russia reported Central Bank Reserves (including gold) of about $600 billion, including the roughly $300 billion currently frozen held mainly in Europe via Euroclear, a clearing house in Belgium. According to a report by the Council on Foreign Relations (CFR), the assets could generate up to $10 to $15 billion in interest until 2027. Recall that some central bank reserves are held in bonds. Bonds have fixed maturity dates. The CFR reports that roughly $175 billion of the frozen assets were held in bonds that have already matured.

“Once a bond in Russia’s immobilized portfolio matures, the interest income currently doesn’t fall into Russian ownership. Maturing bonds held in custodians like Euroclear roll over into a non-interest-bearing deposit account, and the custodians now generate substantial interest income investing frozen Russian funds that are trapped in these accounts. Using the stream of interest income doesn’t cross Europe’s red line: the principal remains an asset of the Central Bank of Russia (CBR); the income is already going to European custodians (rather than to Russia)”

Earlier this month, leaders of the Group of Seven (G7) agreed to lend Ukraine 50 billion dollars to help in the war with Russia. Collateral for that loan is slated to partially come from the above-mentioned interest earned on the frozen assets. Will the West go so far as to confiscate the frozen assets? This is much harder and will have far greater consequences for the West specifically the United States and the dollar as the global reserve currency.

Consequences

The clear consequence of the United States sanction is a loss of confidence in the dollar and US Treasury assets among other central banks. Like it or not, the message sent by the US is that if we don’t like your country’s actions or policies, we reserve the right to use the US dollar as a financial weapon and seize foreign-held dollar-denominated assets. Does this mean the end of the dollar? Far from it. The dollar remains the largest holding of international reserves at close to 60%. Further, the dollar is involved in almost 90% of all foreign exchange transactions. However, the US should learn to be more careful in the future regarding sanctions involving their sovereign debt.

References

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