US freezing of Russian central bank assets over Ukraine war puts China in a quandary
- The international financial system is based on the trust that all participants will play by the rules, and honouring debt obligations is one of the most important
- If all foreign assets can be frozen in a split second by reserve-currency countries, policymakers should not waste their time with hedging measures like diversification
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 were savagely battling each other during the 1853-56 Crimean War, they continued to service their debts to each other.
The international financial system is based on the trust that all participants will play by the rules, and honouring debt obligations is one of the most important rules there is. Whatever the justification, freezing a country’s foreign exchange reserves is a blatant breach of that trust.
The Asian financial crisis in 1997 seemed to vindicate the argument that China needed large foreign exchange reserves with which to fend off predatory attacks by international speculators.
The 2008 global financial crisis compelled China to recognise that its foreign exchange reserves might be in jeopardy.
Then-premier Wen Jiabao expressed these concerns publicly in March 2009: “We have lent a huge amount of money to the US, so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries.” He then urged the US government to “maintain its credibility, honour its commitments, and guarantee the security of Chinese assets”.
The US government did honour its commitments, and China carried on accumulating foreign exchange reserves, which peaked at US$3.8 trillion in 2014, before falling by US$800 billion in the following two years as the Chinese central bank intervened heavily in the foreign-exchange market to stabilise the renminbi in the face of large capital outflows.
Whatever the causes, there is no denying that China has accumulated an excessive volume of foreign exchange reserves. As I have been arguing for decades, there are two big reasons it should reduce these holdings.
First, with more than US$2 trillion of net international assets, China’s net investment income has been negative for almost 20 years, because its holdings are disproportionately in low-yield US Treasuries. This is a grotesque misallocation of resources.
Debt and sanctions will hasten end of US dollar hegemony
Given this possibility, I have long advocated a floating exchange rate regime for the renminbi, a cautious approach towards capital account liberalisation, diversification of foreign exchange reserves, patient market-driven internationalisation of the renminbi, and more balanced trade with the US.
But all these suggestions assume that the US will play by the rules. Now that it has unilaterally frozen the Russian central bank’s foreign exchange reserves, the foundation 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 should not even waste their time with hedging measures like diversification.
Now that the US has proved its willingness to stop playing by the rules, what can China do to safeguard its foreign assets? I don’t know. But I am sure that Chinese policymakers, and perhaps those in other countries as well, will be thinking very hard about solutions.