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The human tragedy of the Ukrainian conflict continues unabated inflicting enormous suffering on its people. Western policy since the onset of conflict has been to impose economic restrictions and political pressure on Russia and offer military assistance to Ukraine.
These policies have taken the form of numerous economic sanctions, attempted political and diplomatic isolation, and transfer of armaments to Ukraine. Some examples of sanctions introduced in the recent past are barring Russia from the Swift interbank international transfer system, preventing Russian commercial banks from accessing western capital markets, oil price cap, freezing Russian central bank reserves in western bank accounts, denying maritime insurance to Russian cargo vessels, and many others. They have had mixed results.
Now the focus is on a proposal to confiscate Russian central bank reserves located in western financial institutions in order to assist Ukrainian reconstruction.
Gold and foreign currency reserves are an integral part of modern central banking. They are crucial in cross-border trade and commercial settlements. They also have a precautionary character as they assist countries in buffering against any unanticipated currency shocks. They often take the form of cash held in foreign bank accounts as well as foreign currency-denominated financial assets (such as treasury bonds) held in foreign financial institutions.
Central banks around the world practice some degree of reserve portfolio diversification depending on the size of their reserves, but they are meant to offer reserve currency (primarily dollar) liquidity to the internal interbank lending market when merited. In other words, if a commercial bank in Russia needs dollars to support dollar-based transactions by its customers, it can always borrow dollars from another commercial bank or the central bank at the interbank lending market.
The latest data released by Central Bank of Russia (CBR) indicates that the value of reserves as of June 14 is US$596 billion (£469 billion) which includes approximately US$300 billion of frozen assets in western jurisdiction. These assets are primarily held in Euros and US dollars.
Even though outright confiscation has been ruled out for now, it is understood that the G7 nations led by the US has set up a working group to deliberate on the prospect of seizing the frozen assets. Using the interest accrued on these assets to assist Ukraine has already become policy – although it remained unclear whether this would be part of west’s military assistance or reconstruction aid.
It appears that a proposal that is currently on the table is to offer Ukraine loans from international financial institutions such as the World Bank and the IMF and use the US$300 billion CBR frozen asset as collateral for these loans. Given the adoption of interest income confiscation as policy, the likelihood of the collateral element becoming policy is very high.
Challenges and prospects
A key aim of sanctions policy in general and the reserve confiscation policy in particular is to inflict economic hardship on Russia in order to change its foreign and military policy stance with regards to Ukraine. In theory, an unanticipated reserve confiscation shock could trigger a dollar liquidity crunch in the interbank lending market that could lead to rapid devaluation of ruble, banking crisis, recession, and very high inflation.
But it could also have unforeseen consequences for an interdependent global financial system through contagion.
Would such a scenario be realised in this particular case? The answer is probably no, as these reserves are already frozen and thereby the shock is not unanticipated. Furthermore, Russia can raise dollar and Euro liquidity from non-western jurisdictions particularly India and China. They can do this through a complex chain of proxies of nominal holders or directly transact with Indian and Chinese banks. Russian banks and businesses are not sanctioned outside the west.
So what purpose would such a policy serve? It could ease the burden on western finances over supporting Ukraine militarily. It could offer partial relief to Ukraine in restoring some of its infrastructure. But it would come at a cost of undermining the “safe haven” status of western financial institutions.
Non-western countries are likely to reduce their exposure to western country currency denominated assets. This is already taking place. US dollar’s share as a reserve currency is declining steadily and it has lost about ten percentage points of its share since the turn of the century. Although the dollar has maintained its transactional dominance in international trade so far, it is also looking increasingly fragile.
Doubts around the notion of “safe haven” would challenge the reserve currency status of the dollar and the Euro. This would reduce demand for these currencies in the international currency market and make them weaker. A weak dollar, or euro or pound would imply higher cost of importing energy and other essentials and would be inflationary for western economies.
Finally, the Russian government has promised retaliation if the policy of confiscation is implemented. Retaliatory policies would imply the confiscation of assets of western businesses located in Russia.
Ukraine, Europe and the wider world would benefit enormously from a peace dividend (the economic boost a country gets following war). Not to mention the importance of putting a final stop to its human tragedy, a peace dividend will allow Ukraine to focus on rebuilding its economy, infrastructure, and human capital.
For Europe, a peace dividend would imply refocusing its resources and energy on global challenges such as climate change, the energy transition and a digital future. For the developing world, a peace dividend could imply tackling food security, hunger and poverty. It is unlikely that the proposed policy of confiscation of Russian sovereign reserves would be able to deliver the ultimate desirable outcome of peace.
Sambit Bhattacharyya receives funding from UK Government, ESRC, ERC, and UKRI.
