What Russia’s fortress balance sheet can tell us about the dollar’s future

This is a guest post by Robert McCauley, non-resident senior fellow at the Global Development Policy Center at Boston University and an associate member of the Faculty of History at the University of Oxford.

What impact will the freeze of Russian central bank reserves have on the dollar’s dominance? Russia’s own attempts to fortify its balance sheet after the 2013 Crimean annexation offer some clues.

In response to the initial wave of western sanctions after the first Ukrainian crisis, the Central Bank of Russia moved its dollars out of the US — but, to a remarkable extent, held on to them.

Instead of offloading dollar exposure, Russia fortified its finances in four ways:

1) It increased reserve levels.

In response to the western backlash against its annexation of Crimea, the CBR increased its overall foreign reserves by 24 per cent from the end of 2013 to $630bn by the end of 2021

2) It stockpiled gold.

Most of the extra savings went into gold. At end of 2013, the precious metal amounted to 8.3 per cent of Russia’s FX reserves; by the end of last year it stood at 21.5 per cent. However, the downside is that gold secure at home cannot be readily used as collateral for loans.

3) It reduced its exposure to countries, not currencies:

In 2013, France, the US and Germany amounted to 80 per cent of Russia’s FX reserves. By 2020, their share was less than half that size, 36 per cent. China and Japan received most of the corresponding increase, with weights up from zero and negligible to 19 per cent and 17 per cent, respectively.

Most notably, the CBR shifted its dollars offshore, away from direct US jurisdiction. Assets in the US fell from 31 per cent of FX reserves in 2013 to 9 per cent in 2020.

The reported onshore/offshore split reversed from 69/31 in 2013 to 32/68 in 2020. Such a high offshore share of dollar reserves is four or five times the global norm. In fact, the CBR placed more dollars in Japan than in the US, judging from the larger claims on Japan (17 per cent of FX reserves) than yen holdings (5 per cent).

4) It modestly cut down on its dollar holdings:

On the surface, it appears that the CBR de-dollarised substantially between 2013 and 2020, reducing the greenback’s share of FX reserves from 45 per cent to 28 per cent. Its euro allocation held up better, slipping from 42 per cent to 38 per cent. The gainers were China’s renminbi with 17 per cent of FX reserves in 2020 and the yen with 5 per cent. (The share of neither the Canadian nor the Australian dollar rose.)

But the footnotes of the CBR Annual Report point to more dollars off of its balance sheet. Forward sales of foreign currency against foreign currency amount to 9.5 per cent of FX reserves. These are most likely dollars swapped for yen and renminbi.[iii] If so, the CBR held about a tenth of its FX reserves in synthetic dollars: for instance, yen securities combined with a forward sale of yen for dollars. If so, its dollar allocation fell to 38 per cent, matching the euro share. The swaps could both raise dollar yields and keep the dollar exposure out of Uncle Sam’s reach.

To summarise, the CBR changed its geographic exposure, the where of FX reserves, more than its currency exposure, the what.

The biggest shift was moving away from US country risk, but it reduced its French and German exposure as well. Both moves made sense if the US was the most likely source of further sanctions but there remained other possible sources.

Partial reporting for end-2021 shows a halving of the dollar share and a notable rise in the renminbi share of its reserves. But without data on FX swaps, it is hard to interpret these moves beyond the near certainty that the CBR cut exposure to US country risk further.[iv]

The first lesson of the CBR’s reserve fortifications is that even a central bank preparing for sanctions might mostly maintain its dollar share, despite the US pre-eminence in sanctions and despite an official policy of de-dollarisation. Offshore dollars and synthetic dollars, out of the immediate reach of US law, can substitute for onshore dollars.

The second lesson is that effective country diversification may have to go to uncomfortable lengths. The broad imposition of sanctions frustrated Russia’s diversification, China apart. With 20-20 hindsight, effective diversification would have required taking additional the credit risk involved with placing reserves with, say, Brazil, India and South Africa, as well as China.

Again, with 20-20 hindsight, the Russian authorities might have sought less a fortress balance sheet and more a siege stockpile. Of course, its main focus was currency, as stockpiling semiconductors and aeroplane parts is more difficult than accumulating reserves. But now Russia lacks key imports, not the means to pay.

In sum, as reserve managers ponder how to defend their reserves from sanctions, they could seek to avoid US country risk more than the dollar. That means the dollar’s share of FX reserves, properly measured, might not suffer much. Any real risk to the dollar’s use would come only if reserve managers are willing to extend their allocations into higher-risk countries.

That also raises questions for the $3tn of reserves in China, which faces limits in diversifying its country risk. Even assuming a willingness to take more credit risk, there are practical challenges to investing in bond markets of currencies that have not heretofore attracted official reserves. The status of China’s BRICS Local Currency Bond Fund initiative is not clear,[v] but in any case its scale would be very small in relation to China’s reserves.

[i] https://www.cbr.ru/eng/hd_base/mrrf/mrrf_7d/

[ii] See https://www.cbr.ru/Collection/Collection/File/8317/ar_2013_e.pdf and https://www.cbr.ru/Collection/Collection/File/39294/ar_2020.pdf

[iii] For background see Guy Debelle’s “How I learned to stop worrying and love the basis”, https://www.bis.org/review/r170526b.htm .

[iv] https://www.cbr.ru/Collection/Collection/File/41054/rb_2021.pdf

[v] See http://brics2022.mfa.gov.cn/eng/zg2022/CPTI/ , dated February 22, 2022, mention in paragraph on Financial and Monetary Cooperation, but see also http://brics2022.mfa.gov.cn/eng/hywj/ODMM/202206/P020220607348199719292.pdf , dated June 7, 2022.