How damaging is freezing central bank assets?

Business Standard, 7 March 2022

A new level of economic and financial restrictions have been imposed on Russia after the invasion of Ukraine. One element of this is the freezing of central bank (CB) assets. The adverse impact upon the CB, from freezing assets, is less extreme than is commonly supposed. It remains possible for the CB to construct the ruble and to do inflation-targeting, it just interferes with the ability of the CB to influence the market price of the exchange rate.

When China initiated hostilities against India, they argued that economic activities should continue unhindered, while soldiers kill each other at the border. This was an unpleasant position for the Indian side. India has put the economic relationship with China into a deep freeze, and asserted that the joys of economic engagement with India are predicated on good behaviour in other aspects.

The extent to which India can actually cut off economic links with China is limited because India is a small part of the Chinese economy while China is important to the Indian economy. India faced its China problem alone. Given the strategy of Indian foreign policy, no other country was willing to undertake actions that would adversely impact China.

Foreign policy strategy in Ukraine is different; Ukraine is not isolated, and Zelensky is a global hero. Numerous countries all over the world have come together in the new doctrine that the gains from globalisation: the benefits of economic and cultural engagement with the world are conditional on good behaviour. If Russia behaves like the erstwhile USSR, it will have to suffer self-reliance as in the erstwhile USSR. An important audience for these moves is in China, where the enthusiasm to invade Taiwan will be recalibrated.

One element of this is the freezing of CB assets. The terminology and press coverage of this is exaggerated. The root cause of confusion is the phrase "foreign exchange reserves". This phrase suggests a pool of assets that is available to the CB or the state on a rainy day. This is not correct.

At the heart of every CB is a `monetary balance sheet'. In this balance sheet, rubles are the liability and there are commensurate assets. The assets and the liabilities must be equal. That is, for every ruble issued, there must be an asset. The CB prints rubles, sells them in exchange for assets, and stores these assets. Conversely, it can choose to sell assets, obtain rubles, and extinguish them.

On the asset side, the CB can choose to hold domestic or foreign assets. It is these foreign assets that are confusingly termed `foreign exchange reserves'. They are not reserves in the sense that they cannot be used at will. They are spoken for: They are matched against rubles. If the CB chooses to sell those reserves, this will commensurately require shrinking the amount of rubles in the economy, which would involve increasing the short-term interest rate.

At a practical level, nothing has changed: There are rubles supporting transactions in the Russian economy, and they are associated with some assets that can't be traded. The basic machinery that constructs fiat money is working as it did before. The everyday task of the CB is to continuously change the size of its balance sheet (i.e. change the short-term interest rate) so as to deliver low and stable inflation. They are fully able to do this.

In fact, foreign assets on the CB balance sheet are not essential. It is quite feasible to create a fiat money by only having domestic assets on the CB balance sheet.

What the Russian CB is now unable to do is intrude upon the currency market. Normally, supply and demand determines the exchange rate. CBs have the ability to print local currency and use it to buy foreign assets such as US government bonds. These large trades could be used to distort the market-discovered price on the currency market. Once the Russian CB is frozen out of the global financial system, they are not able to do these trades.

Most well-structured CBs do not distort the currency market: They are organised around delivering an inflation target. The exchange rate is an important price in the economy, and as with the price of steel or petroleum products, state interference in this market subtracts value. A good organisation of monetary policy involves the CB staying out of the formation of the exchange rate, and focusing its power upon the job of delivering an inflation target.

When the Russian CB is cut off from trading its foreign assets, then, the impact is relatively mild. Nothing changes on the core business of a CB, to produce a fiat money and stabilise domestic inflation. For the duration of the sanctions, the Russian CB would not be able to engage in currency policy.

The USD/RUB exchange rate has gone from 84 to 124 in the last week. This seems like a reasonable response to the invasion, putting together the direct fiscal cost of the war, and the adverse impact of going back to self-reliance. If the Russian CB had access to foreign assets, and tried to fight this depreciation, it would be harmful to Russia.

The larger context is an important one. For countries like Ukraine and Taiwan, which have the state capacity in foreign policy to do coalitions as opposed to being isolated, aggressors are facing a new doctrine: "The joys of globalisation are conditional on good behaviour, the world will come together and endure pain in unplugging you if you misbehave." Within this overall framework, blocking the ability of the CB to trade foreign assets is one small component. It gets an exaggerated treatment owing to the confusing phrase `foreign exchange reserves'. However, all that happens is that the CB is not able to manipulate the currency market, the exchange rate has to be determined by the market.

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