Vladimir Putin takes global markets back to the noughties

At the turn of the century, forex traders, hedge funds, and powerful economists were obsessed with central bank foreign exchange reserves.

The euro was a baby, and supporters faced a daunting task of making it a currency with global impact, entangled in international trade and investment. Any data suggesting that it is eating away at the dollar’s dominance in the coffers of global central banks was taken as a sign of progress towards that goal and prompted abrupt shifts in the euro exchange rate.

It was a not unfounded obsession that proved lasting. In the Greek debt crisis, which peaked in 2012, one of the reasons for loud (and incorrect) predictions that the euro would fall below parity against the dollar was central bank reserve managers’ confidence in the legal and policy framework behind the European currency could lose and throw it out of their rainy season reserves.

Central bank reserve diversification became a good explanation for every elusive intraday currency move. pick up euros? Ask any trader and he (it was invariably “he”) would often tell you that “Boris” (ie Russia) or some other central bank was buying. Or maybe China has wiped dollars from its reserves.

Russia’s invasion of Ukraine is bringing this market concern, which has largely been dormant for several years, back to the fore. The US has made spectacular use of what Valéry Giscard d’Estaing, the former French president and finance minister, controversially put it in the 1960s, in its attempt to punish Russia for the Ukraine conflict.

As the dollar lures of two decades ago frequently remarked, the dollar’s global role, its outsized share of world trade, and its dominance of financial markets give the US tremendous power to use sanctions to bend geopolitics to its will.

Now, one can argue whether that is appropriate. What if a less predictable White House used that privilege on much more contentious cases in the future? Should any country have the power to weaponize money?

decent questions. What matters from a market perspective, however, is that the sanctions imposed by the US and its allies on the Russian central bank will prompt other countries not geopolitically allied with the US to consider keeping that many dollars on their books.

Currency analysts at Goldman Sachs said “the result could be a depreciation of the dollar,” adding that they had seen “great client interest” in the issue. It’s one that hedge funds could really get their teeth into.

On the other hand, the US investment bank warns against excessive excitement. “We should emphasize that the structure of FX markets will not change overnight and there are many interrelated reasons why the dollar maintains its dominant global role,” it said.

There’s another reason not to farm on an imminent collapse of the dollar: the US did not freeze Russia’s reserves of its own accord. Officials involved in drafting the sanctions against Russia knew they would work best in cooperation with the EU, the UK and other G7 countries.

So, sure, Moscow or some other prickly regime may shy away from dollars in the future, but where to go instead? Russia cannot switch to the euro, pound sterling or yen as payment sanctions extend to these as well. It could avoid them all, but then its funds for buying basic necessities or defending the ruble would all be in currencies of limited international use. Furthermore, it seems rather naïve to opt for the renminbi to avoid politically motivated freezes.

Still, the potential for the dollar’s reserve status to decline is real. The implications are potentially profound and could take years to become fully clear. Gita Gopinath, Deputy Managing Director of the IMF, has spoken of the potential for the global financial system to “fragment.”

Previous market fixations on this theme suggest that despite the tectonic pace of change, traders will be keen on seeing near-term opportunities.

A IMF study last month, which focused on the “silent erosion of dollar dominance” offers clues as to where those opportunities lie. The dollar’s place in international reserves has shrunk significantly since the turn of the century, from 71 percent in 1999 to 59 percent in 2021, the IMF said, reflecting “active portfolio diversification” by central banks.

Interestingly, the share of reserves in the other ‘Big Four’ currencies – sterling, yen and euro – did not offset the doldrums. “Rather, the dollar’s reallocation has been two-way: one-fourth into the Chinese renminbi and three-fourths into the currencies of smaller countries, which have played a more limited role as reserve currencies,” the IMF said.

The greater availability of easy-to-trade assets and more sophisticated trading technology have made it easier to acquire Australian and Canadian dollars, the Chinese renminbi and a number of Nordic currencies.

“The competition for reserve currencies is usually referred to as the battle of the giants,” the IMF said. In fact, the issue isn’t whether the dollar will be replaced, but whether smaller currencies will get a bigger slice of the pie.

The next time a minor currency bounces for no apparent reason, expect that to be offered as an explanation. Vladimir Putin takes global markets back to the noughties

Adam Bradshaw

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