Crossing the Rubicon
There is an old anecdote about the colonial British government in India, which was concerned about the number of venomous snakes in the cities and so introduced a bounty for their capture. As a result of the incentive, people began raising cobras in order to receive the bounty payments. Soon after realising this, the British stopped these payments …and those breeding cobras promptly released them into the wild. Policies have unintended consequences.
The decision among the West to sanction the CBR, freeze access to its foreign exchange reserves and disallow certain banks from using SWIFT (financial messaging infrastructure for cross-border payments) might have larger ramifications than most. As the US has expanded the use of sanctions over the years, one consequence of this is that developing nations have begun to find workarounds. In this week’s testimony, Fed chair Jay Powell noted that efforts by China and Russia to develop their own payments infrastructure (CIPS and SPFS, respectively) has “been going on for some time…but this [week’s actions] may change the trajectory”.
As a first order impact, one would expect a significant reallocation of foreign exchange reserves over time away from dollars (and euros) and into other neutral reserve assets. This would particularly be the case where there is not wholehearted geopolitical alignment with the West.
Source: BIS
The share of gold in world FX reserves has declined from the Bretton Woods era (c. 60-70%) to <20% currently. EM’s have had a rising share of gold in reserves since the GFC, but are still at relatively low levels.
A prime case for reserve diversification may be in India. While it is part of ‘the Quad’, India has had long-standing arms arrangements with Russia, was politically neutral during the Cold War, and also voted to abstain in the vote against Russia at the UN Security Council recently. Indian households own an estimated 50% share of GDP in gold, so there is a cultural acceptance of it as a store of wealth and yet the share of official gold (i.e. Reserve Bank of India) is 7% of total FX reserves, which is below average of EMs. China officially has only 3% of its FX reserves in gold, but the country goes years between updating the figures and many estimate its true holdings to be materially greater.
"A million metaorder analysis of market impact on Bitcoin". J. Donier and J. Bonart.
What are the alternative allocations for FX reserves? Ideally, a reserve asset would be liquid, portable, and durable. Long ago, in addition to gold, nations have occasionally used silver (e.g. China and Japan) or copper (e.g. Sweden) as a benchmark ‘safe’ asset. Because of copper’s industrial purposes (and potential use for decarbonization efforts), it might not make financial or ecological sense to use it for monetary purposes. This is true to more limited extent for silver as well. Expanded use of SDR’s are an option to supplement foreign exchange reserves but countries do not have much ability to accumulate them at will and they run a risk of being unavailable (e.g. the IMF restricted their use by Afghanistan). Cryptocurrencies have some potential, but at the moment, liquidity seems inadequate (on right) for institutional players on the scale of central banks. For example, if a market participant wanted to execute a trade for 10k bitcoins (around $400m at today’s prices), one would expect to move the price by nearly 10% even if they split this large order over time. Moreover, as cryptocurrency often trades like a a risk asset, the price might be under pressure at the same time central banks need access to cash. I won’t exclude the crypto possibility (market depth can improve) but it does not seem very feasible in the short run.
Putting this all together. Central banks acquired 11% of net supply of gold in the past few years. Using an overly simplistic stock-to-flow model, if central bank purchases doubled (equivalent to a 0.2% reallocation of global FX reserves to gold p.a.) it would have a c. 15% impact on the gold price. If the proportion tripled (i.e. a 0.4% reallocation p.a.), it would have a 35% impact on the gold price. (Private sector industrial/jewellery demand may fall somewhat as an offset, but private investment demand is often directionally correlated with price).
More philosophically, why would non-allied nations run perpetual current account surpluses? If there is less (official) demand for US treasuries and equities from trade partners, how will the U.S. fund its trade deficit?