Why sanctions are not deterring Russia from its targets

We tend to think of forex reserves as a stash we have tucked away for some unforeseen emergency. This is only partially true. Forex reserves do come in handy if our current availability of hard currency falls short of the demand. The central bank would sell foreign exchange from its reserves in the local foreign currency market and make good the deficit, to smoothen out sharp changes in the value of the currency. If the shortfall is seen as a trend, the central bank would stop intervening, and let the rupee weaken, to provide a corrective that would even out supply and demand.

How do we get foreign exchange? It comes in as export of goods and services, including information technology services and IT-enabled services, tourism, including healthcare tourism, the money foreign students bring in to pursue studies, remittances from our workers abroad, portfolio investment inflows, foreign direct investment inflows , foreign currency loans taken by Indians and profits and dividends earned abroad.

What are the sources of demand for foreign exchange? Imports — of which energy (oil, coal and liquefied natural gas) is a major component — the expenditure of Indians who travel abroad for education, healthcare and tourism, the servicing of past loans and payment of profits and royalty to foreign companies with investment in India, outflows of portfolio investments, the demand for foreign exchange of Indian exporters who offer export credit, the foreign exchange demand for foreign acquisitions of Indian companies and remittances back home of expats working in India are the major sources of demand for foreign exchange.

In what way are forex reserves dissimilar to a stash to be availed of in an emergency? A stash is entirely separate from the funds available to the saver for current spending. But that is not the case with forex reserves. To appreciate that, let us see how the central bank, the RBI, gets foreign exchange in the first place.

Foreign exchange is bought and sold by banks with the license to function as primary dealers, from those who want to convert their dollars to rupees and rupees to dollars. If their demand and supply positions result in a significant net position, the RBI would intervene. Suppose a lot of dollar investments come in as a chunk. That would create a temporary glut of dollars, the price of dollars would fall sharply, that is, the rupee would strengthen in a way that does not reflect the economy’s relative productivity or competitiveness vis-à-vis our trade partners. If India were to let real economy transactions be affected by the fluctuations in the exchange rate created by chunky capital flows, that would not be sensible. So, the RBI would intervene to prevent that temporary glut of dollars from strengthening the rupee beyond what the real economy warrants. It would buy up dollars, to add to its foreign exchange reserves.

When it buys dollars, it buys it with rupees. When the central bank releases rupees into the economy, that adds to the money supply. In other words, the dollars in India’s reserves have counterpart rupees added to the money supply. The ‘stash’ is not a real stash that Indians do not touch, its equivalent rupees are at work in the Indian economy.

It need not always be as additional rupees. Large additions to the money supply could stoke excess demand and inflation. So, the RBI would mop up the rupees created by its dollar purchases by selling bonds in its stock. Banks would surrender money to hold bonds. But in the process of regulating the money supply in this fashion, the RBI increases the supply of bonds. When the supply of anything goes up, its price falls. When bond prices fall, bond yields rise. The price, therefore, of a forex reserve is either increased money supply or higher rates of interest. The stash is at work in the domestic economy. Forex reserves are apart of the domestic money supply.

If there is a shortage of dollars in the market for foreign currency, the RBI would sell dollars from its forex holdings, easing the downward pressure on rupees.

Does this not amount to currency manipulation? It does not, so long as the effect of such interventions is to smoothen out fluctuations around the trend value of the rupee, and not to alter the trend value.

A central bank holds forex reserves in liquid assets that earn a return, typically safe government bonds. American gilts are the world’s favorite haven. Whenever risk goes up in the global economy and capital flees to safety, its preferred destination is US government bonds. In 2011, rating agency S&P downgraded US government debt in the wake of politicking in Congress that blocked legislation to raise the American government’s debt ceiling, triggering the possibility of default. In shock, global finance took a reflexive flight — into US government bonds, from around the world! Were rating agencies to downgrade Indian government bonds, capital would flee from the bonds, not into them.

If forex reserves are frozen, the central bank would not be able to liquidate its forex holdings to sell in the domestic market for dollars. That would affect its ability to smoothen out demand-supply mismatches in the local currency market. So, freezing the Russian central bank’s foreign exchange reserves has the effect of preventing the Russian central bank from intervening to supply dollars, as capital flees Russia, dumping rubles and demanding dollars to move out. That has led to the sharp depreciation of the rouble.

The bulk of the export of oil and gas, Russia’s prime exports, are based on contracts, where prices are fixed or linked to benchmarks. But in the spot market, demand and price can both fall, curtailing the availability of dollars earned through exports. And since forex reserves cannot be run down to support the rouble, lower export earnings come in as added pain. The Russian central bank raised its policy interest rate from less than 10% to 20%, to incentivize capital to stay put and dampen capital flight.

Regulating interest rates to target inflation is a primary function of a central bank, along with maintaining financial stability. Those functions are unaffected by foreign governments freezing their external assets.

Russia could help the ruble and stabilize the domestic currency market in other ways. One way for central banks to obtain foreign exchange is to swap currency with other central banks. Russia has a swap line with China, which has forex reserves of well over $3 trillion.

In theory, Russia could lighten the pressure in its domestic ruble market by asking those who owe it dollars, say, for arms or gas exports, to settle payments due to those, to whom Russia has to make dollar payments, without these flows coming into the Russian domestic market for dollars. Provided, the relevant central banks permitted this.

UK-based cross-border money transfer company Wise (earlier known as TransferWise) operates on this principle. It aggregates those who need to make payments from, say, Britain, to residents of Russia, and aggregates, simultaneously, those in Russia, who need to make payments to residents of Britain. Rubles are taken from those who need to pay Britons and paid to Russians who are to receive payments from Britons. Pounds are taken from those who need to transfer money to Russians and paid to those who are to receive payments from Russia. All payments are made, people get to make and receive payments, without money actually crossing borders and entering local currency markets (if the payments to and from are mismatched, the net amount would still need to enter local currency markets). For this to work, central banks and other regulators must cooperate, that is all.

Strict sanctions were imposed on Iran, including secondary sanctions on those who violated the primary sanctions. In the absence of secondary sanctions, an Indian or a Chinese entity that deals with a sanctioned Russian bank would not be cut off from dollar networks the way the sanctioned Russian bank is. Even those stricter sanctions did not stop Iran from functioning as a regional power or developing its nuclear technology. Sanctions are unlikely to stop Russia.

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