The banking system is built on trust that the money one places in the care of others will be there when needed. This is as true for the retail investor with deposits at the local commercial bank, as it is for the sovereign with FX deposits at a foreign central bank. Hard earned trust is part of the magic that enables developed market sovereigns to massively deficit spend with limited consequence. The world happily holds their liabilities, be it in the form of deposits or sovereign debt. But that trust is weakened when sovereigns are seizing the assets of their own citizens and other sovereigns without due process of law. The liabilities of the banking sector and sovereign then cease to be risk free assets. Foreign sovereigns must now diversify as a matter of national security, and some citizens must now diversify as a matter of self preservation. This regime change can force a wild scramble into stores of value outside of the banking system including gold, real estate and even crypto.
Western sovereigns appear to increasing view the banking system as an efficient weapon for enemies both abroad and within. Targeted financial sanctions have the advantage of quickly subduing without the death and destruction of conventional weapons. The Russian economy was brought to its knees overnight through sanctions that effectively confiscated the deposits the Central Bank of Russia (“CBR”) held at major central banks. There is even ongoing discussion of confiscating the CBR’s assets held at the IMF. Without access to its foreign reserves, the CBR was unable to defend the ruble from significant outflows and watched helplessly as it collapsed by 50%.
Canada also recently deployed similar measures against its own citizens. Canadian Prime Minister Trudeau invoked emergency powers to seize the bank accounts of truckers protesting pandemic related restrictions. Reports also suggested that donors who made legal donations to the protestors were prosecuted based on a retroactive application of the order. Protestors lost assets without any warning, due process of law, or potential recourse. Although this happened in Canada, many outside Canada took note and interpreted it in light of the rapid expansion of government power they see in their own countries. They realize that money in a bank can go poof at anytime regardless of deposit insurance.
Just in Case
Sovereigns across the world are now all alerted to sizable tail risk that they must manage. Foreign reserve managers are a risk averse group who are far, far more interested in safety than profit. They will happily accept -5% real yields, but even a remote prospect of losing all their assets is completely unacceptable. They now understand that the US and EU view banking sanctions as an effective tool that can even be deployed against prominent members of the global community. Risk free assets are no longer risk free.
Just as the unveiling of nuclear weapons in WWII set off a global arms race, so this revelation will start a scramble for alternatives. Any sovereign who aspires to conduct its affairs without kowtowing to foreign powers must be able to survive the confiscation of its foreign reserves. A quick glance shows enormous vulnerabilities for China and India, who both interestingly voted “abstain” on the UN resolution condemning Russian actions. Fiat currencies will continue to be essential for global trade, but there is no point in keeping so much if they may disappear when most needed. A much larger gold allocation is a necessary safeguard against the existential risks posed by financial sanctions.
Some members of the public will also hedge their assets in fear of government seizure. At least in the U.S., a sizable percentage of the population already perceive that they will lose their job or be “cancelled” for holding dissenting opinions. Trudeau’s actions confirmed their worst suspicions – “debanking” as a tool to suppress dissent. The public’s potential alternatives are broader than reserve managers and include gold, but also assets like real estate, crypto, and paper currency. Dollar currency in particular has long been a favorite of those evading government.
Safety is Priceless
Safe asset status plays a key role in underpinning the the ability of advanced economies to run loose monetary and fiscal policy with limited consequence. In 2020, advanced economies spent 12% of their GDP on pandemic related fiscal stimulus while the emerging market economies only spent 6%. Poorer countries understand that they could not follow the US and spend 25% of their GDP without imploding their currency. Global investors happily hold newly printed dollars, but would quickly get rid of less established currencies.
This privilege can fade even without affecting the relative dominance of the dollar and euro. Investors could simply follow a well trodden playbook of shifting out of currencies and into tangible assets. This is common behavior in any country with weak institutions and increasingly relevant as advanced economies tarnish their halos. For the typical country, forever deficits and zero interest rates imply high and persistent inflation.