VALENTIN KATASONOV | 18.03.2016 | OPINION

Can the US Federal Reserve System Be Trusted with Reserves?

According to some estimates, all the international reserves of all the countries of the world total approximately $10 trillion. The vast majority of all international reserves are held in the US.

Statistics provided by the US Federal Reserve give a general picture of the breakdown (table 1).

Table 1

International reserves held in the US (in billions of dollars)

Type of asset (financial instrument)	2012	2015
Total	5,474.8	5,979.9
US bank deposits	372.7	336.7
US Treasury bonds and notes	3,658.5	3,758.5
US securities other than US Treasury securities	1,290.2	1,498.4
which includes
US agency securities	484.1	378.7
US corporate bonds	120.7	142.6
US corporate stocks	685.4	977.2

Source: federalreserve.gov

The total quantity of international reserves held in the US has risen 9% in three years (2012-2015), but no particular changes can be seen in the breakdown of the holdings (see table 2). The geographical distribution of the owners of the international reserves held in the US is also fairly stable. The vast majority of the reserves (73.5% in 2015) come from Asia, since some countries there (China and Japan) possess international reserves that are at record highs.

Table 2.

The geographical distribution of the owners of the international reserves held in the US (in billions of dollars)

Area	2012	2015
Total	5,474.8	5,979.9
Europe	840.7	949.4
Canada	33.9	37.7
Latin America	498.8	521.6
Asia	4,031.5	4,394.8
Africa	42.4	45.4
Other countries	28.1	30.8

Source: federalreserve.gov

As a rule, international reserves that are held in the US provide the monetary agencies of other countries with only minimal interest rates (US Treasury securities offer interest of approximately 1% on average). Of course the IMF and rating agencies explain that such is the price of purchasing an investment that comes with virtually zero risk. Oh really?

There are many reasons to question such an assertion. In early February, the media reported that quite a large sum of money had been stolen in the US, as a result of «electronic hacking». We have long grown accustomed to news about «electronic bank robberies», but this was truly a bizarre event. First of all, the funds were stolen from an account at the Federal Reserve Bank of New York, which is known to be extremely secure. Second, this was not a theft of private money, but of $100 million of the foreign currency reserves belonging to the Central Bank of Bangladesh.

The funds were reportedly moved to accounts in Sri Lanka and the Philippines. That $100 million dollars was then transferred out of the banking system, ending up on the black market where it was subsequently sold. It left the country for an unknown destination via intermediaries, after being laundered in three casinos in the Philippines. The reports were later updated to clarify that the thieves did not make off with the full $100 million – merely $81 million – although they had originally planned a heist of $1 billion. The hackers made a serious spelling error in their fifth request, which was for another $20 million. That misspelling alerted the employees at the Federal Reserve Bank of New York. Were it not for that mistake, the Central Bank of Bangladesh could have lost 40% of its foreign reserves.

This event makes one reconsider the risks of depositing one’s international reserves in the US banking system. So what are those risks?

1. Technical risks. It turns out that even the Federal Reserve Bank of New York (advertised as a «safe haven» for foreign reserves) is not able to ensure that money is kept intact and secure. So what does that say about the abilities of ordinary, private US banks, where the monetary agencies of some countries have also opened accounts to hold their reserves (because of the higher interest rates)?

2. Economic risks. At the beginning of 2016, the US banking community began to wonder if perhaps the Federal Reserve should follow the example of some foreign central banks – such as those in Sweden, Switzerland, Denmark, and Japan – that had begun imposing negative interest rates on deposits. And beginning in 2014, the European Central Bank (ECB) also started to introduce negative interest rates. This made the US Fed seem attractive, because unlike those central banks, it would at least preserve the integrity of the funds that were deposited there. This situation will change if those reserves begin to melt away.

3. Legal risks. The question of the US Fed’s responsibility to keep foreign reserves intact and secure has never been raised. I do not think that the Fed’s obligations regarding missing funds have ever been spelled out in its contracts. It can be assumed that the New York Fed has no intention whatsoever of compensating Bangladesh for its losses. Let’s look back at the history of the monetary gold that makes up the international reserves of many countries and which is being held in the vaults underneath the Federal Reserve Bank of New York. Germany, for example, has been trying to retrieve its gold from the cellars of the Federal Reserve Bank in Manhattan ever since 2012. The Germans have to date received only a very small portion, and the gold bars that have been returned are not even the same ones that Germany originally stowed in the Manhattan vault.

4. Commercial risks. These are especially relevant for the foreign reserves that are being held in US commercial banks. The US banking system is currently extremely unstable. There are many signs of an impending banking crisis. If a commercial bank goes bankrupt, it is not at all certain that the monetary agencies of other countries would be even partially compensated for their losses. The bankruptcy of Lehman Brothers, once one of the biggest banks on Wall Street, was an extraordinary symbol of the financial crisis in the US. No one could have imagined that such a Titanic would sink all the way to the bottom and create problems for Ukraine. Prior to the February 2014 coup in Ukraine, the Verkhovna Rada repeatedly tried to piece together what had happened at Lehman Brothers and to identify the individuals who had made the decision to deposit Ukraine’s international reserves in a Wall Street bank.

5. Political risks. It is theoretically assumed that central bank funds are immune to many types of economic sanctions – such as seizure, freezing, confiscation, etc. But in the real world this works quite differently. We have frequently witnessed various countries’ international reserves being frozen or seized, and invariably it is Washington that is behind such actions. Iran is a vivid example. Its international reserves were frozen back in the twentieth century. An estimated $50 billion of funds have been blocked. Washington has announced that some of Iran’s hard currency accounts will be unfrozen, but only a total of $1.7 billion. Libya is another example – that nation possessed very sizable international reserves during the Gaddafi era. According to some estimates, the US and its allies – bowing to pressure from Washington – have blocked a total of $150 billion belonging to the Central Bank of Libya and to that country’s sovereign wealth funds.

Using reserves to purchase US Treasury bonds and notes also entails specific risks. These securities are held by special depositories under the jurisdiction of the US or its European allies. Washington has the ability to put pressure on these depositories, i.e., to block transactions involving treasury securities. With all this in mind, it would seem that the US and its closest allies are becoming extremely dangerous places to deposit international reserves. Especially the reserves of countries that are trying to pursue an independent foreign policy. So what other options do such countries have? There are many ways to minimize the loss of international reserves. I will list only three.

Number one, by converting the currency portion of reserves into monetary gold. Given the negative interest rates at central banks (and those negative rates could spread to private commercial banks in the future), buying precious metal could prevent losses. Moreover, the market is now entering a growth phase for the price of gold, making it one of the most lucrative assets. In addition, gold is an absolutely crucial strategic resource for any state.

Number two, by using foreign reserves to make central bank loans to commercial banks on the domestic market.

Number three, by putting a portion of a country’s reserves into yuan, especially since as of late last year the Chinese currency is now considered an official reserve currency.

And speaking of the yuan as an international reserve currency, it should be noted that even before it was granted that official status, it was, according to some accounts, already part of the international reserves mix of three dozen countries. However, alternatives should not be limited to the yuan. One might also consider including in one’s international reserves other notes that do not have the status of reserve currencies, but which are the legal tender of countries that are major trade and economic partners.

Tags: FRS 

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