Trust, Russia, and the Dollar: Why a New Reserve Currency is Still a Long Way Away

With the souring of relations between the United States and Russia, Russia has expressed its desire to become less dependent on the US dollar. This is an understandable concern, given the political tension between the two countries, coupled with the threat of tougher US Sanctions on the Russian economy[1]. Simply put, the Russian government knows that it is at a disadvantage. The United States is Russia’s 5^th largest trading partner, with 11$ Billion in trade volume, while Russia is United States’ 20^th largest trading partner, with about 27$ Billion in trade volume. It’s pretty clear why Russia is scrambling to limit its exposure to the United States and the Dollar

           Source: CNN

         

At first glance, one would point to the warming of relations between Russia and China as a step in the right direction. These warming relations can be key in diminishing Russia’s exposure to the dollar[2]. China after all, is the worlds 2^nd largest economy, and it has its own concerns about the weakening strength of the dollar. By this closer association, Russia and China would hypothetically be able to conduct their transactions in Yuan, completely bypassing the need for using the US dollar.

         

However, such a transition from dollar to Yuan will take a painstakingly long time. Central banks would have to slowly replace their foreign reserves with Yuan instead of dollars, a bottom up process that would require small and medium enterprises to use the Yuan in commercial transactions.

         

On top of this, the main commodity that will be traded between Russia and China is Gas/Oil, which is globally denominated in Dollars[3]. With the 400 billion dollar Gazprom contract signed earlier this year, such a large volume of trade would involve a large volume of currency swaps from Yuan to dollar then dollar to ruble. Completely cutting off a currency that is pegged to the value of the main commodity being traded, gas, will be a difficult task. Yet steps are being taken by both Russia and China to slowly wean their economies off of the Dollar

         

China has recently been taking steps to hedge the risk of dollar devaluation by buying up large amounts of gold and euro’s to diversify its foreign reserves, and offset the losses brought upon the devaluation of the dollar[4].

       

 In addition to China’s hedging, The Bank of China and Russian Bank VTB signed an agreement in conjunction with the Gazprom deal in which both sides agreed to pay each other in their own currencies, essentially cutting out the dollar. Yet this move does raise some questions, mainly with the volatility of both the ruble and the Yuan, since neither of those currencies is as trustworthy as the dollar. The values of both currencies are set by each governments central bank making the true value of each currency is uncertain, and using those currencies to replace the dollar as the reserve currency is dangerous.  

CEO of Gazprom Alexei Miller and CNPC General Manager Zhou Jiping  with President Putin and President Xi  Jinping looking on. May 24^th 2014 (Source: CNBC)

       

Both governments understand that weaning themselves off of the dollar by either diversifying their foreign reserves or cutting out the dollar from trades will be an uphill battle. However, this is just part of the problem. The real issue is trust in both markets. China has less of an investor trust issue, as its economy is fairly open to foreign investment, and it is fairly regulated. On the emerging market risk ranking China ranks as the 27^th riskiest emerging market. Russia however, is in a different predicament. It is ranked as the 11^th riskiest emerging market. That risk is mainly embodied in the rampant corruption in its economy. Transparency International’s corruption index ranks Russia as 112^th, in joint position with Iran and Kazakhstan[5].

     

These corruption rankings pose a greater problem for the Russian economy. Of course, it is possible to start and run a business in Russia effectively. The problem is trust. Western investors don’t trust the markets, seeing too much of a risk of losing their money. This impedes Russia from taking meaningful steps to abandon the dollar. In fact, if it tries to abandon the dollar before it builds trust in its own economy and currency, investors will pull their money out of Russia very quickly, since its lack of a stable foreign reserve currency, such as the dollar, will create an environment similar to the 1998 Russian Crisis.

    

It is pretty clear that this movement to knock the dollar off as the reserve currency is going to take quite a while. It is also clear that certain steps must be taken both by Russia and by China to strengthen the trust in their economies before they embark on the quest to drop the dollar. For Russia, the issue lies in finding a way to strengthen trust in its markets and its currency. For China, the task lies in hedging any risk it has of losing its money if the dollar devaluates. Either way, both countries have a long way to go to achieve their goals.