The Russian ruble got a little stronger yesterday, which isn’t saying much: On Wednesday, Dec. 17, the currency had its biggest one-day fall since 1998; overall, it is down nearly 50 percent for the year. Worse, the tumble has defied efforts by the Russian central bank to defend the ruble by selling off its foreign currency reserves. It started the year with more than $450 billion in foreign assets; now it has $360 billion.
This wasn’t supposed to happen anymore. Emerging market economies are particularly vulnerable to economic conditions abroad or changes in commodity prices, both of which are out of their control, so after the financial crises of the 1990s (Mexico, 1994; Russia and Asia, 1998; Argentina, 2001), they bought trillions of dollars worth of safe assets to protect themselves in exactly this kind of situation. In the event of an economic shock, a central bank can sell its foreign assets to defend its currency.
Starting in the late 1990s, countries stockpiled reserves as never before. Emerging markets’ foreign asset holdings increased more than 10-fold, totaling more than $8 trillion in 2014. About half, $3.8 trillion, is allocated to U.S. dollar assets, rivaling the Fed’s $4.4 trillion balance sheet. The figure below shows the increase in Russian reserves from 2005 to 2014.
Until this week, it looked as if reserves had made the world safer from currency crises. Research indicates (pdf) they helped emerging markets escape the 2008 global financial crisis relatively unscathed. But safety has costs. Foreign governments bought an enormous amount of U.S. debt, a spike in demand that contributed to lower interest rates. There’s concern that low rates induce investors to take on more risk, “searching for yield,” which may have already caused or will contribute to future asset bubbles.
Now it seems the financial crisis wasn’t a sufficient test. Reserves may provide some protection from an external shock, such as a fall in commodity prices in an otherwise-healthy-commodity-exporting country. But, as we see in Russia, they are no match for internal problems. “Reserves can’t make up for poor fundamentals,” said Harvard Kennedy School economist Carmen Reinhart. “The Russian central bank can sell reserves and raise interest rate, but it can’t print dollars.”
What reserves are good for, Reinhart says, is buying time. “But you need to use that time to change policies and restore confidence—otherwise you burn through your reserves and prolong the process.” That’s important. Crisis used to unfold quickly and catch people off guard. Now they may occur more slowly and give policymakers an opportunity to prevent complete meltdowns. But structural reforms, changing labor markets, and cracking down on corruption are easier said than done—even with a crisis looming.