A couple days ago, the Russian ruble got a little stronger, but that’s not really saying much: this Wednesday, the currency had its biggest one-day fall in 16 years, and is overall down nearly 50 percent from last year. Even worse, this tumble has defied efforts by the Russian central bank to defend the ruble by selling off its foreign currency reserves, losing $90 billion in foreign assets this year alone.
Interestingly enough, this wasn’t supposed to be happening any more. 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, they bought trillions of dollars worth of safe assets in an effort to protect themselves in this exact kind of situation. In the event of an economic shock, a central bank can sell its foreign assets to defend its currency. Starting back in the late 1990s, countries had stockpiled reserves like they never before had. Emerging markets’ foreign asset holdings increased more than 10-fold, totaling more than $8 trillion in 2014. About half of this was allocated to US dollar assets, rivaling the Fed’s $4.4 trillion balance sheet.
Until this week, it looked like reserves had made the world safer from currency crises. Research indicates that they’d helped emerging markets escape the 2008 global financial crisis relatively unscathed, but safety of course has costs. Foreign governments bought an enormous amount of US debt, which contributed to lower interest rates. Therefore, there’s a concern that low rates induce investors to take on more risk, which may have already caused future asset bubbles. Now, however, it seems that 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 country. Yet they’re still no match for internal problems. Reserves can’t make up for poor fundamentals, and while the Russian central bank can sell reserves and raise interest rates, they still can’t print dollars. More than anything else, reserves are good for buying time, but you need to use that time to effectively change policies and restore confidence, or else you’ll burn through your reserves and prolong the process. Earlier, crises would unfold quickly and catch people off guard, but now they can occur much slower and give policymakers a chance to prevent complete meltdowns. However, structural reforms, changing labor markets and cracking down on corruption are a lot easier said than done.