Central Bank of Russia’s Foreign Reserves: Let Me Count the Ways…Freeze, Immobilize, Confiscate
Dear BWR Subscribers,
“Barbershop Whispers….Russia” begins with “My Takeaways” on the main topic, followed by the main topic discussion. The last two sections of “Barbershop Whispers…Russia” are “Follow-ups” regarding previous publications and “Quick Bites” briefly addressing emerging events.
In last week's BWR, I discussed the global agrochemical world and Russia’s shifting export markets in this sector. How are Russian fertilizer companies adapting to the changing business environment created by Putin’s war on Ukraine?
In this week’s BWR, I will discuss the EU’s changing attitude toward the long-awaited confiscation of the Central Bank of Russia’s (CBR) foreign reserves. Why is the EU hesitating, and what are the innovative methods being considered to exploit the CBR foreign reserves short of confiscation?
I have written about the CBR frozen foreign reserves in the past, and Jamison Firestone wrote a contributor’s piece in BWR about the case for confiscating them. The state of the CBR foreign reserves is a continuing important and consequential feature of the war.
Takeaways:
ECONOMIC IMPACT: The West can mitigate the legal risks associated with the confiscation of the CBR foreign reserves without risking the integrity of the rule of law system that underpins Western economies. The EU is concerned that confiscation will result in investors and central banks withdrawing from the Eurozone because the bulk of the confiscation will take place in the Eurozone. Rules-based governments and companies will not be deterred by the confiscation and will continue to invest in the Eurozone and EUR and USD-denominated financial instruments.
GLOBAL CURRENCIES: No currency alternative to G7 currencies—particularly USD and EUR—offers the depth of global market liquidity and the utility of transaction settlement and value storage. Russian energy companies are experiencing this firsthand, with billions of CNY and INR stuck in China and India.
SEIZURE OF WESTERN ASSETS: The EU leaders are concerned the Kremlin will seize Western assets in Russia, but the Kremlin is already de-facto seizing Western assets in Russia. The exit process for Western companies includes a 50% discount on the value of their assets (and that’s value as determined by the Kremlin) and then a contribution of 10% of the proceeds of the sale to the federal budget.
Background
Following Russia’s 2014 invasion of Ukraine, the Central Bank of Russia (CBR) began reducing USD-denominated cash and securities deposits in favor of EUR, CNY, and other currencies. This was done to preserve liquidity in the event that the US restricted Russia’s global USD use or froze CBR assets, including its foreign reserves.
By the time Russia launched its second invasion in February 2022, the CBR had reduced its exposure to USD assets but, as planned, its exposure to the EUR had grown. The Kremlin believed EUR-denominated assets and Eurozone jurisdictions would be more “secure”—safe from seizure or restrictions—but provide a similar level of liquidity as the USD. The Kremlin did not anticipate a coalition of EU countries joining the US, UK, and Japan and freezing the CBR’s foreign reserves in the Eurozone.
Western Financial Support and Political Will in 2024
As the war moves into its third year, Western political will and financial support for Ukraine’s war effort appears to be weakening, particularly in the US where former president Trump, now the Republican candidate for President in November, is influencing a dysfunctional Congress led by the Republican Party and holding up $60B in Ukrainian military aid. US foot-dragging contrasts with EU approval of €50B in financial assistance to Ukraine late last year. Trump has publicly stated he will not provide Ukraine with “another penny” of aid if elected president.
As of 15 February 2024, the World Bank estimated the cost of Ukraine’s recovery and reconstruction at $486 billion—far in excess of the $351B+ in frozen CBR assets held in G7+ jurisdictions.
This number does not include the war's ongoing financial and military costs.
Confiscation
In anticipation of the growing funding needs for war and post-war reconstruction, Western governments have been searching for innovative ways to fund Ukraine’s war effort against the Russian aggressor. In January 2024, Jamison Firestone, a globally recognized expert on sanctions, wrote a contributor’s piece in BWR entitled “The Case for Confiscating the Central Bank of Russia’s $350B+ Foreign Reserves”.
In it, Firestone laid out the legal and moral justification for confiscating the CBR’s foreign reserves to fund Ukraine’s war effort and rebuild Ukraine. Central to the confiscation legal argument were collective countermeasures against Russia, the aggressor state, and likely post-war reparations demands.
The legal case against confiscation is sovereign immunity under international law. A violation of these domestic and international laws may risk eroding and bringing into question the integrity of the rule of law environment that underpins Western economies.
At the time of Firestone’s publication, there appeared to be a strong US-led Western consensus and momentum for confiscating the CBR reserves. However, today, the EU governments and the European Central Bank (ECB) are reconsidering the confiscation route and exploring other mechanisms to exploit the CBR reserves short of legal confiscation. The Europeans believe that seizing the sovereign assets of another country would damage the Eurozone’s rule of law principle and may result in the withdrawal of investors from the EUR. They are also concerned Russia may seize Western assets, estimated at around $288B.
It should be noted that $210B of the approximately $351B+ CBR foreign reserves are deposited and held with Euroclear, a private central securities depository and clearing house in Belgium.
These asset holdings are primarily comprised of interest-bearing government bonds.
Alternatives to Confiscation
Two prevailing mechanisms are being considered for exploiting the CBR reserves outside of confiscation. The first mechanism, and most likely the easiest to execute immediately, is the disbursement to Ukraine of the interest revenues earned on cash the CBR accumulates in the CBR’s account at Euroclear Bank. The second mechanism is a collateralized loan product in which the CBR foreign reserves located at Euroclear are the collateral for loans to Ukraine.
Neither mechanism will fully cover the costs of Ukraine's reconstruction, but both will have a material and moral impact on Ukraine’s ability to finance the war of aggression by Russia. For Russia, the immobilized status of these assets has no financial impact on Putin’s ability to prosecute his war. Putin wrote these assets off long ago and is relying on the world’s thirst for Russian energy and his ability to evade sanctions to finance the war.
Earned Interest Revenues
Euroclear holds the securities for its clients, and when the bonds mature, the proceeds are paid into the client account at a separate legal entity, Euroclear Bank. Once those interest payments are deposited into the bank account, clients transfer the funds to another banking institution or reinvest the money. Euroclear Bank does not pay interest on deposits, so there is no incentive to leave the money there. Due to Western sanctions, the CBR has been unable to transfer more than €130B in accumulated cash in their Euroclear Bank account. While the CBR legally owns the money, it does not own the interest earned on the money. Euroclear Bank has since been earning interest on this money by depositing it with other financial institutions. In 2023, the interest earned on this money was approximately $6B.
While the CBR does not have an ownership claim on these revenues, Euroclear and its shareholders do, as does the Belgian government, through taxes levied on them. However, this mechanism benefits the EU by allowing the ownership claim to be worked out within the EU and eliminating any pretext violation of Russian ownership rights.
Collateralize CBR Foreign Reserves
Belgium first circulated a plan among the G7 in February to raise debt obligations for Ukraine based on the collateralization of CBR foreign reserves. This mechanism relies on the expectation that Ukraine will be awarded war reparations to cover the debt obligations at the war's end.
According to the Lawfare Institute, collateralizing CBR assets is not straightforward and has legal challenges. The key factors are transfer rights, default risk, the involvement of third states, and permanent effects.
1. CBR Assets in Escrow
The most straightforward way to collateralize CBR assets is to put them at Ukraine's disposal by placing them into an escrow account held in trust by a third party. Ukraine could then use the account as collateral.
If Ukraine cannot repay the debt, the collateral will be released to the creditors, resulting in permanent confiscation of the assets. To avoid this situation and the legal challenges associated with permanent confiscation, Russia would need to provide its reparation, or an international court would need to award damages to Ukraine.
2. Investing CBR Assets in Ukraine’s Bonds
In this case, the default risk is shifted to Russia by way of CBR assets invested in Ukrainian-issued catastrophe bonds (CAT Bonds). CATs are high-risk investments where bondholders risk losing their principal if a specified trigger event occurs. In this case, the trigger would be Ukraine awarded war reparation—through either a judgment or a negotiated settlement. Russia would then forfeit its assets, transfer ownership to Ukraine, and relieve Ukraine of any legal obligations to pay. In this case, the CBR retains ownership of the investment.
3. G7 Countries Issue Loans with CBR Assets as Collateral
This option prevents Ukraine from accumulating debts to Russia. The G7 countries act as creditors for Ukraine, using CBR assets as collateral. The G7 countries can issue a syndicated loan to Ukraine backed by the CBR assets they control as a guarantee for repayment. The underlying concept is that when Ukraine is awarded damages against Russia, these funds can be used to repay the G7 (or the bondholders, in the case of the SPV). Specifically, if Russia fails to fulfill its obligation to pay damages voluntarily, Ukraine can set off the damages claim against the claim held by the G7 against Ukraine.
For more details on these options, I recommend reading the Lawfare analysis.
Conclusion
Whether the CBR assets are “temporarily” frozen, as is the case now, or confiscated, it will have little impact, if any, on the Eurozone and the global rules-based economy. The Demand for G7 currencies—particularly USD and EUR—and the financial instruments denominated in those currencies that underpin the global economy will not be affected. They will continue to be in demand and grow because no other currencies provide the global depth of liquidity, transaction settlement utility, or storage of value. These valued characteristics of G7 currencies will always attract rules-based governments and businesses. A case in point is the problematic trade settlement position Russian energy companies are now in, with billions of CNY and INR stuck in China and India due to domestic capital restrictions and the relatively low global demand for those currencies.
The G7+ leaders need to wake up to the reality of the Russian threat and take decisive action against it. The legal and moral basis for confiscating and deploying the CBR assets to defend and rebuild Ukraine already exists. Such action will not deter rules-based governments; only those governments that act illegally will see risk in the confiscation of CBR assets. And in the latter case, the G7+ decisive action to confiscate the CBR assets should help deter such illegal actions.
The absence of clear and severe costs only encourages the Kremlin. The Putin regime has demonstrated, time and time again, that it only responds to strength. Putin will exploit any perceived sign of weakness. Western foot-dragging on confiscating CBR assets is exactly the message of indecisiveness and weakness that Putin will exploit.
Follow-ups & Quick Bites:
Follow-ups:
Russian Security Agency Failure and Duty to Warn
Sergei Naryshkin, Russia’s Foreign Intelligence Service (SVR) Director, told reporters that U.S. warnings of a possible extremist attack were too broad to have prevented the deadly attack outside Moscow last month. Naryshkin stated:
“The Federal Security Service (FSB) received some information from the U.S. intelligence services that such a thing was unfortunately possible,”
Reuters reported that Iran also warned Moscow of an imminent attack by ISIS.
The US has a history of Duty to Warn as do some of America’s most ardent adversaries. In 1984, Cuban diplomat Néstor García Iturbe, serving as counselor to the Cuban Mission at the United Nations, placed a late Saturday evening call to Robert Muller, head of US Security at the UN, with information about an assassination plot against President Reagan.
The US Secret Service acted on the information and rounded up the suspects. This particular story, and others, are told and documented in an excellent book by William LeoGrande and Peter Kornbluh, “Back Channel to Cuba”.
Quick Bites
Roman Abramovich – Denial of Service
Israel's Supreme Court upheld Bank Mizrahi-Tefahot’s denial of service to their customer, Roman Abramovich.
Abramovich ordered an 8M NIS (USD 2.2M) wire transfer to ZAKA, a charity organization with an account at Bank Mizrahi-Tefahot. The bank declined to execute the transfer because of international sanctions imposed on Abramovich.
However, the bank is not bound by US or EU sanctions, and the requested wire was in Israeli shekels, not USD or EUR. Nevertheless, the bank’s internal risk management department advised against the transfer.
This action highlights the power of US and EU sanctions, even on those financial institutions not obligated to enforce the sanctions.
Western Appeasement and Misplaced Priorities
Ukraine drones are striking Russian oil refineries deep inside Russia. The most recent strike was in Tatarstan, approximately 1,300KM from the Ukrainian border.
The White House has publicly expressed concern about the negative impact these strikes will have on the global oil markets (Come again? Seriously?). Western allies are clearly divided on this issue as was displayed during a joint press conference in Paris between US Secretary Blinken and French Foreign Minister Stéphane Séjourné:
Blinken:
“The US has neither supported nor enabled strikes by Ukraine outside its territory,”
Séjourné:
“The Ukrainian people are acting in self-defense, and we consider that Russia is the aggressor….In such circumstances, there is hardly anything else to say…I think you understood me.”
Putin will continue to exploit Western indecisiveness and lack of commitment to Ukraine. If the West is not committed to a Ukrainian victory, Putin will perceive this as Western acceptance of a Ukrainian defeat. Russia and Ukraine will define victory and defeat to their respective constituents and stakeholders.
Vol 2, No 17 - BWR 07.04.2024
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