Will Western sanctions change the global financial system?

Faced with the horrors of Russia’s invasion of Ukraine and aware of the limited military options available to them, Western governments deployed their economic and financial arsenal. Such sanctions have been imposed on errant countries before, of course, with varying success, but not to the same extent as against Russia today.

Notably, the United States and its allies seized much of the Russian central bank’s foreign exchange reserves and cut off some Russian banks’ access to the SWIFT financial messaging system for international transactions. The world learned a new word – “untangle” – and the financial system was militarized like never before.

It is too early to assess the impact of sanctions against Russia; there is no sign yet of a decisive effect on President Vladimir Putin’s regime or policies. But the longer-term damage to the Russian economy is likely to be considerable.

At the same time, the consequences of the current Western-led sanctions will not be limited to Russia and Belarus, their direct targets. Other countries wonder if they too could find themselves cut off from the dollar-based financial system if their governments cross a US red line. Saudi policymakers are worried, and China has worried for some time about its vulnerability to US financial sanctions.

I don’t know if there is an ideogram in Mandarin to untangle. But Zhou Xiaochuan, the former governor of the People’s Bank of China, spoke of the risk to China from US sanctions and advocated defensive measures to increase the use of the renminbi in global markets. Others have openly questioned whether Chinese action against Taiwan would trigger similar sanctions from the West.

In recent years, China has taken steps to mitigate this risk. For example, it has established its own cross-border interbank payment system, which has the same messaging format as SWIFT, to offer cross-border Renminbi settlement among its members. CIPS grew rapidly, with some active participation from major Western banks, although the volume of transactions handled through it before the war in Ukraine was still less than 1% of SWIFT’s volume. While this number will likely increase as Russian SWIFT-cut banks seek to use CIPS as a substitute, their transaction volumes will be too low to make a significant difference.

Although CIPS has so far not seriously threatened the global hegemony of Western payment systems, China’s development of the digital renminbi could have a greater impact. Many central banks are exploring the possibility of introducing digital currency (Sweden, where cash is rapidly disappearing, is more advanced than most); but among the biggest economies, China is way ahead of the game. greenback.

Western central banks are acting cautiously on digital currencies. There are technical issues to resolve, as well as serious privacy issues. Citizens may resent the idea that the central bank can control every penny they spend. These considerations are of little relevance to the PBOC. A recent Hoover Institution report on the outlook for the digital renminbi describes it as “a stunning improvement in authoritarian control.” But, from a Western point of view, the international implications are more serious than the problems of internal control.

China’s leadership in digital currencies could greatly increase cross-border use of the renminbi, and countries participating in China’s Belt and Road Initiative are now being “encouraged” to use it. The Hoover Institution report, written just before the war in Ukraine, argues that the ability of the United States to effectively exercise financial sanctions would be diminished if China succeeded in promoting, through its digital currency, “yuanization”. (again a new word for me) global trade flows.

The United States is well ahead in the development and promotion of private cryptocurrencies – speculative vehicles with high transaction costs that offer the prospect of higher returns for savvy speculators. China, on the other hand, leads in cheap payment systems that reduce the cost of cross-border transactions for individuals and businesses in the real economy. There could be a lesson there.

The death of the dollar has been repeatedly predicted, of course, and although the greenback’s share of global foreign exchange reserves has fallen from 71% in 2000 to just under 60% today, there are currently few signs of its disappearance. But the increased use of financial sanctions as a weapon of war has created new incentive for China and other countries to explore ways to minimize the impact should similar measures be used against them. The longer-term implications for the global financial system could be significant.

howard davies, first Chairman of the UK Financial Services Authority (1997-2003), is Chairman of NatWest Group. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Chief Executive of the Confederation of British Industry.

Disclaimer: This article first appeared on Project Syndicate and is published by special syndication agreement.

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Don F. Davis