Global Courant
After a record wave of new sanctions against Russia, there is a long-running debate over whether the overuse of sanctions “jeopardizes the reign of the dollar‘ has resurfaced. There is no easy answer, as the premise of whether sanctions are overused is subjective and depends on politics as well as economics.
Even if there is general agreement that overuse exists, it is not clear that the costs and risks of future sanctions justify creating an alternative to the well-oiled global dollar machine.
An exception would be the risk of sanctions the United States could impose on mainland China in the event of military action related to Taiwan – as it and a coalition of countries imposed sanctions on Russia in the aftermath of the invasion of Ukraine – which would force countries to choose between joining the global dollar system or joining China.
Countries can try to build alternatives to the US dollar system to avoid being forced to make such a choice – whether or not they succeed. US sanctions extend beyond borders, leading most companies to abandon sanctioned entities rather than risk sanctions themselves.
Despite a deluge of sanctions against Russia in 2022, it’s hard to see a major dent in dollar dominance. The dollar is near historical highlight—88% of currency transactions involve the dollar on one side. The RMB’s jump from 4% to 7% in the past three years has come at the expense of other currencies, not by eroding the dollar’s share.
Nearly 58% of global reserves were held in dollars at the end of 2022, almost the same as before the Russian invasion of Ukraine. Powerful network effects reinforce each the role of the dollar.
Dollar trading and dollar borrowing means that actors want to build up dollar reserves to ensure they can afford their imports and interest payments even on a rainy day. The United States has the deepest capital markets in the world, accessible through an open capital account.
A cashier counts dollar bills in a restaurant in the US. Photo: Global Courant Files/AFP
China is less reliable due to controls that keep capital within its borders. For most countries, the liquidity of the US dollar means that it is often cheaper, safer and more efficient to handle US dollar trades.
The ecosystem around the dollar means exposure risks are easily hedged and there are plenty of good US dollar assets to invest in before they are needed. Despite the mess of the US debt ceiling and other issues with US institutions, the US Treasury market is considered a “risk-free” asset.
Sanctions are the textbook example of “armed interdependence” when the central node of a network exploits that position for its own interests. But it’s hard to say how weaponized sanctions really are. The effects of different sanctions vary widely and not all sanctions create frictions that cause others to question the use of the dollar.
In matters such as North Korea and Syria, there was a high degree of international consensus. But unilateral action by the US has caused friction in other cases, even with allies. When the United States pulled out of the Iran nuclear deal and re-imposed sanctions, European countries were outraged that Washington was able to stop their companies from doing business with Iran.
And despite the strong political will, efforts to create a sanctions-resistant financial institution for doing business with Iran paid off fruitless. Daniel McDowells book on sanctions and the US dollar, “Bucking the buck”, concludes that “dollar dependency remains a reality, even for sanctioned regimes.”
Sanctions against Russia send a mixed signal. They appear to be weakening the US dollar, leading countries fearful of future sanctions to diversify their currency choices. While many countries have not joined the sanctions, major reserve currency issuers have, even Switzerland. Countries fearful of sanctions can learn from Russia’s case that diversification away from the US dollar does not provide the protection they hope for.
Barry Eichengreen and others have found it that while reserves are gradually diversifying away from the US dollar, only a small portion has gone into RMB. There are countries all over Asia to develop more ways to trade and invest with their own currencies, but those trades tend to be small and expensive.
While the People’s Bank of China sees a future with directly connected central bank digital currencies, these are still in their infancy. It is not clear whether they can reduce the use of dollars enough to be impervious to sanctions.
Even if Washington were to lift sanctions, currency diversification would continue as it is largely driven by other concerns, such as the global impact of US monetary policy. Thinking about currency can be compared to the global discussion about supply chains, where there is an increasing willingness to incur costs to reduce over-dependence on one supplier or country.
While not unique to US dollar transactions, concerns about global financial infrastructures such as the SWIFT messaging system, which, while based outside the United States, removes sanctioned entities from its network, have not led to viable alternatives. China’s cross-border interbank payment system is not a true replacement for SWIFT and trusts on SWIFT for many of his posts.
China has big plans to internationalize the yuan, but it is not there yet. Image: Getty/iStock
The biggest threat to the global currency system is the possibility of sanctions against China, a dog that so far has mostly not barked in the trade and technology war between the US and China.
While many of China’s top tech companies, such as Huawei, are on export control and investment ban lists, the US Treasury Department has refused to put them on the sanctions list. If sanctioned, they would become radioactive to global affairs and cause a backlash from countries suddenly unable to maintain their networks.
Some countries may disagree, but current US policy has rightly been cautious about avoiding excessive unilateral sanctions, especially against China. Such sanctions could make building and moving to a real alternative to the US dollar worthwhile.
Large-scale sanctions against China would be much more costly and less likely to receive the broad international support that the sanctions against Russia have. US policymakers should be very clear that broader Chinese sanctions would prove to be a significant risk to the dollar’s international role.
Martin Chorzempa is a Senior Fellow at the Peterson Institute for International Economics.
This article was originally published by East Asia Forum and has been republished under a Creative Commons license.
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