The ability to restrict the cross-border flow of goods, services, capital, people, and data, and thereby to impose economic costs on others is a potential source of coercive power. It is also a source of economic and political vulnerability from the point of view of the economic actor targeted by such restrictions. This power is particularly pronounced if a government controls the flow of difficult-to-substitute goods, such as rare commodities or critical technology. Export controls, for example, allow governments to prevent sanctioned entities, whether companies, individuals, or entire countries, from obtaining designated goods. Financial sanctions allow governments to prevent sanctioned entities from engaging in designated types of transactions with the domestic financial system. Measures targeting sanctioned actors are called primary sanctions. Measures (indirectly) targeting actors that engage in sanctioned activity with sanctioned entities are called secondary sanctions. Such measures effectively extend the sanctions regime to third parties. Secondary sanctions are often necessary in order to make the primary sanctions effective by preventing them from being undermined by so-called third-party spoilers or black knights[1].
The United States, for example, has imposed secondary sanctions on Chinese technology companies. These sanctions not only prohibit US companies from selling semiconductors to the sanctioned companies. They also prohibit third parties that use US-produced/ -licensed components in their production of semiconductors from selling them to the Chinese companies. If these third parties fail to comply with US sanctions, they risk losing access to their US suppliers (including IPR licenses). US secondary sanctions, in particular, are often very effective because the potential costs stemming from penalties, let alone from the loss of access to US markets (or goods), are typically far greater than the economic losses incurred by complying with US sanctions. At least this is true in the case of difficult-to-substitute goods. The costs incurred by a bank in case of loss of access to the US financial system typically far outweighs costs stemming from, for example, terminating a commercial relationship with a sanctioned entity. Access to US financial markets and, specifically, access to dollar funding and clearing is a difficult-to-substitute good. It is the relative lack of substitutability that makes US primary and secondary dollar sanctions so impactful.
What Can Be Done in the Face of the Secondary Sanctions Threat?
The EU has proposed legal remedies to cope with the threat of secondary sanctions[2], including resorting to various available inter-state dispute settlement mechanisms or, in the case of companies and citizens, bringing complaints in front of US and EU courts. Such legal recourse is costly, time-consuming and not necessarily likely to succeed. The EU has also proposed policies aimed at supporting companies and individuals affected by secondary sanctions, such as information sharing and providing support. But this does not solve the problem, either.
With specific regard to secondary dollar sanctions, various proposals have been put forward[3], including the creation of a public bank to prevent European financial institutions from falling afoul of dollar sanctions; creating an EU resilience office to support affected European entities; enhancing the international role of euro and/ or introducing a digital currency to avoid using the dollar (or using it less at any ratee); and enforcing the EU blocking statute[4]. However, the creation of a special purpose vehicle to circumvent the Trump administration’s Iran sanctions has fallen short of expectations. Furthermore, creating a resilience office is more of a palliative than it is not a remedy. Enforcing the existing blocking statute might help deter the imposition of secondary sanctions; but if it fails to do so, it potentially risks jeopardizing transatlantic financial relations, while failing to shield European companies, and especially banks, from incurring hefty penalties, including denial of market access. After all, it is far from clear that enforcing the statute would lead US policymakers to refrain from imposing dollar sanctions, if only to avoid losing credibility vis-à-vis other third parties. Enhancing the role of the euro vis-à-vis the dollar is the most promising, longer-term option to mitigate the risk of secondary dollar sanctions (see below).
A further complicating factor is that for any countermeasures to be effective and credible, they would require a coordinated, joint EU response. But it is unclear that if the support of individual member-states is required, the EU authorities would be able to obtain it. After all, why would the Baltic countries want to run the potential risk of US retaliation if the original US sanctions primarily target German companies involved in an enterprise the Baltics oppose (e.g. Nord Stream 2)? This allows the US to pursue a selective “divide-and-rule” approach to secondary sanctions. But first and foremost, European companies will have little interest in falling afoul of US secondary sanctions as long as the potential costs of violating sanctions far exceeds the costs of terminating their commercial relationship with a sanctioned entity. The German government could force the German company not to comply with US sanctions. But unless this actually deters US sanctions, German companies will nonetheless incur significant costs in case of US secondary sanctions enforcement, including loss of market access.
Dollar Dominance and Costs of (Secondary) Dollar Sanctions
Fundamentally, it comes down to this. (1) As long as the costs of complying with US sanctions are significantly smaller than the costs of violating them, companies (and especially banks) will have a strong interest to comply with them. (2) And as long European companies are more dependent on the dollar than US entities are on the euro[5], European threats of retaliation will lack credibility. In order to deter secondary sanctions, retaliation has to be credible, and credibility requires the ability to impose economic costs equivalent to (or greater than) the costs potentially incurred. More importantly, from the point of view of an individual company threatened by secondary sanctions, it is almost always the least bad option to forego sanctioned business rather than risk violating US sanctions. This cost-benefit calculus varies, of course. German companies increasingly dependent on China for exports and sales will be more vulnerable in the case of US secondary sanctions than German banks. Why? Because German banks are far more dependent on the dollar than the renminbi. In this context, it is worth noting that China has just passed a law that allows it to retaliate against German companies in case they comply with US sanctions, thus forcing them to choose between the US and China (aka often their most important and second most important overseas market). (This recent measures supplements a blocking statute introduced earlier this years prohibiting Chinese companies from complying with US sanctions.)
This is less of a dilemma for banks in the case of dollar sanctions. Losing access to the US financial system is much costlier than losing access to China’s financial system. At the very least, this is true for banks – the primary target of secondary dollar sanctions – given the far greater importance of the dollar in international trade and finance relative the renminbi[6]. The effectiveness of dollar sanctions is hence closely tied to dollar dominance and asymmetric interdependence[7], which effectively undermines Europe’s, let alone Germany’s ability to deter secondary dollar sanctions. Deterrence lacks credibility because the US has escalation dominance given the greater importance of the dollar compared to the euro.
The dominance of the dollar as an international currency is a source of US power and European vulnerability. Among other things, such as the power to delay and to deflect pressure to adjust balance-of-payments imbalances[8], the dollar provides the US with the ability to prevent both sanctioned and third parties from using the dollar, thereby imposing significant economic costs on them. The former is best called currency statecraft (macro), while the latter, relying primarily on regulatory policies and sanctions, is best called financial and dollar statecraft (micro) – where statecraft refers to the purposeful management of economic instruments to advance political objectives[9].
The dollar remains by far the dominant international currency. For central banks, the dollar is far more important than the euro (FX pegs, FX reserves, foreign holdings of government debt). For the private sector, this is true, too, even if the euro plays a bigger role in terms of trade invoicing. Otherwise, the dollar is clearly dominant (FX market turnover, cross-border lending). The dollar makes up 60% of global central bank reserve holdings, or three times the euro share. As such, few international financial intermediaries can afford to be excluded from dollar transactions and access to US financial markets. And because of this, secondary dollar sanctions are so effective. The dollar continues to play a pivotal role in the international economy. In spite of Beijing’s internationalization efforts, the renminbi will not be rivalling the dollar as long as China is not prepared to more fully open its capital account, modernize its financial markets, and improve governance[10]. The euro is the only realistic medium-term competitor.
The Euro Has the Potential to Rival the Dollar – Long-Term
International reserve currency status is thought to be underpinned by a number of prerequisites[11], including (1) economic size, (2) financial development, (3) effective governance, (4) foreign policy ties and (5) military reach. The euro area largely meets the conditions necessary for the euro to become a dominant international currency – it is, after all, already an important reserve currency. (1) The US economy and the euro area are comparable size-wise. (3) Good governance, rule of law, and respect of property rights are all in place. (4) EU foreign policy ties may be somewhat weaker than those of the US. But its foreign policy ties are sufficiently strong so as not to represent an obstacle to the rise of the euro as international currency. (5) The EU, let alone the euro area, may not be a military power comparable to the US, but the EU is a militarily sufficiently strong actor to alleviate any concerns about its geopolitical position and stability. The structural requirements for the euro to play a more important, co-equal role are largely in place – with the exception of (2) financial market development.
It is therefore essential to create a large pool of safe and liquid assets. Euro-denominated government bond markets are too fragmented, a sizeable share is too lowly rated, liquidity is much lower than in the US government bond market, and investors have residual concerns about the euro’s long-term stability. This calls for completing a monetary union and creating a pan-euro area government bond market backed by the full faith and credit of the euro area governments. Not only is the US more attractive size-wise, but also in terms of market sophistication, development and liquidity, including tightness, immediacy, depth, breadth, and resiliency[12]. Generally, European private capital markets remain too fragmented. National regulation makes it more difficult and burdensome for euro-area banks, financial service firms and investors to operate in it, thereby limiting the scale, efficiency and diversification necessary to compete with US capital markets. In order to make the euro more attractive for private sector agents, Europe needs to create pan-euro capital market comparable to the US financial market.
Euro Co-Equal to the Dollar Will Help Mitigate, If Not Completely Eliminate, Dollar Sanction Risk
The euro has the potential to become a reserve currency co-equal to the dollar. If the euro is successfully promoted, this would help transform what today is an asymmetrical interdependent relationship between the US and Germany/ EU into a more symmetrical one as far as the dollar and dollar sanctions are concerned, thereby rendering the use of secondary dollar sanctions less effective and potentially more expensive if Europe retaliates. The more US banks come to depend on access to the euro and euro area capital markets, the more costly and credible European retaliation will become in response to US secondary sanctions. Similarly, the more international trade and finance is conducted in euros, the less costly dollar sanctions will become. They would nonetheless remain costly, particularly for individual companies and especially banks. But deterrence and retaliation would become more credible. This should reduce the risk of secondary dollar sanctions being deployed in the first place.
Promoting the euro as an international currency is perhaps the only realistic longer-term option to reduce, if not necessarily to completely neutralize, Europe’s vulnerability vis-à-vis the dollar sanctions. Historically, Germany proactively opposed the deutschmark from becoming an international currency for fear of losing control over monetary policy and due to its impact on export competitiveness – and perhaps due to an adherence to ordo-liberalism. The EU and Germany have also been largely passive as far as the international role of the euro is concerned. Proactively promoting the euro would represent an important shift[13]. It would be a logical response to the increasing politicization of international economic relations and the increasing use of secondary dollar sanctions.
A less asymmetric currency interdependence would make dollar sanctions less effective and European retaliation more credible, provided the Europeans can agree on a joint position and maintain unity. The more US companies and banks rely on the euro and the more the euro becomes a substitute for the US dollar for other countries, the lesser the costs of dollar sanctions from a European point of view. And the less effective and more costly they become for the US to wield. In this sense, proactively promoting the euro as an international currency would support the EU’s quest for ‘strategic autonomy’, including the creation and development of trade defense measures, and anti-coercion instruments[14]. Last but not least, completing a monetary and banking union as well as advancing a capital markets union would help make the euro area more resilient, and therefore more attractive to non-European economic actors. Last but not least, a more symmetrical international monetary system would not only make Europe less vulnerable in the face of US financial statecraft vis-à-vis China, it would also enhance the prospect of American-European cooperation[15].
References:
[1] Bryan Early, Sleeping with your friends’ enemies, International Studies Quarterly, 53(1), 2009
[2] European Parliament, Extraterritorial sanctions on trade and investment and European responses, 2020
[3] EUCFR, Meeting the challenge of secondary sanctions, 2019
[4] A blocking statute shields companies against sanctions by prohibiting them from complying with foreign sanctions by obliging them not to recognize foreign court rulings.
[5] Congressional Research Service, Iran Sanctions, 2021
[6] Peterson Institute, Can China blunt the impact of new US economic sanctions? July 2021
[7] Markus Jaeger, The logic (and grammar) of US grand strategy, 2021
[8] C. Randall Henning, The exchange-rate weapon and macroeconomic conflict, David Andrews, Orderly change (Ithaca, 2008)
[9] Benjamin Cohen, Currency statecraft (Chicago, 2019)
[10] Markus Jaeger, Yuan as a reserve currency, Deutsche Bank, Research Briefing, 2010
[11] Elias Papaioannou and Richard Portes, Costs and benefits of running an international currency, European Economy Economic Paper (348), 2008
[12] IMF, Measuring liquidity in financial markets, Working Paper (232), 2002
[13] The multipolar character of the international monetary system is often blamed for its rapid demise, see locus classicus Charles Kindleberger, The world in depression, 1929-1939 (London, 1973) – though this proposition is more than debatable.
[14] European Parliament, Extraterritorial sanctions on trade and investment and European responses, November 2020, European Commission Trade defence measures, 2021
[15] Markus Jaeger, What is Germany to do in the face of US-Chinese geo-economic conflict?, 2021