The financial sanctions imposed on Russia by the United States and its allies have put Beijing on notice. In the event of a military clash over Taiwan, China now knows what to expect on the economic front. Beijing probably was not very surprised to see to what length America and its allies have gone to punish Russia for its war against Ukraine.
China’s far greater economic weight compared to Russia might make some American allies more hesitant to support US financial sanctions. But the threat of US secondary sanctions should help persuade them to support US policies nevertheless – even if the economic costs of doing so will be considerable. Should the US navy impose a blockade on Chinese seaborne trade, financial and currency sanctions will become less meaningful, as they derive their effectiveness largely, if not exclusively from restricting a country’s international trade.
China is the world’s second-largest economy. It is the world’s largest trading nation and the largest trading partner of a hundred-odd countries. It is the world’s third-largest creditor, and it is a major lender to developing economies. China is also America’s second largest international creditor. And yet China is highly dependent on the dollar and access to America’s financial system in terms of international trade and finance. Control of the dollar and Indirect control of the international financial system provide Washington with the ability to restrict China’s trade and financial transactions, including relations with third countries in the guise of secondary sanctions, as well as to impose financial losses.
Sources of American Currency Power
What underpins US currency power? Answer: Its widespread international use. First, as an international currency, the dollar serves as a medium of international exchange. The private sector engages in FX trading and settlement, and the official sector (central bank) uses the dollar for intervention purposes. Second, as an international currency, the dollar serves as a unit of account with the private sector using it for trade invoicing purposes and many central banks as an anchor currency. Third, as an international currency the dollar serves as a store of value in the form of financial investment in the case of the private sector or FX reserves in the case of the official sector.
Nothing reflects the importance of the dollar (as a medium of exchange) more than the fact that 80% of international trade (defined as trade involving neither the US nor the euro area) is denominated in dollars. A stunning 90% of the time it is on one side or the other of foreign-exchange transactions compared with a mere 4% in the case of the renminbi. If one wants, for example, to convert Turkish lira into Chinese renminbi, one typically needs trade ‘through’ the dollar.
(Some) Sources of American Financial Power
What underpins US financial power? Amongst other things the need to hold liquid dollar assets to engage in international trade and financial transactions. This in turn depends on ready (direct or indirect) access to the US financial system. Moreover, US financial markets are the deepest and most liquid in world, in addition to being very open and sophisticated, providing foreigners with unmatched opportunities to trade, invest, raise and hold funds. This makes foreigners interested in as well as dependent on maintaining access to the US financial system. Currency and financial power go hand in hand.
The need to hold dollar liquidity to engage in international transactions renders countries vulnerable to asset freezes and other financial restrictions, as Russia just found out. Ironically, it is America’s international liabilities that give it power, and it is China’s financial claims on the United States that make it vulnerable. China is officially the second-largest foreign holder of US government debt to the tune of more than $ 1 trillion dollars. Freezing Chinese assets and excluding China from US financial markets would make it much more difficult, if not necessarily impossible to engage in international trade and financial transactions.
Holding international financial claims on a geopolitical competitor is risky for this very reason. (The Soviet Union used to hold its dollars in the London offshore Eurodollar markets.) But while China may be wary of holding US assets and of relying on the dollar, in practice it has no viable alternative. As it stands, the dollar will remain the dominant international currency for the foreseeable future. Although the demise of the dollar as the dominant international reserve currency has been foretold many times, its dominance has endured, not least because international currency competition can be likened to a ‘reverse beauty contest.’ True, the dollar’s importance as a reserve currency has recently declined somewhat. But it is telling that this has not benefitted its two major actual or potential competitors: the euro and the renminbi.
Beijing Is Keen to Reduce Dependence on US-Centered International Financial and Monetary System
By laying the foundation of an alternative international financial regime, Beijing effectively seeks to reduce its dependence on the present US-dominated system and networks. China has created an Asian Infrastructure Investment Bank, initiated the Belt Road Initiative, is experimenting with a digital e-yuan and has set up a renminbi-based interbank payments system. It has also taken a pro-active approach to promoting the renminbi as an international currency by having it included in the IMF’s special drawing rights currency basket and by offering renminbi swap lines to other countries. Taken together, these initiatives amount to a conscious strategy to enhance the international role of the renminbi.
China is also uncomfortable about its dependence on international trade in general and on trade with the United States in particular. In terms of trade, China is seeking to reduce its dependence, as reflected in its ‘dual circulation’ and Made in China 2025 policies. It is also reflected in its market access policies, including the recent agreement on the Regional Comprehensive Economic Partnership and its application to the Comprehensive and Progressive Trans-Pacific Partnership. Both are aimed at diversifying trade away from the United States and at creating more Sino-centric regional trade relations.
But Beijing Has Only Made Very Modest Progress Thus Far
Despite all these efforts, China has made only very limited progress in terms of challenging the dominance of dollar. A closed capital account, a managed exchange rate, underdeveloped financial markets and a vulnerable banking system remain major impediments. Concerns about the rule of law, Beijing’s willingness to let market forces greater rein, and geopolitical risk also curtail the attractiveness of the renminbi. Most importantly, the reforms required to successfully promote the renminbi would effectively bring about the demise of China’s long-standing economic development model. With policymakers struggling to rebalance the economy and make economic growth more sustainable, may of the necessary renminbi-promoting reforms would increase the risk of economic and financial instability at a very inopportune moment. Therefore: reform is not going to happen, at least not anytime soon.
Combined with China’s relative greater trade dependence vis-à-vis the US, this will continue to make Beijing vulnerable to American geo-financial coercion. Beijing’s best ‘play’ is to grow its economy and thereby reduce its relative trade dependence while increasing the relative dependence of the United States (and its allies). This would make it increasingly costly for Washington to resort to financial and currency sanctions vis-à-vis China. It would also diminish the power of US secondary sanctions, as third parties become more willing to incur America’s wrath in order to maintain amicable economic relations with China. For this to work, however, these third parties and China would need to find a means of international exchange. This would be complicated and costly, but it could be done, provided there is sufficient political will on both side. This then would effectively seal the fragmentation of the international monetary system.
What About Europe?
In terms of currency power, the euro has a sizeable presence in international markets. Excluding (or threatening to exclude) others from using the euro is effective, if not necessarily efficacious. But Europe found itself on the receiving end of US (secondary) dollar sanctions in the past. It would therefore seem desirable to promote the international use of the euro to diminish the effectiveness of secondary dollar sanctions.
But for the euro to rival the dollar as the dominant international currency, the euro area will need to overcome important structural weaknesses. While the euro area members are committed to ‘completing’ banking union and the EU is pushing ahead with capital markets union, this will not be sufficient to make the euro co-equal to the dollar. The euro area needs to strengthen monetary union through well-designed fiscal integration if the euro is to become a true competitor to the dollar. Only then may the euro gain sufficient credibility, and the euro area will be able to issue enough safe, risk-free sovereign assets to rival the dollar. This is a necessary but not a sufficient condition. Reform should indeed be complemented by the creation of a capital markets union to create deeper and more liquid capital markets as well as the completion of banking union to make the euro a more attractive currency to the private sector and hence by the attention to the official sector as a potential alternative to the dollar.
This would significantly improve Europe’s ability to counter the threat of secondary sanctions, provided it manages to mobilize its latent financial and currency power potential. It would also provide Europe with greater influence in terms of a common, coordinated transatlantic geo-economic sanction policy. The economic and political obstacles to the reforms necessary to transform the renminbi and the dollar into an international currency co-equal to the dollar are considerable. For the foreseeable future, the dollar will remain the dominant currency providing Washington with considerable financial and currency power vis-à-vis other countries.