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The dawn of financial warfare

The FT this week ran a brace of big reads on the sanctions slapped on Russia, how they happened and what the longer-term impact will be. It’s an important subject, and both pieces are worth reading at leisure. (Editor: that means after you’ve finished with this one.)

However, FT Alphaville had some follow-up thoughts on the subject, after having spoken to many experts in the field (two current and one former FT Alphavillain were involved). Our biggest takeaway? People seem very relaxed about threats to the dollar.

This might, in time, prove to have been overly sanguine, but we broadly share that assessment. China is the main contender, but until Beijing opens its capital account fully it cannot be a realistic challenger. And even when it does, who will the world realistically trust the most, the US or China?

Even countries that regularly clash with Washington will not feel much safer with the renminbi, given that China has shown even more willingness to economically sanction countries that don’t toe the line on issues like Taiwan. For example, India might not like the dollar’s hegemony, but that it would plough meaningful amounts of its foreign reserves into the renminbi seems preposterous, even if China allowed it to.

The reality is there are many facets that make, support (and break) reserve currency status, and established reserve currencies only fall over a long period of time. As fellow FT Alphavillain Claire Jones wrote Thursday, sterling’s top dog status lasted well into the 1950s, decades after the UK had become a middling power.

Like a social network, the advantages of the incumbents are huge. Countries can try to mitigate their vulnerabilities to financial sanctions from Washington, but they cannot eliminate them (especially if Europe and other allies like Japan join in, as they have in the case of Russia). It’s telling that even Barry Eichengreen, the daddy of dollar historians, is more chilled about the greenback dominance than he’s been in the past.

Despite Eichengreen publishing a wildly timely paper on the “stealth erosion” of the dollar’s dominance in March, he admitted that he had been surprised by the resiliency of the greenback’s role in the global financial system, with most of its market share losses going to smaller western currencies like the Canadian and Australian dollars, rather than the renminbi.

Here’s Eichengreen:

I think the Trump years may have changed that conversation a little bit. An erratic US foreign policy, to put it politely, didn’t significantly erode the singular role of the dollar or of US banks. That slightly reassuring experience in combination with the extraordinarily aggressive Russian action produced an outcome which I, for one, did not entirely see coming.

We’ve seen the difficulty that China and Russia are having in creating alternatives to the Western monetary and financial system. The fact is that the renminbi has not gained much importance as an international reserve currency, that it doesn’t provide much of a backdoor for countries in Russia’s position.

But the euro hasn’t gained ground as an international currency in its first two decades, and the renminbi has barely gained ground. The movement has been into these smaller, high-quality currencies.

That is making for a somewhat more diversified international monetary and financial system that we’ve had in the past, but not the one that many of us saw coming. We thought we’d see a tri-polar system dominated by the dollar, the euro and the renminbi. Instead we have seen smaller players gaining the ground that the dollar has lost.

In terms of other more far-reaching changes. I still don’t really see it. I think it’s revealing that the payments system for the renminbi that China has developed — the cross-border interbank payments system (Cips) — sends its messages through Swift.

However, this raises the most intriguing implication of all: If the backlash is likely to be de minimis, and the impact potentially severe (most countries will be even more vulnerable to sanctions like this than Russia) the temptation to use these tools again is going to be overwhelming.

As one veteran investor told us: “It’s a crossing of the Rubicon. The precedence is really important. This puts a lot of countries on notice that the US is willing and able to go after them in an aggressive way . . . Any precedent becomes a tool if it doesn’t blow up in your face.”

Just like how cruise missiles and later drones became an easier and cheaper method than sending in the US marines — let alone long-term state-building — financial sanctions might become a tempting weapon to deploy more often, even in cases less clear-cut than Russia’s invasion of Ukraine. Precedents are forged by extreme cases, not humdrum ones.

This is what Juan Zarate thinks will happen and he’s no stranger to militarising the world of money. As president George W Bush’s deputy national security adviser, Zarate became one of the key architects of the US government’s far-ranging and often controversial efforts to disrupt terrorist financing networks after 2001.

Zarate pointed out to FT Alphaville that the Russian sanctions weren’t some deus ex machina. They were a natural next step in a decades-long period of development, deployment and gradual escalation (some of which he oversaw). Everything aimed against Russia was part of a pre-existing armoury, whether Swift exclusions or central bank reserves being frozen. Only the size of the opponent and the aggressiveness was novel:

All these elements are part of a playbook that was already being implemented — but in degrees and with calibration . . . This is as maximalist an approach against a major economy that one can imagine.

The gloves are off, in financial and economic terms . . . This is where we’ve been heading for 20 years, in part because of a lack of desire to commit kinetic forces and the search for alternative ways of coercion in statecraft . . . But until now I don’t think that the use of economic and financial predominance as a core tool of statecraft has been embedded in the transatlantic view of the world. (Russia) has galvanised that idea . . . This battlespace is now coming to the fore.

Perhaps a new era of financial warfare is about to dawn? Smarter people than us, please share your thoughts below.

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