Qiyuan Xu & Aizong Xiong. China Economic Journal. Volume 15, Issue 3, 2022.
Since the outbreak of the Russia-Ukraine war in early 2022, the US and Europe have imposed a package of financial sanctions on Russia. These sanctions have not only a severe impact on the Russian economy and financial system but also have a profound impact on the current international monetary system. In order to observe this effect, we need to analyze the financial sanctions themselves, which will be covered in the first part of this paper.
The international monetary system involves four elements: the international reserve currency, the exchange rate system, the balance of payments adjustment mechanism and the international financial infrastructure. Among them, the second part of this paper will analyze that financial sanctions may have an impact on the aggregate demand for global reserve currency, in turn, on the choice of exchange rate regime and balance of payments adjustment mechanism. In the long run, financial sanctions can furthermore affect the structure of the global monetary reserve system as well. International financial infrastructure is also a key factor of an international monetary system, the third part will focus on the impact of financial sanctions on the infrastructure.
The last part is the conclusion and outlook. Probably we will see that the impact of financial sanctions both on the global monetary reserve system and the international financial infrastructure will show the characteristics of decentralization and de-globalization. Meanwhile, the stability of the exchange rate system will decline significantly, accompanied by the trend of more tightened regulations on capital flows.
I. Financial sanctions imposed by the United States and Europe on Russia
After the Crimea incident in 2014, the United States and Europe imposed severe financial sanctions on Russia. After the outbreak of the Ukraine crisis, the financial sanctions have been further escalated, some of which are the first to be used against a big country like Russia. Overall, financial sanctions mainly involve three aspects:
The first is to freeze or confiscate the assets of the entities concerned. The Office of Foreign Assets Control (OFAC) of the U.S. Treasury Department imposes asset freezes on relevant individuals and enterprises through the Specially Designated Nationals List (SDN), and prohibits U.S. citizens from trading sanctioned entities to restrict their liquidity. After the outbreak of the Ukraine crisis, the U.S. Treasury Department put several Russian state-owned and private entities on the SDN list to freeze their assets in the United States, such as Sberbank and VTB. The European Union and the United Kingdom have also imposed asset freezes on Russian individuals and entities. More seriously, on 28 February 2022, the US and Europe imposed a freeze on the assets of the Russian Central Bank in order to restrict its ability to use its international reserves, which left approximately US $300 billion of Russian assets frozen and caused significant shocks in Russian financial markets.
The second is to restrict Russian institutions’ access to the US dollar payment network and SWIFT system. The United States is at the core of the international payment and settlement system. By restricting or even cutting off the links between Russian financial institutions and the US dollar payment network, it makes Russia impossible to conduct international economic transactions with overseas as usual. For example, in the sanctions imposed by the U.S. Treasury Department on the Russian Savings Bank on 24 February 2022, it required all U.S. financial institutions to close any Russian Savings Bank agency account or remittance account within 30 days, thus kicking the bank out of the US dollar payment and settlement system. In addition, driven by the United States and Europe, some of the key Russian banks, such as the Vneshtorgbank, the Vnesheconombank (VEB) and the Promsvyazbank, have been excluded from the SWIFT system. Hence, these Russian financial institutions will be restricted to operate their international trade and financial transactions as usual.
The third is to cut off overseas financing to sanctioned entities. The OFAC publishes the Sectoral Sanctions Identifications List (SSI). Once an entity is placed on the list, the U.S. Treasury Department will prohibit individuals or companies from providing financial support to the entity. For example, on 24 February 2022, the US Treasury issued directive 3 under Executive Order 14,024, which prohibit U.S. individuals or companies from participating in or providing debt financing or equity financing in the U.S. to Russian-related entities with a maturity of more than 14 days. On 25 February, the EU also extended existing financial sanctions to cut off Russian access to European market financing. In addition, the U.S. and Europe have used their influence in international financial institutions to prevent Russia from getting loans or financial assistance. On 11 March 2022, the G7 announced that they would block Russia’s access to financing through international financial organizations such as the IMF and the World Bank.
II. The impact of financial sanctions on the international reserve currency system
Among the four key factors of the international monetary system, the international reserve currency system is the most critical one. In last century, the replacement of pound sterling by the US dollar, and the replacement of the US dollar as the single reserve currency by multiple reserve currencies, marked fundamental changes in the international monetary system. Whether this round of financial sanctions against Russia will shake the current international reserve currency system? There is a heated debate in this regard.
(1) Different views in the literatures
Some viewpoints were expressed that financial sanctions are unlikely to threaten the dollar’s position. Brunnermeier, James, and Landau (2022) argue that the current round of financial sanctions is carried out in such a special situation as the war between Russia and Ukraine, which is extremely rare. The United States is still committed to maintaining and protecting the safe asset attributes of the dollar. Furthermore, there is no strong alternative to the dollar at present. Even some researches show that financial sanctions may further strengthen the status of the US dollar. Dooley, Folkerts-Landau, and Garber (2022) and others believe that for some countries on the periphery, reserve currencies are not only a safe asset but also a ‘collateral’ to ensure the confidence of foreign investors. Some ‘problem countries’ even need to mortgage a large amount of assets in the United States to attract the inflow of international private capital. The financial sanctions imposed by the United States on the specific countries are a punishment for the ‘wrong’ behavior of these countries, which will push other ‘high-risk’ countries to accumulate more dollar reserves in order to maintain the confidence of foreign investors. This mechanism will further strengthen the status of the US dollar as a reserve currency.
However, such views assume that some countries are ‘problem countries’, which imply a sense of moral superiority. While we also need to emphasise that today’s status of the US dollar is based on its attributes of global public goods. If other countries believe that the public goods attributes of US dollar assets are weakened and the risk of holding US dollar assets increases, then the status of the US dollar may indeed be affected. It will be a process of self-fulfilling, no matter how the US government regard the sanctions as necessary reactions, so long as other countries consider it as a risk. The countries holding foreign exchange reserves, in particular, which are mainly emerging markets and developing countries.
More views conceive that the freezing of Russian reserve assets by the United States breaks the principle of sovereign equality and property rights protection. These concerns will accelerate other countries away from US dollar assets, thus weakening the status of the US dollar. Arslanalp et al.(2022) points out that the decision of the United States and its allies to freeze Russia’s foreign exchange reserves has triggered a heated debate about the future of the international monetary system. The share of the US dollar in global reserves has been declining in the past 20 years. Financial sanctions will accelerate the diversification of the international monetary system. Gopinath also said that the US financial sanctions against Russia could weaken the dominance of the US dollar, which lead to fragmentation of the international monetary system. In reality, before the outbreak of the Ukraine crisis, many scholars pointed out that the ‘weaponized’ abuse of the dollar would eventually threaten the global dominance of the dollar (Frankel 2019).
(2) Reactions of Russia and emerging market countries to financial sanctions
Sanctioned countries will be inclined to reduce their dependence on the US dollar assets, which is a natural response to the sanctions. This will not only reduce the threat of future US financial sanctions but will also reduce the negative impact of current financial sanctions, such as Russia has progressively reduced its dollar asset and the use of dollar following the Crimean incident. According to a report issued by the Central Bank of Russia, the proportion of US dollar assets in Russia’s international reserves including gold had dropped from 43.4% in June 2014 to 16.4% in June 2021. Over the same period, the proportion of Russia’s reserve assets which issued by American entities also dropped sharply from 29.7% to 6.6%.
The large-scale financial sanctions imposed by the United States on Russia could further accelerate the Russia’s policy stance of de-dollarization. For example, in a 31 March decree, Vladimir Putin ordered that gas exports to Europe should be paid for in rubles instead of euros or dollars. Additionally, Russia is seeking payment in non-US dollars for oil exports to some Indian customers.
US sanctions against Russia are also an alarm bell ringing for emerging countries. As an important geopolitical shock itself, sanction policy will exacerbate emerging market countries’ concerns about the dollar system. It will force emerging market economies to rethink their management framework of international reserves, currency composition of foreign exchange reserves and alternative reserve assets. In particular, they need to assess cautiously whether and how to achieve currency and asset diversification of foreign exchange reserves (Ramaswamy 2022).
Besides Russia, many countries such as Turkey which have been sanctioned and threatened by US have begun to reduce their holdings of US dollar assets in recent years as well. In June 2021, Turkey’s holdings of U.S. securities were $3.23 billion, down sharply from $29.58 billion in June 2018. Of course, it was mainly caused by the pressure from foreign exchange market and consequently the central bank’s intervention, but it was also to a large extent a reaction to the US sanctions on Turkey since 2018. Especially from June 2020 to June 2021, Turkey’s foreign exchange reserve increased from $ 36.2 billion to $ 54.1 billion, while among the reserve the amount of US treasury bills slightly decreased from $ 3.48 billion to $ 3.23 billion. It means the proportion of US treasury bills in Turkey’s reserve declined substantially, and the Turkey continued to diversify its foreign exchange reserve away from US dollar even in 2020 and 2021.
Traditionally, the choice of the currency composition of official foreign exchange reserves mainly considers economic motives, such as precautionary demand, transactions demand and investment demand, but in nowadays geopolitical risks have become an essential consideration. Eichengreen et al. (2019) point out that the management strategy of international reserves can be divided into ‘Mercury Principle’ and ‘Mars Principle’. The former considers that the management strategy is mainly affected by economic factors, while the latter deems that geopolitical factors are decisive. Actually, both factors play significant roles. Especially in recent years, the U.S. government has increasingly relied on financial sanctions to realize its foreign policy interests. Hence, more and more countries will at least attempt to reduce the proportion of US dollar reserves, although the outcome is uncertain.
(3) In the medium term, the status of the US dollar comparing with other reserve currencies is unshakable, but it does not assure the stability of the international monetary system.
In the medium term, as the dominant international currency, the US dollar will remain its status stable. This round of sanctions is jointly imposed by developed countries such as Europe, the United States and Japan. It reduces the space for diversification from the US dollar to other reserve currencies. While the scale of financial markets and the liquidity of financial assets in the euro zone are inferior to those in the United States. Besides, the RMB is still far from being totally internationalized. Therefore, in the medium term, the relative status of the US dollar is indeed difficult to shake.
In the first quarter of 2022, the US dollar still accounted for 58.9% of global foreign exchange reserves, which was 38.8 percentages higher than euro which is the second key reserve currency. In May 2022, the International Monetary Fund completed its five-year Special Drawing Rights (SDR) valuation review. It decided to raise the weight of the US dollar in the SDR basket to 43.4%, an increase of 1.65 percentage point. Actually the US dollar is the reserve currency getting the biggest proportion increase in this round. After the outbreak of the Ukraine crisis, the US dollar also saw a significant appreciation due to the rising risk aversion and the tightening of monetary policy by the Federal Reserve, all of which indicate that the US dollar’s position as the dominant international currency is still firmly in place in the short term.
However, the stability of the status of the US dollar does not mean that the international monetary system will remain stable as well. The freezing of Russia’s reserves by the United States and Europe has led many other countries to re-examine the role of foreign exchange reserves. Financial sanctions will weaken the incentive for countries to hold foreign exchange reserves and have a significant impact on global reserve’s aggregate demand (Brunnermeier, James, and Landau 2022).
The credit of sovereign reserve currencies has been impacted, hence gold and the scheme of super-sovereign reserve currencies will be more attractive. According to the World Gold Council, driven by the Ukraine crisis and soaring inflation, global gold demand grew 34% year-on-year in the first quarter of 2022, the highest level since the fourth quarter of 2018. A gold demand survey covering 57 central banks released by the World Gold Council in June 2022 shows that 42% of respondents believe that the proportion of the dollar in global reserves would decrease. Some analysts even consider that the current international monetary system is evolving from the second-generation Bretton Woods system based on the US dollar to the third-generation Bretton Woods system based on gold and other commodities (Zoltan 2022). Besides gold reserve, there are various ways in which the peripheral countries could reduce the reliance on foreign exchange reserves or find other substitutions. Such as increasing the reserves of strategic materials like oil.
When the peripheral countries reduce foreign exchange reserves aggregate demand, these countries will have to tolerate a more flexible exchange rate regime to better absorb external shocks, instead of intervention in the foreign exchange market with the reserves. In a situation where foreign exchange reserves are significantly falling, while exchange rate is more volatile, the capital outflows could be more challenging for the government or even beyond its capability. The peripheral countries will have to strengthen their capital and financial account regulation. Brunnermeier, James, and Landau (2022) think this will to some extent cause a setback in financial globalization. At the same time, the peripheral countries could also further strengthen the regional financial safety network, especially the construction of bilateral currency swaps and regional financial arrangements, in order to reduce the demand for foreign exchange reserves. Against this background, the new trend of the international monetary system will be the following: (1) the exchange rate system will be more flexible. (2) if some of the countries cannot bear a flexible exchange rate and a more severe capital outflow, then there will be a rising tendency of capital account regulation. (3) Both means the trend of de-globalization of the international monetary system. The cooperation of the regional financial safety network is also a manifestation of de-centralization of the international monetary system.
III. Impact of financial sanctions on the international financial infrastructure
Another major sanction imposed by the United States and Europe on Russia is to exclude some Russian financial institutions from the SWIFT system. SWIFT is a communication system for cross-border payment and settlement. It plays an important role in global cross-border payment, so the SWIFT sanction is often referred to as a ‘financial nuclear weapon’. It not only has a significant impact on Russia-related cross-border transactions but also threatens the stability of the international financial order. Like any other financial sanctions, the more frequently SWIFT is weaponized, the less it will be regard as a public good, and the more likely a substitute will emerge. Historically, Iran, Russia and even European countries themselves have been plagued by the SWIFT sanction.
(1) Iran has been sanctioned by SWIFT, and European countries have also been affected.
In 2012, the US and Europe imposed financial sanctions on Iran, removing four select Iranian banks from the SWIFT system. It is worth noting that in the UN Security Council vote, the policy stance of sanctions on Iran was procedurally approved in advance (China and Russia abstained from voting). Therefore, this round of financial sanctions against Iran in 2012 has received the full moral support from European countries and SWIFT. It can be seen that the use of SWIFT for financial sanctions in 2012 was permitted by the international community and have an extensive consensus.
Subsequently, in July 2015, Iran signed the Joint Comprehensive Plan of Action (JCPOA) with the United States, Britain, France, Russia, China and Germany, according to which the international community gradually lifted sanctions against Iran. Iranian banks were able to re-enter SWIFT in February 2016.
However, in May 2018, the Trump administration unilaterally announced its withdrawal from the Iranian nuclear treaty JCPOA and demanded that Iran should be kicked out of the SWIFT system again. The SWIFT sanction against Iran this time was a unilateral act of the US government. Morally, the UN Security Council did not pass the sanctions plan, and European countries did not support it. It was also not in the interest of the EU countries and SWIFT itself with economic interests in Iran. Therefore, the board of directors of European countries and SWIFT did not support financial sanctions against Iran. However, the CHIPS system of the United States (New York Clearing House Bank Dollar Interbank Payment System) has an absolute dominant position in the international payment and settlement system. In fact, SWIFT is also difficult to exist independently from CHIPS. Since the message system of cross-border payment itself is difficult to separate from the cross-border payment business. This gives the United States the potential possibility of ‘holding the emperor to command the princes’. Finally, under the coercion and threat of the United States, the Europe and SWIFT had to choose the lesser of two evils and reluctantly accepted the excessive demand of the United States.
To this end, in January 2019, Britain, France and Germany announced the establishment of a trade support tool settlement mechanism: Instrument for Supporting Trade Exchanges (INSTEX), whose purpose is to seek to bypass US sanctions and continue economic and trade exchanges with Iran. In December of that year, six European countries, Belgium, Denmark, Finland, the Netherlands, Norway and Sweden, announced their accession to INSTEX. In March 2020, France, Germany and the United Kingdom completed the first transfer transaction with Iran through INSTEX. Although the effectiveness of INSTEX is not as high as expected or even rather limited, it shows Europe’s dissatisfaction with the unilateral sanctions imposed by the United States and the trend of diversified trend of international financial infrastructure.
(2) Russia established SPFS to replace SWIFT
In addition to Iran, SWIFT has also imposed sanctions on financial institutions in North Korea, Iraq, Libya and other countries. In view of Russia’s status in the global economy, especially in global energy trade, the impact of the SWIFT sanction on select Russian financial institutions is much greater than that of aforementioned countries. Russia and previous examples of the SWIFT sanction show that by getting command of critical international financial infrastructure, the core countries can cause great damage to other countries, and even European countries suffered in turn in some cases.
For this reason, states have also had to start thinking about promoting to create their own international financial infrastructure or a more predictable one. Facing the possibility of the SWIFT sanction for many years, Russia has developed its own SWIFT-like payment and settlement message system. After the Crimea crisis in 2014, in response to the risk of possible disconnection from the SWIFT system, the Central Bank of Russia established the financial messaging system SPFS at the end of 2014 to provide financial information transmission services to domestic financial institutions. Subsequently, Russia has promoted the international use of the system. In June 2019, the Russian State Duma passed a bill allowing foreign entities to access the SPFS, according to which the Central Bank of Russia is qualified to provide financial information transmission services to foreign banks, international organizations and central banks of other countries. Russia has also gradually strengthened cooperation with India, China, Turkey and other countries, hoping to extend the SPFS system to more overseas institutions. More than 400 Russian and foreign entities have already joined the SPFS system, and on 29 June 2022, Elvira Nabiullina, Governor of the Bank of Russia, said that 70 foreign financial institutions from 12 countries have been already connected to the system.
(3) Other emerging market countries explore the establishment of a new international financial infrastructure
For example, some Indian scholars suggest that emerging economies could establish a new messaging system that is similar to SWIFT, while deals only with the currencies of emerging market economies. It will be used to transmit the payment and settlement information within emerging market economies, which would create significant network effects (Ramaswamy 2022).
In terms of payment and settlement network, the BRICS countries established the BRICS Payments Taskforce in 2020 to encourage cross-border payments in BRICS currencies. During the Russian Presidency in 2020, the Taskforce examined the development of cross-border payment infrastructure and studied the prospects for interconnecting country-specific payment card systems within BRICS countries. At the country level, China launched its RMB Cross-border Interbank Payment System (CIPS) in 2015 to facilitate the cross-border use of the RMB. Since its launch in 2015, the number domestic and foreign institutions accessing CIPS has continuously increased and the network coverage has simultaneously expanded. By the end of 2021, the CIPS system has covered more than 3,600 banks (in terms of legal persons) in 178 economies worldwide. In July 2022, the Reserve Bank of India launched the International Trade Settlement in India Rupees (ITSI) mechanism for international trade, thereby enabling Indian importers and exporters to use Rupees for pricing and settlement.
In addition, SWIFT sanctions have stimulated the development of decentralized technology (such as the block chain) and the use of digital currencies. In the future, more alternatives of the international financial infrastructure could probably emerge for international payments and financial information transmission. The diversification of international financial infrastructure provides countries with more options and reduces the risk of sanctions, thus providing them with more financial security. However, the diversification could also result in higher transaction costs and lower transaction efficiency due to the reduction in transaction volume and system fragmentation. In order to balance the efficiency and security of international financial infrastructure, the international community needs to strengthen the interface and coordination between different systems to avoid even serious fragmentation of the international financial system.
IV. Summary and future outlook
The US dollar as a reserve currency, SWIFT as a global inter-bank messaging system—these are public goods in the global financial markets. The most important characteristics of public goods are, firstly, it is non-competitive. Some entities benefit from this product without affecting others who benefit from it. Secondly, it is non-exclusive. The international public good cannot be exclusive to one country or a group of countries. Both of these two attributes will ensure that there is no interest conflict between the beneficiaries.
Meanwhile US dollar is the base of exorbitant privilege for US to issue debt in the world’s reserve currency, and also the exorbitant privilege for US to sanction the ‘wrong’ behavior countries. For a long time, the Federal Reserve operate its monetary policy just according to domestic economic situation. As a national currency, it gives no cause for much criticism, but US dollar plays a role of global public goods. That is why there are initiatives to develop a super-sovereign currency especially after the 2008 global financial crisis.
Again, awakened by waves of financial sanctions using US dollar and SWIFT system, these public goods are frequently weaponized for financial sanctions against more countries. This is impacting the foundation of the US dollar and SWIFT as the public goods for the international monetary system. Fundamentally speaking, why the US dollar and SWIFT have become public goods in the past is largely based on the political mutual trust between countries. If this trust is impacted and shaken, the role of the US dollar and SWIFT as public goods will also be affected. As a result, there are more and more discussions on a super-sovereign financial infrastructure.
But from a realistic point of view, a real alternative that can pose a strong challenge to the US dollar or SWIFT has not yet appeared. The US dollar or SWFIT both have strong network effects, which will further result in a inertia of the international monetary system and hinder fundamental changes. But as we have explained in the above, this does not mean that the international monetary system will remain stable.
On the one hand, the US dollar will remain dominant in the international reserve system, the structure of the international reserve currency will remain relatively stable. The SWIFT system will continue to be the most vital message system in the world. On the other hand, as the main holder of foreign exchange reserves, the emerging market countries could be more prudent to increase their foreign exchange reserves or even decrease the amount. This will be accompanied by increased tolerances for exchange rate volatility in emerging market countries, or increased interventions of cross-border capital flows.
On all accounts, the financial sanctions imposed by Europe and the United States on Russia will have a decentralized and deglobalized impact on the international monetary system. This impact will not achieved mainly by affecting the structure of the international reserve currency, but by affecting the overall size of the international reserve currency. In this process, the relative status of the US dollar as a reserve currency probably would not decline for a considerable long period. But the willingness or the aggregate demand for foreign exchange reserves will decline, which is a kind of manifestation of the de-centralization and de-globalization of the international monetary system. Moreover, it will also reduce the stability of the international monetary system (increasing volatility of exchange rates) and increase transaction costs (reducing the liquidity of cross-border capital).