About the Author: Eswar Prasad is a professor at the Dyson School at Cornell University, senior fellow at Brookings, and author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance.
The United States and other Western economies deployed a powerful array of financial weapons against Russia with remarkable speed. Cutting off access to global financial markets and Russia’s foreign exchange reserves has dealt a crippling blow to the Russian economy.
Will these actions come back to haunt the West? Speculation is rife that when the dust settles, China, Russia and others will intensify their efforts to break free from the dollar-dominated system and reduce their financial vulnerability.
The reality is likely to be much less dramatic. Some of the changes already underway as a result of new financial technologies could gain momentum. But the fundamental structure of global finance, including the status of major reserve currencies, will not be easily shaken. This would require sweeping reforms that China and Russia have long despised.
Financial sanctions are a powerful tool of economic warfare. They can hit deeper and faster than economic sanctions, such as trade barriers that limit the flow of goods and services. Their power reflects the continued dominance of the West, and particularly the United States, over global finance, even as the center of global gross domestic product has shifted to emerging market economies.
The power of this set of tools is based on the status of the US dollar as the world’s preeminent currency for international payments and also for central bank foreign exchange reserves. The United States also has an outsized influence on the Swift messaging system.
Could China and India allow Russia to evade sanctions? The relatively small financial footprint of these economies and their exposure to secondary sanctions limits the viability of this loophole. But the lesson that these countries will certainly learn is the need to reduce their vulnerability to sanctions. This will be feasible in some dimensions but not in others.
International payments and messaging systems are ripe for change. New financial technologies make it easier to conduct financial transactions directly between emerging market currency pairs. Directly exchanging rubles, rupees or renminbi for each other without first exchanging these currencies into dollars or dollars becomes cheaper and faster, reducing reliance on dollar finance.
Swift’s messaging system eliminates barriers related to differences in operating language, technology protocols and regulatory requirements between banks in different countries. Innovations such as Bitcoin’s blockchain technology could render Swift’s business model obsolete within a few years.
Country-level initiatives will accelerate these changes. China’s cross-border interbank payment system, set up in 2015, will soon facilitate direct payments and settlements with those in other countries, including Russia. CIPS also has messaging capabilities that could bypass Swift.
In short, the dollar’s dominance in international payments will inevitably erode, although it will likely remain the most important payment currency, and Swift’s relevance will fade.
What about the configuration of global reserve currencies? Russia had accumulated a war chest of foreign exchange reserves – mostly in dollars, euros, pounds and Chinese renminbi – to protect the value of the ruble in times of economic or geopolitical turmoil. The freezing of Russian central bank accounts in Western financial capitals has effectively sealed this war chest.
This will certainly lead not only Russia, but also other countries, to abandon the dollar and the euro in favor of the currencies of friendlier countries such as China. But as Russia finds out, in critical times renminbi reserves are of limited help in preventing the ruble from collapsing.
The renminbi remains a non-convertible currency. The Chinese government might resent Russia getting rid of the renminbi to buy dollars and euros and using these “hard currencies” to back up the rouble. Unless China abandons restrictions on capital flows across its borders and strict management of its currency, the renminbi will not become a major reserve currency.
Moreover, private investors are unlikely to place their trust in a reserve currency that is not backed by a strong institutional framework. Such frameworks – which encompass independent central banks, open and transparent governments, an institutionalized system of checks and balances, and the rule of law – remain the major asset of the United States and other Western countries.
The consequences of the Russian invasion of Ukraine will have repercussions on the international monetary system. However, unless the rest of the world is willing to embrace some of the key traits of liberal democracies, these changes are likely to be modest evolutions rather than the sweeping transformation that China and other US rivals would very much like to see.
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