The Great Economic War (GEW) (Part 3: The financial nuclear bomb)
Phuah Eng Chye (27 August 2022)
In reaction to Russia’s invasion of Ukraine, the West launched a comprehensive economic war aimed at isolating Russia in the physical (e.g. airspace, ports, export and import bans) and information (e.g. ownership, finance) realms. The main offensive took place in the financial realm where the equivalent of a nuclear bomb – seizure of central bank foreign reserve assets and the removal of Russian banks’ access to SWIFT – was dropped.
It should be noted the physical and financial versions of the nuclear bomb work differently. Nuclear bombs annihilated two cities and resulted in Japan’s immediate surrender and the end of World War 2. In contrast, the financial nuclear bomb marks the launch of GEW. There was instantaneous impact on the Russian economy but the effects were quickly neutralised. Of greater concern is the financial nuclear bomb triggered black swan magnitude economic, social and political after-shocks that will fracture and severely damage the global economy.
Background: Western-Russian financial warfare and dollar unilateralism
Financial warfare featured strongly during World War I. Jon Danielsson, Charles Goodhart and Robert Macrae notes “the assassination of Archduke Franz Ferdinand of Austria on 28 June 1914, amid raised expectations of an impending war. This anticipation created worries that financial institutions would have trouble getting cross-border loans repaid – after all, if two countries are at war, enforcing contracts across borders is difficult. The specific crisis trigger was that major trading nations Austria, Germany, and France, intent on protecting their own financial markets, prohibited payments to foreign names. The cessation of cross-border loan payments and clearing created immense difficulties for banks with clients in those countries, rapidly spreading to all banks. As a result, a typical systemic risk feedback loop emerged, with everybody hoarding liquidity and not providing credit, while financial institutions and real economy firms faced the threat of bankruptcies. Moreover, further sanctions exacerbated the crisis once the war started, with the central powers particularly suffering from blockades…The policy remedy was familiar: massive creation of liquidity…The resulting quantitative easing was immense and succeeded in containing the liquidity crisis. However, that wasn’t sufficient, and many governments suspended requirements for making most private loan payments. In addition, the governments of Britain and the US closed the stock exchanges for half a year, as they were then the primary trading venue for bonds”.
The birth of the Soviet Union provides a perspective on the hostilities. Eric Toussaint relates “in early January 1918, the Soviet government suspended payment on foreign debt, and in early February 1918 it decreed that all Tsarist debts were repudiated as were those contracted to continue the war by the provisional government between February and November 1917…all assets of foreign capitalists in Russia would be confiscated and returned to the national heritage. In repudiating these debts, the Soviet government was implementing a decision made in 1905 by the soviet (people’s council) of Petrograd…Russian public debt amounted to £930 million (roughly 50% of GDP) in 1913”. “The Soviet government’s call for worldwide revolution combined with its desire to end the war, its repudiation of debts…and its nationalization measures convinced the Western leaders that they should launch a massive attack[1] against Soviet Russia to bring down the revolutionary government and restore capitalist order. The foreign intervention began in the summer of 1918 and finished at the end of 1920 when the Western capitals took stock of their failure and were obliged to acknowledge that the Red Army had taken back control of the territory”.
“From 1918, the Allied powers led a blockade against Soviet Russia. The Soviet government was prepared to pay in gold to import goods of absolute necessity, but none of the major banks or any government in the world could accept Soviet gold without crossing swords with the Allied governments. In fact Paris, London, Washington, Brussels all considered that they had a right to Russian gold to compensate Russia’s expropriated capitalists and repay debts. This became a huge obstacle to Soviet trade. In the United States any person or company wishing to use gold for any transaction or to take gold into the country had to sign an official statement that the gold in their possession had nothing to do with the so-called Bolshevik government and that they guaranteed that the US had a right on it without any reservation…after the German capitulation of November 1918, France managed to recover the heavy ransom in gold that Berlin had got from Russia in application of the Brest-Litovsk peace treaty signed in March 1918. France refused to return this gold to Russia, considering it as part of the reparations Germany owed Paris. The blockade of Russian gold was carried on to some extent for years. This was how France again managed in 1928 to get the Washington authorities to prohibit a payment in Russian gold for a contract between Russia and a private US company”. Allied governments “came to the rescue of the bankers who should have been held responsible for financing the Tsarist regime and been made to bear the consequences of the repudiation of odious debt” by allowing bond-holders of Russian debt to exchange Russian bonds for their own debt-paper.
Eric Toussaint notes due to “the dramatic humanitarian and economic situation in Russia”, “the Western capitals believed the Soviet government to be on its knees and were convinced they would get what they wanted by making the new loans and investments Russia needed conditional upon the acknowledgment of previous debts and compensation for expropriated Western companies”. The Genoa negotiations of 1922 was hosted by five major powers: Great Britain, France, Belgium, Japan and Italy. “For its part, the Soviet government was ready to repay part of the debts contracted by the Tsar on several conditions: that the other powers give Soviet Russia official (de jure) recognition; that they grant State-to-State (i.e. bilateral) loans; that they encourage private firms affected by the expropriation of their subsidiaries to accept concessions to exploit natural resources, especially in the remotest areas of Siberia, as compensation. The Soviet government thus hoped that foreign capitalists would invest fresh capital of their own money in activities that would fortify the Soviet economy. Furthermore, the government would not hear of setting up multilateral bodies to manage loans, investments or related legal disputes…If these conditions were met, Moscow promised to resume payment of part of the Tsarist debt within a thirty year time-frame…but that they basically considered that Soviet Russia was fully within its rights to repudiate all Tsarist debt. Finally the conference ended in disagreement and the Soviet delegation maintained the repudiation”.
Eric Toussaint points out “the Soviet Government had obviously been clever in its manoeuvres”. Before and during the Genoa conference, the Soviet Russia signed bilateral treaties with Poland, the Baltic Republics, Turkey and Persia. It managed to sign a trade agreement with the UK that recognised “Soviet laws of nationalization before UK courts and this meant that companies that traded with Russia no longer ran the risk of getting into trouble…Russia also succeeded in signing a treaty with Germany whereby each party renounced any demand for compensation”. “Every capital was keen to sign an agreement with Moscow in order to prevent other powers from seizing the opportunities offered by the Russian market. In 1923-24, despite the failure of the Genoa conference, the Soviet Government was recognized de jure by the UK, Italy, the Scandinavian countries, France, Greece, China and a few others. In 1925, Japan also recognized the Soviet Government…From 1926, in spite of debt repudiation, European private banks and governments started to grant loans to the USSR…Eventually, under the presidency of Franklin D. Roosevelt, the United States recognized the USSR de jure in November 1933”.
Eric Toussaint notes “in 1997, six years after the dissolution of the USSR, Boris Yeltsin signed an agreement with Paris to put an end to litigation over Russian bonds. The 400 million US dollars France received from the Federation of Russia in 1997-2000 are a mere 1% of the amounts claimed from Soviet Russia by the French creditors…the agreement between Russia and the UK signed on 15 July 1986 made for a 1.6% compensation of the bonds’ updated value”. “In August 1998, as it was affected by the Asian crisis and the consequences of capitalist restoration, Russia unilaterally suspended its payment of the debt for six weeks. Its external public debt amounted to USD95 billion, USD72 billion of which to private foreign banks and the remainder mainly to the Paris Club and the IMF. Complete suspension of payment followed by a partial suspension over the following years led the various creditors to agree to a haircut that varied between 30% and 70%. Russia, which was going through a recession before suspending payment, experienced an annual growth rate of about 6% afterwards (1999-2005)”.
Financial warfare should also be viewed within the paradigm of dollar unilateralism. Suzanne Katzenstein observed the “profound shift toward dollar unilateralism by the U.S. government as it advances core national security goals”. “Dollar unilateralism occurs when the government uses the unique status of the U.S. dollar in global financial markets to pursue policy goals independently, rather than work through traditional inter-governmental and multilateral channels”. The US government “elicits cooperation from foreign banks, including those with weak or no ties to the United States, by deploying three tactics that fall along a continuum of legal formality: financial sticks, high-profile blacklists, and direct diplomacy. Financial sticks are the most formal…They are congressional or executive measures that impose obligations on U.S. actors, but with the goal of pressuring foreign banks…high-profile blacklists involve the naming of entities or regions as potentially engaging in illicit conduct but without imposing obligations on U.S. financial actors…for material and reputational reasons, the government expects such blacklists to make not only U.S. but also foreign banks reduce their business with the named entities…direct diplomacy. In an effort to persuade foreign banks to implement U.S. policy, high-ranking U.S. officials meet with foreign bank executives directly rather than attempt to influence them indirectly through interactions with their governments”.
Suzanne Katzenstein explains “foreign banks appear to cooperate with U.S. harnessing policies for a variety of reasons, including avoiding government scrutiny and heavy fines, preserving their access to the U.S. financial market (and with it, U.S. currency), and minimizing the reputational risks of being associated directly or indirectly with a U.S.-targeted actor. They may cooperate for less material reasons as well, including out of a wave of international support and empathy in the aftermath of terrorism, or out of professional and social incentives that emerge from interacting with powerful U.S. officials”. However, “the harnessing of foreign banks raises questions about the government’s political accountability, both domestically and internationally, that are generally overlooked by both domestic and international law literatures. These accountability concerns vary according to context (domestic or international) and the nature of the government’s legal tactic (formal or informal)…For some actors, this newfound power comes at a price. Even when conservatively deployed, dollar unilateralism has unintended humanitarian consequences”.
Key battles in the financial realm
Ivan Timofeev notes the extensive Western financial sanctions include:
- Sanctions against Central Bank, Ministry of Finance and National Welfare Fund…freezing Russian reserves. Freezing and possible confiscation of assets of designated Russian individuals and organisations – bank accounts, real estate, yachts and football clubs.
- Financial sanctions against Russian banks, infrastructure, energy and others. Blocking sanctions (ban on transactions and blocking assets) on designated banks and companies, bans on USD settlements (restricting use of correspondent accounts in US banks) and restrictions on lending.
- Blocking sanctions against major Russian businessmen (oligarchs) and high-ranking politicians and family members.
- Bans on investments in Russian energy and other sectors.
- Ban on import of cash dollars and euros into Russia and restrictions on deposits in some countries.
Russia’s response has been disciplined – perhaps modelled on how China, Hong Kong and Malaysia dealt with speculative attacks during the Asian crisis. Adam Tooze notes “the Russian central bank has since 2008 acquired a wide range of tools to dampen stress in financial markets and limit their impact on the real economy…Russia’s central bank announces a slew of measures to support markets as it scrambles to manage the fallout from Western sanctions, including: Buying gold on domestic market, repurchase auction with no limits, easing curbs on banks’ open foreign currency positions, blocking the exit for foreign investors and requiring companies to sell 80% of their foreign currency earnings – buy rubles – which in effect substitutes private balance sheets for the central bank which is sanctioned. The central bank also has the ability to allow financial institutions not to reflect losses from the revaluation of securities on the balance sheet to interventions in the foreign exchange market and provision of ruble and currency liquidity to banks. On Monday the first line of defence was to hike interest rates to a punitive 20 percent and suspend markets temporarily”. Since, the pressures have eased and the rouble and interest rates have recovered their early losses[2] despite a strong USD. Key battles are shaping in several areas.
- Payment in roubles. Since Russia is unable to transact in Western currencies, Russia now requires “unfriendly countries” to pay for oil and gas in roubles. Yves Smith explains “Gazprom Bank will open an account in rubles, and a parallel account in foreign currency”. The customer would deposit the foreign currency into their Gazprom account and instruct the bank to procure roubles for payment. Gazprom Bank will then sell the euros on the Moscow exchange, credit the rubles to the customer’s account, and then remit the payment to Gazprom for oil and gas delivery. The key difference is “the EU buyer is now required to deliver roubles, not Euros, to Gazprom at an unblocked account or an unsanctioned bank. Since there is very little in the way of roubles outside Russia, the buyer will now need to open and maintain rouble accounts in a Russian bank”. This would transfer these transactions to a Russian jurisdiction – thus eliminating the risk of payments being interrupted or outright blocked. The EU warned member countries this constitutes a breach of its sanctions. The battle is thus over whether Russia can operate outside the Western financial system and without using Western currencies. In this regard, Russia is threatening to expand the non-Western currency arrangement across its exports of minerals and commodities and to promote the use of “friendly” currencies such as the yuan and Indian rupee.
Michele Savini Zangrandi points out competing hypotheses on rouble payment mechanisms. He thinks it is unlikely aimed at supporting the currency as the regime of forced export revenue conversion and capital controls proved more than sufficient. He did not think it is intended to facilitate charging exorbitant exchange commissions, avoid penalties for breach of contract or to circumvent financial sanctions. He argues it is likely “the ruble payment scheme is intended to protect Moscow Interbank Currency Exchange (MICEX) – a cornerstone of ruble trading and a central piece of Russia’s financial architecture – from financial sanctions. MICEX’s reliance on correspondent accounts with Western banks makes it vulnerable to US sanctions. Should it come under sanctions, ruble price fixing and ruble trading could be thrown into disarray”. “What is unique about MICEX, however, is that it is the sole organised exchange for ruble trading, and by far the most liquid ruble market. Arguably, no other market is deep enough to provide a solid anchor for ruble price-formation. In clearing the foreign exchange leg of transactions, MICEX relies on euro and dollar correspondent accounts with foreign banks. Specifically, the National Clearing Centre – which provides clearing services for the exchange – holds its euro and dollar correspondent accounts with US bank J P Morgan. Should the US freeze these accounts, MICEX would no longer be able to clear transactions in euros or dollars, throwing the main ruble trading venue into disarray. While alternative pricing mechanisms and trading venues would emerge, the short-term damage to Russia’s economy could be material”. “In tying gas exports to the EU to the functioning of MICEX, the Kremlin might have constructed a clever incentive scheme by which it encourages the EU to lobby the US against sanctions that the US could otherwise impose on a unilateral basis. This hypothesis could mark a new step in the dynamic of weaponisation of interdependencies. Indeed, economic sanctions evolved from straight bilateral trade restrictions, to extraterritorial financial sanctions, to value-chain propagated target trade restrictions. As sanctions broaden their extraterritorial reach, so might sanction defences”.
- Pegging rouble to gold. Russia announced it is pegging the rouble to gold. Ronan Manly explains “by offering to buy gold from Russian banks at a fixed price of 5000 rubles per gram, the Bank of Russia has both linked the ruble to gold and, since gold trades in US dollars, set a floor price for the ruble in terms of the US dollar…with the new gold to ruble linkage, if the ruble continues to strengthen (for example due to demand created by obligatory energy payments in rubles), this will also be reflected in a stronger gold price…This immediately links the price of natural gas to rubles and (because of the fixed link to gold) to the gold price…In fact, this can be applied to any commodities…By playing both sides of the equation, i.e. linking the ruble to gold and then linking energy payments to the ruble, the Bank of Russia and the Kremlin are fundamentally altering the entire working assumptions of the global trade system while accelerating change in the global monetary system. This wall of buyers in search of physical gold to pay for real commodities could certainly torpedo and blow up the paper gold markets of the LBMA and COMEX…Buyers would then scramble to buy physical gold to pay for Russian oil exports, which in turn would create huge strains in the paper gold markets of London and New York where the entire gold price discovery is based on synthetic and fractionally-backed cash-settled unallocated gold and gold price derivatives…Linking the ruble to gold via the Bank of Russia’s fixed price has now put a floor under the RUB/USD rate, and thereby stabilized and strengthened the ruble…If a majority of the international trading system begins accepting these rubles for commodity payments arrangements, this could propel the Russian ruble to becoming a major global currency. At the same time, any move by Russia to accept direct gold for oil payments will cause more international gold to flow into Russian reserves, which would also strengthen the balance sheet of the Bank of Russia and in turn strengthen the ruble. Talk of a formal gold standard for the ruble might be premature, but a gold-backed ruble must be something the Bank of Russia has considered…central banks around the world are obviously taking note. Western sanctions such as the freezing of the majority of Russia’s foreign exchange reserves while trying to sanction Russian gold have now made it obvious that property rights on FX reserves held abroad may not be respected, and likewise, that foreign central bank gold held in vault locations such as at the Bank of England and the New York Fed, is not beyond confiscation…Since 1971, the global reserve status of the US dollar has been underpinned by oil, and the petrodollar era…what we are seeing right now looks like the beginning of the end of that 50-year system and the birth of a new gold and commodity backed multilateral monetary system…the Bank of Russia’s move to link the ruble to gold and link commodity payments to the ruble is a paradigm shift…As the dominos fall, these events could reverberate in different ways. Increased demand for physical gold. Blowups in the paper gold markets. A revalued gold price. A shift away from the US dollar. Increased bilateral trade in commodities among non-Western counties in currencies other than the US dollar”.
- Russian debt default. Jorge Vilches notes the US is attempting to trigger a Russian default by freezing its reserves and blocking its payments. Russia is trying to avoid a default by offering alternative arrangements such as by crediting the rouble-equivalent, in lieu of foreign currency, as payment in its National Settlement Depository. Harry Robertson notes “a default would likely unleash a long and complex battle between bondholders and the Russian state”. First, the default is occurring under highly unusual circumstances rather than the lack of ability or willingness to repay. Second, the geopolitics means traditional default resolution processes are not workable. Third, regardless of claims, Russian external assets will be tied up in litigation possibly for decades. This would include reparations claims for Ukraine reconstruction and the possibility of seizure of the disputed assets. James A. Haley notes “a Russian default on foreign-currency-denominated bonds would introduce additional complications…because foreign bondholders would immediately mobilize an army of litigators to seize Russian assets – ships, planes, property – in foreign jurisdictions to cover their claims. The legal merits of those suits would be uncertain, given the evolving jurisprudence on the doctrine of sovereign immunity, and, in any case, would take years to resolve. But the nuisance value of such actions may well be enormous. In this respect, countries and firms that might otherwise trade with Russia, either for profit or to thwart sanctions for geopolitical reasons, may well think twice. The reason for caution is that the transaction may entail exposure to legal risk. Consider…the purchase of grain. In the absence of bondholders’ litigation, a country may be willing to buy Russian grain, paying in dollars. But if that grain must be shipped via another jurisdiction, the purchaser is exposed to the legal risk that the grain is seized and sold to service bondholders’ claims. The purchaser would then be in the position of having to sue Russia to recover the dollars transferred as payment. Now, the Russian central bank may well decide to continue servicing the dollar-denominated debt coming due in order to avoid such problems. Doing so could help to preserve the trade channels that remain open. But that means drawing down its limited supply of foreign exchange not frozen by international sanctions, reducing its capacity to buy critical inputs for military and industrial production on the one hand and critical medicines on the other hand”. Hence, placing Russia in “technical default” will facilitate US extension of secondary sanctions on countries and financial institutions still inclined to provide financing to Russian entities or to invest in Russian assets.
Stephen Bartholomeusz notes “Russia’s default on its foreign currency sovereign debt…is one of the stranger outworkings of the web of sanctions the West has woven around Russia’s finances. While the failure of about $US100 million of interest payments to reach foreign bondholders is being described as a default, and technically is one, the ratings agencies that would normally declare the default have yet to do so. They can’t, because the sanctions prevent them from rating Russian bonds. The bondholders who haven’t received their money could themselves declare a default but, in a practical sense, it would have no near-term impact. Russia didn’t waive its sovereign immunity in the bonds’ documentation and it is unclear who, if anyone, would have the jurisdiction to hear any claim they might have or whether Russia would observe any judgment if one were made”. “Russia had gone to great lengths, until the weekend, to avoid triggering any defaults, but a pathway through the sanctions net that had been deliberately left open and that allowed US bondholders to receive payments from the Russian government was closed by the US Treasury…Then the EU sanctioned Russia’s National Settlement Depositary, completing the wall around Russia’s ability to transfer funds out of the country. The bizarre aspect of the situation is that Russia has the funds to meet the payments and avoid default…The problem is that the agent is unable to deposit those funds in the bondholders’ accounts because of the sanctions. Perversely, it’s not Russia being punished by the default but the foreign bondholders who haven’t received their interest payments. The default is being widely described as symbolic, which was perhaps the point of the decisions by the US and EU to act to ensure Russia couldn’t complete the payments and force it into its first default on foreign debt in more than a century”. “The US and Europe presumably wanted to attach the odious label of defaulters to the Russians, as well as signalling that the net of financial sanctions had been completed and that Russia is now largely – albeit not entirely given its relationships with China and India and a handful of others – cut off from the core of the global financial system. It was a manufactured default that will inevitably be followed by others as interest and principal payments on other issues of the $US20 billion of debt owed to foreigners fall due…Theoretically, the bondholders could try to sue for payment although, as noted, that’s not straightforward. They could also try to convince a court to allow them to seize assets, including the central bank reserves that have been frozen in offshore jurisdictions, or Russian government properties offshore. Sovereign and diplomatic immunities would complicate those efforts. Alternatively, they could simply wait for the eventual resolution of the war in Ukraine and hope that the sanctions will eventually be lifted and Russia allowed to re-engage with the global financial system and bond markets and be able to repay their debt. As Argentina has demonstrated – even after defaulting eight times on its sovereign debt – for investors, time and attractive yields heal most wounds”.
Financial nuclear bomb threatens sanctity of global monetary order
Dominik A. Leusder points out “not all of the sanctions were a surprise. Sanctions on the assets and financial transactions of key Russian businessmen and companies have already been in effect; and Iranian banks were excluded from SWIFT in 2012, and correspondent banking relationships were severed in 2019”. “It’s the subsequent measures, put in place in the Sunday after the invasion, that have constituted the real geoeconomic break: the freezing of Russian’s foreign reserve assets held abroad, and the outright ban on transactions with the Russian central bank… deprived Russia of the half of the $630 billion war chest of foreign exchange earnings…the extreme step of the central bank freeze suggests that we are in a new phase of monetary combat. Not even Nazi Germany was fully exiled from the international monetary system. Relations between the Bank of England and the Reichsbank persisted well into the 1940s, while the Bank of International Settlements allowed the German central bank access to its clearing and settlement facilities throughout the entirety of the war. One infamous case in 1939 involved the clearing of looted Czecho-Slovakian central bank gold via the BIS in cooperation with the Bank of England. The nature of central bank reserves is quasi-sacrosanct, but already in 2015 we could see the contours of the new monetary warfare…The most blatant example of this type of coercion occurred just months before the Russian invasion. After the remaining US forces withdrew from Afghanistan…the central bank, which held an estimated $7 billion in reserves in the United States. The Biden Administration promptly froze and confiscated the reserves, and, in a cynical move, distributed half to the families of victims of the September 11 attacks…In a very meaningful way Russia had prepared for the current conflict. But it was also guided by a belief in the sanctity of foreign reserves held at the world’s central banks. If such a sanctity ever existed, it has been obliterated overnight”.
The nuclear fall-out triggered several chain reactions.
- The spillover effects are substantial and still on-going in the global economy. New policies and rules on finance are constantly being introduced to ensure MNCs did not stray across geopolitical red lines. They are disruptive and costly. Market responsiveness and business resilience to new shocks is being worn down and monetary fragilities are becoming exposed.
- A financial show-of-force is in the offing with the West preparing to extend secondary sanctions while Russia and others (like China) are preparing to counter-attack. More enforcement actions such as fines, sanctions, asset seizures and cross-border legal disputes are around the corner.
- Long-term patterns of production, trade, savings recycling and currency usage are already undergoing drastic changes. In particular, the freezing of central bank reserves and Switzerland’s participation in GEW has seriously damaged confidence in the concept of safe assets and safe havens. The status of euro and yen has been undermined by rising energy and commodity prices. Generally, OECD currencies will fold into a “shrinking” USD currency area and this will clip their ability to conduct independent (of US) monetary policies.
The freezing of Russian central bank foreign exchange reserves has set off a furious debate. Some are highly critical. David C. Hendrickson labels it as the great expropriation; “something that just wasn’t done in the 18th and 19th centuries, even in terrible extremities. Debts were paid, even to cretins. The reputation for trustworthiness was the banker’s most precious asset, and it became the creed of nations. Only by an authoritative legal process, governed by the law of nations, might someone else get their hands on your stash. In name the central bank actions are a freeze, but in actuality they constitute a debt repudiation, a default…The situation is made all the more incredible by two facts. First, the contemporary default occurred at the center of the financial order, not at its periphery. That makes it staggering and unlike any other. Second, it was cooked up in a couple of hours by U.S. government staffers…the confiscation of the enemy’s property in war is a grotesque violation of justice and that invasions of justice are fatal to credit and reputation”.
Others advocate Russia’s frozen assets be confiscated and sold, with the proceeds used as reparations to rebuild Ukraine[3]. Previously, the US government had seized the assets of Iran, Venezuela, the Taliban and Russian individuals (for human rights violations based on the Magnitsky Act). However, Paul B. Stephan points out current US laws, such as the International Economic Emergency Powers Act of 1977, only provides the power to seize or freeze property ownership rights; i.e. “forbidding anyone to dispose of or use an asset or take income from it”. “The owner at least retains the hope that, when the conflict is over and the freeze order ends, the property – or its equivalent in money – will return”. “The Patriot Act, adopted in the wake of 9/11, created a limited exception to the confiscation ban in instances in which the United States is at war”. This authority has never been used and the US is not at war with Russia. Most scholars agree “the Constitution’s Fifth Amendment guarantees due process before the government can confiscate a private citizen’s property”; even those belonging to foreign citizens. In addition, “international law provides a certain degree of immunity from confiscation to foreign nations and their assets overseas”. Russia is mirroring these sanctions by threatening to seize foreign assets and providing waivers to foreign IP ownership rights[4].
Nicolas Véron and Joshua Kirschenbaum argue it wasn’t timely to confiscate Russia’s assets. First, it detracts from urgent and consequential actions such as reducing European oil and gas imports from Russia and increasing direct financing to Ukraine. Second, confiscation upfront reduced bargaining options. Third, it may hurt consensus among EU members (1) concerned about systemic financial stability and the international rule of law; (2) exposed to direct Russian retaliation due to geographical proximity, security vulnerability and density of economic linkages. Fourth, it entailed unnecessary risks to the stability of the international financial system. Fifth, it may lead to perceptions of hypocrisy and double standards “when the US and its partners talk about defending the international rules-based order”.
Nicolas Véron and Joshua Kirschenbaum point out “the key point here is one of principle: credibly standing for a rules-based order is worth more than the billions that would be gained from appropriating Russia’s money. Countries place their reserves in other countries trusting they will not be expropriated in situations short of being at war with each other – and the jurisdictions holding Bank of Russia reserves, even though they actively support Ukraine, are not currently at war with Russia…It is apparent that international reserves enjoy some protection under international law, even though this may not include sovereign immunity from judicial processes, as mentioned above, and precedents are scarce. The moral high ground is also worth defending in relation to Russian public opinion”.
Michael P. Dooley, David Folkerts-Landau and Peter M. Garber argue[5] “sanctions are not only justified but indeed the natural outcome, should countries renege on the global social contract. Collateral should be seized if actors behave badly. For them, the sequestration of Russian assets sets an example for other nations that the US is capable of exercising its power to usurp dollar assets. The seizures, they argue, will only reinforce to geopolitically risky economies that they must put up more collateral to participate in global supply chains”.
Michael P. Dooley, David Folkerts-Landau and Peter M. Garber explain “an influential academic theory for persistently depressed real interest rates in the center is that the US supplies safe assets to the rest of the world. This is only part of the story. The US also produces assets that are unsafe to those who misbehave. The center country must provide safety for good behavior and punishment for bad behavior…the dollar is the dominant reserve currency because the US is the only country with sufficient power to impose exactly such sanctions when a country like Russia misbehaves. The US earns the exorbitant privilege of having the global reserve currency by daring to impose penalties when justified by the behavior of the owners of reserves…It is clear that Russia will for the foreseeable future drop out of the dollar-based periphery and attempt to persuade the formation of a new bloc. But Russia is small in economic terms, and a bloc of its own satellites will also be small. The important question is: what will China choose to do? China has an enormous stake in the dollar-based system. Exports account for 18.5% of its GDP, and it holds $3.2 trillion in reserves. Moreover, the huge expansion in the last decade of its vulnerable foreign investments makes China’s existing collateral even more valuable than in earlier years. But the Russian experience also highlights the constraint on geopolitical actions posed by participation in the dollar-based system. Are the economic incentives for continued participation sufficient to offset limitations on territorial and other political objectives? If China chooses geopolitical independence, capital flows within its new proprietary bloc likewise will depend on its own financial and military threats to its periphery members. China is unlikely to open its domestic financial market to massive net or even gross capital inflows. But what is China’s financial clout over a member of its bloc that is a pure debtor to China? As in the history of the Western empires, it would need to have bases or quasi-colonial dominance to be confident enough for such uncollateralized lending to occur. All those foreign ports that it owns and manages can turn into naval and marine bases overnight. However, what if China allows large net capital inflows from bloc members to serve as hostage? Then, as did the US, it will have to tolerate an overvalued CNY exchange rate and watch as its labor market suffers from imported unemployment”.
Notwithstanding the diversity of views, the deafening explosion from the financial nuclear bomb has been heard around the world. Zoltan Pozsar’s hypothesis is that “wars also upend the dominance of currencies and serve as a doula to the birth of new monetary systems”. The seizure of Russia’s foreign exchange reserves is a catalyst for changes in the global monetary order that will evolve into Bretton Woods III[6].
Zoltan Pozsar envisages the emergence of Bretton Woods III will be driven by Asian fears that their foreign reserves are at risk of expropriation in future geopolitical disputes and will opt to increasingly park their surpluses outside the Western sphere. This will herald the rise of “commodity-backed currencies in the East” and end USD hegemony. “Bretton Woods II served up a deflationary impulse (globalization, open trade, just-in-time supply chains, and only one supply chain [Foxconn], not many), and Bretton Woods III will serve up an inflationary impulse (de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left)”.
Mona Ali argues “while codependency between China and the US (evocatively described as “Chimerica”) was a characteristic trait of Bretton Woods II, Bretton Woods III is a virulent strain of the global dollar system” – “marked by acute dollar encroachment and its weaponization of the world economy”. Weaponizing the world dollar has already wrought destruction through intensifying lawfare and an appreciating dollar that is once again inflicting pain on the poorer parts of the global economy. “Stability at the core of the global dollar system, ensured by any means necessary, will be countered by tremendous instability in the periphery. The complexities of wielding the world dollar as a weapon in economic warfare restage the old dilemmas of hegemonic currency management”. She suggests “there are at least two ways a weaponized global dollar regime can play out. Aligning regimes in the Indo-Pacific and MENA with the North Atlantic apex of the world dollar order via military and monetary aid is the predictable path. (Countries receiving dollar liquidity tend to be entwined in the global networks of US banks and military networks.)”. Alternatively, “proponents of benevolent hegemonic stability like Charles Kindleberger and Ronald McKinnon, meanwhile, advocated for defanging the dollar order via multilateralism…A defanged world dollar order would involve basic income provisioning for vulnerable communities via Fed accounts, fair debt restructuring for poor economies whose futures have been hobbled by onerous debt burdens, and public financing for green infrastructure in the Global South”.
At the end of the day, the freezing of Russia’s central bank reserves may be more symbolic rather material. Central bank reserves are essentially a digital bookkeeping entry between creditor and debtor countries. It signifies the creditworthiness of a country; i.e. its ability to meet external obligations. They do not represent a loss of Russia’s own physical wealth. On the other hand, the freezing Russia’s central bank reserves reflect Western sovereign issuers of USD, euro and yen government debt have repudiated their IOUs and impaired Russia’s ability to transact in foreign currencies. The consequence from loss of safe asset status could be more be more severe for OECD currencies and have a corrosive impact on their future values and purchasing power.
Mapping the contours of the new world order
The financial nuclear bomb was detonated to demonstrate the consequences of defying “international norms”. Treasury Secretary Janet Yellen proclaimed that “we, the sanctioning countries, are saying to Russia that, having flaunted the rules, norms, and values that underpin the international economy, we will no longer extend to you the privilege of trading or investing with us…Rest assured, until Putin ends his heinous war of choice, the Biden administration will work with our partners to push Russia further towards economic, financial, and strategic isolation. The Kremlin will be forced to choose between propping up its economy or funding the continuation of Putin’s brutal war”.
Janet Yellen warned “countries who are currently sitting on the fence, perhaps seeing an opportunity to gain by preserving their relationship with Russia and backfilling the void left by others. Such motivations are short-sighted. The future of our international order, both for peaceful security and economic prosperity, is at stake. And this is an order that benefits us all. And let’s be clear, the unified coalition of sanctioning countries will not be indifferent to actions that undermine the sanctions we’ve put in place”. In particular, “China cannot expect the global community to respect its appeals to the principles of sovereignty and territorial integrity in the future if does not respect these principles now when it counts. China has recently affirmed a special relationship with Russia…I think China needs to take seriously working with us, and it’s not just the United States. Europe and other countries share concerns about some of the practices that China has that negatively impact our national security, human rights concerns. I would like to see us preserve the benefits of deep economic integration with China, not going to a bipolar world, but clearly that’s a danger that we need to address”. The US administration would “modernize the multilateral approach we have used to build trade integration. Our objective should be to achieve free but secure trade. We cannot allow countries to use their market position in key raw materials, technologies, or products to have the power to disrupt our economy or exercise unwanted geopolitical leverage…So let’s build on and deepen economic integration and the efficiencies it brings on terms that work better for American workers. And let’s do it with the countries we know we can count on. Favoring the friend-shoring of supply chains to a large number of trusted countries, so we can continue to securely extend market access, will lower the risks to our economy as well as to our trusted trade partners”.
Her warnings reflect building political pressure to extend secondary sanctions to other countries, particularly China. For example, Chris Devonshire-Ellis notes “U.S. Senators Marco Rubio, Rick Scott, and Todd Young introduced the Crippling Unhinged Russian Belligerence and Chinese Involvement in Putin’s Schemes (CURB CIPS) Act…to sanction Chinese financial institutions that conduct transactions with any Russian financial institutions using alternative financial messaging systems (including China’s CIPs system and Russia’s SPFS network) to the Society for Worldwide Interbank Financial Telecommunication (SWIFT). The bill would freeze or terminate any U.S. based accounts connected to Chinese financial institutions – or block the U.S.-based property of such institutions – that engage in transactions with a Russian financial institution using either CIPS or SPFS…The proposed bill would permit the following actions: Direct the Secretary of the Treasury to impose sanctions on any Chinese financial institution that uses CIPS or SPFS to verify or conduct a transaction with any Russian financial institution or a financial institution in Russia-controlled territories; Include sanctions that would terminate or prohibit any correspondent accounts or payable-through accounts of offending Chinese financial institutions in the U.S., or block all transactions in property of such institutions in the United States or in the possession of a U.S. person; Require a report from Treasury outlining the scope and usage of CIPS and SPFS around the world, the risks of widespread adoption of these systems to U.S. national security, and recommendations to preserve and strengthen U.S. influence in the global financial system”. He points out “the bill would also bring all Chinese global financial transactions under the veto power of the United States, and could be later extended to include other countries who trade with Russia as well. The decision reveals the larger conflict occuring externally from the regional Russia-Ukraine situation – a wider, global struggle between the United States, China and Russia over a reset of the global world order, and the United States desire to impose its will on other nations and bend them to its global policies and ideologies”.
The warnings are clearly heard but is unlikely to be heeded. Global south countries regard the GEW sanctions – particularly the freezing of central bank reserves – as arbitrary, lacking due process, and undermining multilateralism. Conspiratorial theories abound. Michael Hudson[7] observed “in the newspaper, you think the war is all about Ukrainians and NATO fighting Russians, and it’s really a war by the United States to use the NATO-Russia conflict as a means of locking in control over its allies and the whole Western world, and…re-establishing American unipolar power…going along with the policy that’s going to squeeze their balance of payments and lock them into dependency on the United States”. In this context, the large increase in energy and agricultural prices “will leave most of Africa and Latin America unable to pay their foreign debts, which is going to result either in a massive debt default or it will result in a debt repudiation”. He speculates “probably the central economic game of the NATO war against Russia was to reconcentrate control of the world energy trade in the hands of American, English, and Dutch oil companies. So, basically the oil companies and the US are going to let the third-world countries go into a crisis. If they default on their bonds, then the United States and the bondholders get to treat Latin America like they treated Argentina or Venezuela and grab whatever assets they have outside of their country…There’s going to be a huge asset grab…in Latin America and Africa. Maybe some Asian deficit countries…that’s why there’s this fight within the IMF at the upcoming meetings, to create these special drawing rights to give them money on the condition that there is a class war. So, what we’re seeing, really, isn’t a war between NATO and Russia. It’s a class war of the neoliberals against labor across the world to establish the power of finance over labor”.
While there hasn’t yet been much open defiance of Western sanctions, nonetheless Global South countries are reactivating their non-aligned postures. Most are watching whether the West can maintain its resolve and unity as their own economies come under pressure. China seems to be making preparations for what it perceives to be an inevitable confrontation with the West. Hence, the most likely path forward is a fragmentation of the global economy into rival spheres for production, trade, technology, capital and laws. Countries will be pressed to pick sides. Thus, the financial nuclear bomb can be considered the curtain-raiser to a re-mapping of the contours of the world and monetary order.
Conclusion
The decades-long benign Goldilocks economic conditions – of low inflation and interest rates – was taken for granted. However, the Goldilocks economy was probably already on its last legs when the financial nuclear bomb was denotated. The outcomes of a crumbling global economy and swooning markets may already be causing regrets, that perhaps dropping the financial nuclear bomb was an error that is now rebounding badly on the West. But what other non-military choices did the West have to respond to the Russian invasion.
The financial nuclear bomb is a wake-up call for the Global South and businesses. It marks the end of decades of global political and economic cooperation. It affirms the acceleration of deglobalisation, heralds a period of heightened political and economic instability as nations compete to secure access and control of supplies and to build resilience and self-sufficiency at all costs. The weaponization of currencies and financial access is setting the stage for battles to reshape the global monetary order.
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[1] “Fourteen countries sent troops to take part in this attack. France sent 12,000 soldiers, London sent 40,000, Japan 70,000, Washington 13,000, the Poles 12,000, Greece 23,000, Canada 5,300…a total of 180,000 allied foreign troops”. See Eric Toussaint.
[2] See Oleg Itskhoki and Dmitry Mukhin.
[3] Gary Clyde Hufbauer and Jeffrey J. Schott argue the US should seize Russian assets for Ukraine’s reconstruction.
[4] See Wikborg Rein.
[5] This paragraph is based on Mona Ali’s summary.
[6] Bretton Woods I was based on fixed exchange rates anchored on gold convertability into USD from 1952 to 1970s. It ended in August 1971when USD was delinked from gold. Bretton Woods II is based on the recycling of petrodollars and Asia’s massive export earnings into USD safe assets such as Treasuries. See Mona Ali.
[7] See Katie Halper and Aaron Maté