The Great Economic War (GEW) (Part 4: Battles reshaping the global monetary order)
Phuah Eng Chye (10 September 2022)
The global monetary order underpinned by USD hegemony has held up remarkably well over many decades. Despite recurring financial and currency crises, USD hegemony provided the unity, efficiency and stability to drive globalisation. A key feature of USD hegemony was the huge expansion of central bank balance sheets which facilitated the growth of markets and products that freed financial intermediation from traditional bank lending constraints.
During this structural transformation of the monetary landscape, there were legendary battles between hedge funds (the market) and central banks such as George Soros’ successful attack on sterling and Bank of England. Hedge funds then championed their cause on inflicting market discipline on wayward governments and followed up with subsequent attacks on the “tiger” economies (Thailand, South Korea, Indonesia and Malaysia), which culminated in the Asian financial crisis, and on Iceland. Threatened by pending regulation, hedge funds subsequently lowered their profile and modified their strategies. In the aftermath of the crisis, Asian central banks fortified their balance sheets through large-scale sterilisation and undertook financial reforms. These reforms established the base for the emergence of the Goldilocks economy of low inflation and low interest rates with Asian central banks accumulation of USD forex reserves accommodating US monetary and fiscal deficit expansion.
The USD hegemony paradigm started to fray with decoupling. As the US pushed to decouple technology and industrial supply chains, China responded by decoupling their monetary policies[1]. Monetary coordination was shattered by the financial nuclear bomb – which undermined the sanctity of central bank reserves and established that ownership rights of OECD assets are conditional. This signalled the global monetary order based on the unquestioned safety of OECD assets is coming to an end.
The future of the USD empire
At stake is the future of USD empire. Few expect “the status of the dollar as the dominant international currency could be put in doubt or risk”. Markus K Brunnermeier, Harold James and Jean-Pierre Landau argue “the freeze is taking place in a situation that may be perceived as truly exceptional: an armed conflict triggered by the invasion carried out by a major country. No one would expect standard financial relations and arrangements to hold in those circumstances…all actions taken by the US authorities over the last decades demonstrate their commitment to promote and preserve the dollar as a safe asset. Numerous facilities have been deployed by the Federal Reserve to ensure the liquidity of the Treasury market”. “Finally, attractive alternatives to the US dollar do not exist and hence no realistic diversification instrument is available…Avoiding and resisting sanctions means finding alternatives to the dollar. We are therefore drawn back to an old, and still very acute question: are there such alternatives?”
However, Markus K Brunnermeier, Harold James and Jean-Pierre Landau acknowledge “sanctions may have significant long-term effects on the demand for reserves. Countries may reduce their dependence on reserves by limiting their exposure to financial shocks and partially restricting capital movements. The international monetary system may evolve towards to a new architecture, where cross-border financial integration is reduced”. They note “around twenty countries have foreign exchange reserves above $100 billion, most of them emerging economies…those countries clearly face a new tail risk of sanctions, with a very low probability but very high impact…one cannot diversify against those risks. The only way to buy insurance is to reduce one’s exposure…For emerging economies, it means reducing the need for (and dependence upon) foreign exchange reserves”. In this regard, foreign exchange reserves have plateaued since 2015 and this “almost mirrors (with a lag of a few years) the trends in gross cross-border capital flows and international exposures, which expanded until 2010 and then stabilised as a consequence of the Global Crisis…Financial globalisation had essentially come to a halt well before the invasion of Ukraine…New forms of sanctions, even if very rare, may lead to a further retreat and segmentation of the world financial system. Ultimately, sanctions, and their implications, reveal a basic, and forgotten, truth: the movement towards greater financial globalisation has been underpinned by a long-term commonality of purposes, standards and understanding between countries. By supplying a reserve currency (and benefiting from it), by augmenting it in crisis moments such as 2008 or 2020 by swap lines, the US has provided the world with a global public good: widespread access to a safe asset, which can be used as a buffer against financial shocks. Whether that equilibrium can be preserved in a geopolitically divided world is a major question for the future”.
The main challenger to USD hegemony is the yuan. James Galbraith asks “will the Chinese engine, now increasingly tied to a reconstructed Russia and the gravitational pull of the world’s largest demographic, productive, and trading region – the emerging Eurasian Economic Union and Shanghai Cooperation Organization – spell the end of the end of Bretton Woods…for the dollar-based international order? The answer to this question depends not only on the size, productivity, and technical development of the Chinese nation and its economy but also on the role of Chinese financial assets in the world at large, in relation to the incumbent role of the financial assets of the United States, Europe, and other Western nations and international institutions, including the IMF. China…is the world’s greatest trading nation. But it plays neither the global financial nor the security role and has no evident ambitions to do so. Indeed, one may argue that to take on such roles would be antithetical to the Chinese development model, which rests on construction and production rather than finance, and which is entirely defensive militarily and reliant on international institutions, law, and cooperation for the preservation of world peace. China moreover protects its internal assets and limits the external reach of its economic actors with capital controls; it does not run current account deficits that would make obligatory the large-scale expatriation of financial claims, and to do so would be quite incompatible with its position in the structure of world production systems, and risk leading to internal instabilities that the Chinese state cannot afford. Finally, China holds over a trillion dollars in US government bonds, and cannot easily divest these, even if it wished to do so, without affecting either the price of the bonds or the exchange rate of the dollar, and so devaluing its own holdings”.
James Galbraith points out “when trade is unbalanced for an extended period, one party or another may find themselves with financial assets denominated in units that are perceived to be insufficiently stable or liquid. And so the question of an alternative to the dollar-denominated reserve asset is, inevitably, raised. The evident solution to this problem lies in a common reserve asset for the emerging non-dollar trading area. This is the historical role, of course, of gold bullion. In the modern world, gold is unlikely to play this role in full, given the extreme instability of its market price, while other commodities are subject to depletion through use as well as to speculative instabilities originating in activities outside the common reserve zone. The logical approach is therefore an international financial asset, comprised of a weighted set of the national bonds of the participating countries, as in recent schemes for a Eurobond, backed by the joint commitments, in proportion to size and capacity, of China, Russia, Iran and other participating countries, such as Kazakhstan and Belarus. In the realities of Eurasia, this means a predominantly RMB-based bond backed predominantly by China. The durability of such an instrument against the US Treasury bond can only be tested over time. These are the basic conditions for the emergence of a non-dollar financial zone…Efforts by one country or another to move in this direction may be deterred by the threat of sanctions, or thwarted (as in the case of Iraq in 2003) by war. Big changes in the world financial order appear to happen only under extreme circumstances…A tentative conclusion is that the dollar-based financial system, with the euro acting as a junior partner, is likely to survive for now. But there will be a significant non-dollar, non-eurozone carved out for those countries considered adversaries…and for their trading partners. China will act as a bridge between the two systems – the fixed-point of multi-polarity. Should similar harsh decisions be taken with respect to China, then a true split of the world into mutually-isolated blocs, akin to the coldest years of the Cold War, would become a possibility”.
Yu Yongding points out “the incident shows that it is completely possible for the US to seize China’s overseas assets…the geopolitical conflict between China and the US poses a serious threat to the security of China’s overseas assets, especially its forex reserves”. In the meantime, China needs “to be careful about confiscating foreign investors’ assets…China should keep the promise and strictly protect the investment of foreign investors in the country. In fact, a lot of so-called foreign investments in China are actively our own investments while the remaining foreign investors, including the American ones, are those who are relatively friendly to China”. In addition, the risks and costs of holding USD as a reserve is growing as “the possibility that the US will fail…a net foreign debt of US$15 trillion…while the US’ foreign debt-to-GDP ratio kept surging”. “If the rest of the world divests or stops buying US treasuries, the dollar will depreciate”. “The financing cost of such a part of forex reserves is very high. Although China has US$2 trillion of overseas net assets, its investment return has always remained negative for more than ten years, or almost 20 years. This situation is in sharp contrast with the US. The US has a net debt of US$10 trillion but receives an annual investment income of hundreds of billions of dollars. The investment income of the US in 2021 amounted to US$200 billion”.
Yu Yongding advised “China’s balance of international payments and overseas assets and liabilities should not contain a large proportion of US assets. China should not be a creditor, especially not to lend money to someone who is much more powerful, as the debt may not be repaid. It’s not a good deal to be a creditor under the current geopolitical conditions”. “China should reduce holdings of US treasuries and increase holdings of other forms of assets…boosting its investment in strategic resource-producing countries” or “use some technical means, such as IT technology and digital currency”. China should also “shift away from exports to domestic consumption. It also should try to fulfill the Sino-US trade agreement as much as possible. It should spend its forex reserves”. “Despite the US’ containment policy, we still have to walk this difficult path. We do not know the whereabouts of a large amount of our overseas investments. But we should identify all of them and decide our future direction”.
Long-term currency trends
The mainstream view is the USD is unlikely to be dethroned. Rather, the GEW will accelerate the transition from a unipolar to a multipolar currency system. This involves a diversification in holdings and usage away from USD and OECD currencies such as the euro, yen, sterling and Swiss franc towards the yuan, rouble, the Indian rupee and precious metals.
Central Bank forex reserves. Serkan Arslanalp, Barry J. Eichengreen and Chima Simpson-Bell note “a decline in the dollar share of international reserves since the turn of the century…reflects active portfolio diversification…the shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three quarters into the currencies of smaller countries that have played a more limited role as reserve currencies”.
The GEW will accelerate the long-term decline in USD and OECD currency share. First, OECD currencies and assets now carry sanction, legal and compliance risks. Second, central banks in surplus countries will diversify portfolios and reduce USD and Euro holdings to more closely reflect their trade and capital flows. Third, normalisation of OECD central bank balance sheets implies additional international buying of USD will be capped. Tyler Durden notes proposals calling “for spending 4.4 trillion rubles ($70 billion) to buy the currencies of friendly countries, mostly yuan”. He adds Russia’s central bank could become “the first big central bank to hold the bulk of its reserves in emerging market currencies…like offshore Yuan, Turkish Lira, and India’s Rupee”. As compared with earlier projections[2], the USD share of central bank reserves could fall more quickly from its current share of around 59% to between 40% to 45% by the end of the decade. The euro is likely to lose the most ground with its share falling to below 15% instead of maintaining at 20% due to the loss of “neutrality” and its shrinking share of the global economy. The yuan share could rise beyond 10% while the Indian rupee and rouble could record steady gains. The extent of the losses of incumbent reserve currencies would be greater if OECD central banks follow in diversifying their reserve holdings.
Payments, funding and investments. Currently, OECD currencies dominate commercial use and holdings. Barry Eichengreen notes “as of April 2022, the dollar accounted (by value) for 41.8 percent of payment instructions transmitted by SWIFT (Society for Worldwide Interbank Financial Telecommunications), the euro for 34.7 percent, the British pound for 6.3 percent, the Japanese yen for 3.1 percent, and the Chinese renminbi for 2.1 percent”. The USD share of letters of credit and collections is estimated at 87.3%, euro at 5.7% while the RMB share is a miniscule 1.9%. The USD is expected to maintain a commanding position due to extensive support from OECD economies, financial intermediaries and MNCs and its advantages in the international financial and multilateral infrastructure. But unlike on previous occasions, OECD currency holdings and use will be eroded by the impact of sanctions on the ability of OECD intermediaries to handle non-OECD cross-border business and flows, by the OECD MNC retreat from “sanctioned” countries, and by cross-border intermediation deleveraging.
The USD should fare better than other OECD currencies. The euro, sterling, Swiss franc and yen no longer offer diversification benefits due to sanction risks and are suffering from illiquidity. William Pesek notes the dwindling share of the yen to 2.58% has diminished its status. “That could lead to less investment in yen assets, a dynamic that could reduce Nikkei 225 and Topix index valuations and boost long-term debt yields”. He suggests this augurs the decline of Tokyo’s capital market and the rise of Shanghai and Beijing as “the places to go for global borrowing and investment deals”.
Growing intra-trade and investments among developing economies will underpin rising yuan holdings and usage. GEW will foster the emergence of non-OECD MNCs and intermediaries handling non-OECD denominated financial assets. This will take place outside the OECD sphere. Overall, the combined share of yuan, rouble and Indian rupee could rise from negligible levels to exceed 20% (including non-SWIFT transactions) by the end of this decade. This is subject to the progress in building alternative cross-border infrastructure and intermediation capacity. Event risks such as secondary sanctions could speed up the de-dollarisation process.
Battles to reshape the global monetary order[3]
GEW is disrupting the existing global monetary order and forcing the birth of an alternative monetary network. There is no alternative or TINA now means Russia has no choice but to work with other countries to establish alternative cross-border payment, settlement and custodial mechanisms. In this regard, conditions differ markedly from the 1960s Cold War. Then the US financial system was heavily regulated with capital controls and interest rate ceilings but extraterritorial oversight was weak. London facilitated Russia’s USD transactions (including arbitraging US interest rates) leading to the creation of the Eurodollar market. The USD hegemony was ironically built on the greenback being used by everyone including its enemies. In contrast, GEW completely bars Russia from transacting OECD-denominated assets and dealing with OECD intermediaries in a digital and highly regulated environment.
China is expected to lead the challenge to USD hegemony under the BRICS[4] umbrella. Zongyuan Zoe Liu and Mihaela Papa point out “BRICS accounts for 24 percent of world GDP and over 16 percent of world trade. Thus, BRICS’ de-dollarization activities would not only impact inter-BRICS financial relations but also create a ripple effect globally”. “Historically, all five members have experienced US sanctions, with Russia and China still under various levels of US sanctions”. The BRICs are thus committed “to promoting the use of local currencies in international settlements and building a nondollar alternative global financial infrastructure”.
Zongyuan Zoe Liu and Mihaela Papa note BRICs have pushed ahead with “de-dollarization initiatives comprising the use of both institutional and market mechanisms to mitigate BRICS members’ risk exposure to the dollar’s hegemonic power. These initiatives include the New Development Bank (NDB) and development finance de-dollarization; global oil trade de-dollarization; global financial infrastructure de-dollarization through BRICS alternatives to SWIFT; BRICS promotion of de-dollarization initiatives by engaging with non-BRICS members; self-defense measures in US-led institutions against the dollar’s dominance; reforms of the global reserve currency structure; efforts to diffuse the dollar’s dominance as the vehicle currency in trade; and BRICS’ activities in global equity markets”. In 2017, the China-initiated BRICS Plus was launch to “bring in other countries and regional integration institutions, such as the Mercosur, the SCO, EEU, South African Customs Union, South Asian Association for Regional Cooperation, and ASEAN + China. BRICS Plus brings together thirty-five countries to form an expanded platform that can coordinate policies with BRICS’ regional partners across the four continents…for de-dollarization policy coordination and nondollar financial infrastructure construction”. This was reaffirmed by proposals to expand “national currency settlements and lending” and to create “an international reserve currency based on a basket of currencies” at the 2022 BRICS meeting[5].
D. I. Kondratov cautioned while BRICs have grown rapidly, “serious imbalances remain in the BRICS economies, threatening their sustainable development. In China, due to institutional factors, gross fixed capital formation is excessive, the economy is characterized by an orientation towards consumer demand, and the export of goods and services no longer serves as a support for GDP growth. India is characterized by imbalances between accumulation and consumption, which are reproduced largely due to the continued poverty of a significant part of the population. In Brazil and South Africa, on the contrary, the GDP dynamics is determined primarily by the state of domestic demand, while the indicators of accumulation and saving in them are relatively small. In general, there is no shortage of savings in Russia, but the available financial resources are not efficient enough for investment, as a result of which the economy is heavily dependent on the export of mineral products. All BRICS countries also have a number of common socioeconomic problems, including underdevelopment of the most important public institutions, a large share of the shadow sector, a high level of corruption in the state apparatus, sanctions, significant social stratification, and increasing degradation of ecological systems in industrial and raw-material production areas. The difficulties noted seriously worsen the state of the business climate in the BRICS countries”.
In addition, D. I. Kondratov points out “the scale of the use of currencies of developing countries in international circulation is still small and does not correspond to the increased contribution of these countries to world production and exports…The reasons for the weak internationalization of the national currencies of developing countries are well known. The raw materials they import are traditionally quoted in US dollars. Domestic companies prefer to operate in dollars, thus taking on the currency risk. There are some restrictions on international financial transactions in national currency units. The financial capabilities of non-residents in terms of managing ruble and other assets are extremely limited due to the underdevelopment of the capital market. Finally, the general economic environment, including the tax and legal systems, does not favor the use of BRICS currencies by non-residents. In the future, as these barriers are overcome, one should expect a significant increase in the role of national currencies of the largest developing countries in servicing international trade and cross-border capital flows, which will allow them to take a noticeable place in the modern monetary system, corresponding to their importance for the global economy. The internationalization of the yuan is impossible without ousting the dollar out of Southeast Asia. In the field of foreign trade, China will have to adjust currency regulation so that exporters abandon the practice of uncovered currency risk and focus more on the level of profit rather than on gross revenues. One of the solutions persistently promoted by the Chinese authorities is the creation of a currency basket of key world currencies, which would serve as a benchmark for monetary policy in Asia”.
Antonio Graceffo notes the 2022 BRICS Beijing Declaration called for continued collaboration on the BRICS Payments Task Force (BPTF) as a platform for exchanging experience and knowledge, and welcomes the central banks’ further cooperation on the payments track…We should also expand BRICS cooperation on cross-border payment and credit rating to facilitate trade, investment, and financing among our countries. He points out the limited convertibility of the yuan and other BRICS currencies is a major impediment. “If international settlement agreements could be reached among BRICS countries, the BRICS currencies would only be useful in trade with the originating nation. In other words, while South Africa and India may agree to settle trade in rupees, it is unlikely that other nations would accept rupees in trade with South Africa. Furthermore, several of the BRICS countries carry a large amount of foreign debt, which must be serviced in U.S. dollars, not rupees. Consequently, South Africa would sit on a pile of rupees that would be useless for any purpose other than trade with India. To make matters worse, while holding the rupees in reserve, South Africa would be exposing itself to currency valuation risk”. In addition, “China and Russia have attempted to build SWIFT alternatives, but neither system connects with banks in Western nations…agreeing to conduct business in yuan and through the Chinese Cross-Border Interbank Payment System (CIPS), the other BRICS nations would be ceding U.S. control of their cross-border trade for CCP control, which they may not be comfortable with…An alternative recommendation…to use a basket of currencies…Presumably, the BRICS would form a basket of its five currencies, but this would do very little to mitigate the problems of BRICS nations using domestic currencies to trade with one another. Other countries would not want to hold a basket of BRICS currency in reserves. And finally, the U.S. SWIFT system would not accommodate transactions made in a basket of BRICS currencies”.
Indeed, the utility of a basket of currencies may be overstated. Jan Nieuwenhuijs notes “before August 2021 total Special Drawing Right (SDR) allocations to International Monetary Fund (IMF) members stood at 204 billion. (1 SDR is currently worth about $1.3 U.S. dollars). Through the addition of 456 billion SDRs, total allocations increased by 124%. Yet the new issuance has done next to nothing of what IMF’s Managing Director Kristalina Georgieva promised in 2021: This is a historic decision – the largest SDR allocation in the history of the IMF and a shot in the arm for the global economy at a time of unprecedented crisis. The SDR allocation will benefit all members, address the long-term global need for reserves, build confidence, and foster the resilience and stability of the global economy. It will particularly help our most vulnerable countries struggling to cope with the impact of the COVID-19 crisis. When it sounds too good to be true, it usually is. First off, creating more SDRs doesn’t increase global liquidity (the quantity of international reserves). Nor does it benefit all members, build confidence, stabilize the global economy, or foster resilience. The SDR disappoints because it’s not a currency, it isn’t backed by anything, there is no free market to exchange them, and trade is illiquid (difficult to convert large quantities into cash). Regardless, the IMF spreads falsehoods about the SDR to keep up appearances”.
Broadly, Sergey Glazyev[6] sees the freezing of Russian foreign exchange reserves as the “last trump ace in the hybrid war against Russia” that “sharply accelerated the ongoing dismantling of the dollar-based economic world order”. In his analysis, Britain’s inability “to keep its empire and its central position in the world due to the obsolescence of its colonial economic system…was overtaken by structurally more efficient economic systems of the US and the USSR. Both the US and the USSR were more efficient at managing human capital in vertically integrated systems, which split the world into their zones of influence. A transition to a new world economic order started after the disintegration of the USSR. This transition is now reaching its conclusion with the imminent disintegration of the dollar-based global economic system, which provided the foundation of the United States global dominance. The new convergent economic system that emerged in the China and India is the next inevitable stage of development, combining the benefits of both centralized strategic planning and market economy, and of both state control of the monetary and physical infrastructure and entrepreneurship. The new economic system united various strata of their societies around the goal of increasing common wellbeing in a way that is substantially stronger than the Anglo-Saxon and European alternatives. This is the main reason why Washington will not be able to win the global hybrid war that it started. This is also the main reason why the current dollar-centric global financial system will be superseded by a new one, based on a consensus of the countries who join the new world economic order”.
Sergey Glazyev sees this progressing over three phases. “In the first phase of the transition, these countries fall back on using their national currencies and clearing mechanisms, backed by bilateral currency swaps. At this point, price formation is still mostly driven by prices at various exchanges, denominated in dollars. This phase is almost over: after Russia’s reserves in dollars, euro, pound, and yen were frozen, it is unlikely that any sovereign country will continue accumulating reserves in these currencies. Their immediate replacement is national currencies and gold. The second stage of the transition will involve new pricing mechanisms that do not reference the dollar. Price formation in national currencies involves substantial overheads, however, it will still be more attractive than pricing in unanchored and treacherous currencies like dollars, pounds, euro, and yen. The only remaining global currency candidate – the yuan – won’t be taking their place due to its inconvertibility and the restricted external access to the Chinese capital markets. The use of gold as the price reference is constrained by the inconvenience of its use for payments. The third and the final stage on the new economic order transition will involve a creation of a new digital payment currency founded through an international agreement based on principles of transparency, fairness, goodwill, and efficiency…A currency like this can be issued by a pool of currency reserves of BRICS countries, which all interested countries will be able to join. The weight of each currency in the basket could be proportional to the GDP of each country (based on purchasing power parity, for example), its share in international trade, as well as the population and territory size of participating countries. In addition, the basket could contain an index of prices of main exchange-traded commodities: gold and other precious metals, key industrial metals, hydrocarbons, grains, sugar, as well as water and other natural resources. To provide backing and to make the currency more resilient, relevant international resource reserves can be created in due course. This new currency would be used exclusively for cross-border payments and issued to the participating countries based on a pre-defined formula. Participating countries would instead use their national currencies for credit creation, in order to finance national investments and industry, as well as for sovereign wealth reserves. Capital account cross-border flows would remain governed by national currency regulations”.
Sergey Glazyev speculates that “transition to the new world economic order will likely be accompanied by systematic refusal to honor obligations in dollars, euro, pound, and yen. In this respect, it will be no different from the example set by the countries issuing these currencies who thought it appropriate to steal foreign exchange reserves of Iraq, Iran, Venezuela, Afghanistan, and Russia to the tune of trillions of dollars. Since the US, Britain, EU, and Japan refused to honor their obligations and confiscated the wealth of other nations which was held in their currencies, why should other countries be obliged to pay them back and to service their loans? In any case, participation in the new economic system will not be constrained by the obligations in the old one. Countries of the Global South can be full participants of the new system regardless of their accumulated debts in dollars, euro, pound, and yen. Even if they were to default on their obligations in those currencies, this would have no bearing on their credit rating in the new financial system. Nationalization of extraction industry, likewise, would not cause a disruption. Further, should these countries reserve a portion of their natural resources for the backing of the new economic system, their respective weight in the currency basket of the new monetary unit would increase accordingly, providing that nation with larger currency reserves and credit capacity. In addition, bilateral swap lines with trading partner countries would provide them with adequate financing for co-investments and trade financing”.
Overall, the GEW creates favourable conditions for the birth of an alternative monetary network. The BRICS heavyweights have committed to supporting USD alternatives. The growing list of “heavily” sanctioned countries – Russia, Iran, Venezuela, Cuba, North Korea, Afghanistan and Myanmar – is expanding the number of “committed” participants, a number that will be further increased by secondary sanctions. Critically, Russia can extend its military umbrella to protect trade and finance in open defiance of US and Western sanctions.
Monetary fragmentation and changing currency dynamics
The resilience of the USD hegemony monetary order is due to policy coordination among the major economies and continuous central bank support via QE and sterilisation. In contrast, the forthcoming transition from a unipolar to a multipolar currency paradigm will likely be accompanied by monetary fragmentation and changes in currency dynamics. It will be a flashback to the era of currency areas[7] with the USD dominant in the OECD currency area co-existing alongside a breakaway non-OECD currency area based on the yuan-rouble axis. The fragmentation of the monetary order into two currency areas has massive consequences.
- Structural change in savings recycling. Russia and China enjoy huge trade surpluses but they are no longer welcomed to invest in OECD and are exposed to “seizure” risks. If Russia and China can no longer recycle their surpluses back to OECD, it means that trade flows between OECD, Russia and China need to adjust (lower) to reduce the levels of bilateral surpluses and deficits. This can be partially offset by rising trade and investments with Global South countries. The diversion of Russian and Chinese savings to the Global South is likely to constrain the ability of OECD countries to run deficits. Monetary fragmentation is likely to result in liquidity fragmentation and congestion[8], multiplier contraction and restrain central bank balance sheet expansion; all of which will have a negative impact on asset prices.
- Diverging monetary policies. In recent years, China’s monetary policies have tended to move in an opposite direction from US policies. Generally, China appears to have shifted from competing on production to competing on consumption with the US. This implies a shift from currency competitiveness to a strong yuan policy that emphasises on the yuan’s stability and soundness as an alternative to a volatile USD. Hence while the USD has surged, the yuan depreciation has been relatively lower than the euro and yen. In the short-term, the yuan will largely function as a trade currency due to China’s capital controls. China will have to chart the yuan’s transition to becoming a major payment, financing and investment currency for the Global South. In this context, China has generally sought to address its financial vulnerabilities and implemented a Socialism big bang[9] in 2021 to puncture asset price bubbles early and redoubled its efforts to ban cryptocurrencies. The consequences from rising US interest rates, asset price collapses, property defaults, pandemic lockdowns and high energy prices would have been considerably worse if not for China’s earlier actions.
- Shrinking OECD currency area. Fragmentation will lead to a shrinkage in the OECD currency area. OECD currencies and assets are longer attractive diversification assets due to sanction risks, the retreat of OECD MNCs and intermediaries from non-OECD areas, the deleveraging of cross-border intermediation and growing illiquidity. In addition, the shock from higher energy and commodity costs will hit EU, Japan and China. However, OECD central banks are unable to use monetary policy to cushion these shocks given they have reached the limits of balance sheet expansion and are in the process of normalisation. These developments will shrink the use of OECD currencies
- New currency dynamics. Fragmentation creates three new sets of currency dynamics; namely:
- Rouble-yuan. The rouble recovered strongly due to its status as a commodity-backed currency anchored by energy, mineral and commodity prices. Due to the GEW sanctions, its currency is by default linked to the yuan. Given that China is a large importer of resources and exporter of products, Russia can comfortably hedge its financial position by holding yuan reserves and vice-versa for China.
- USD-euro-yen. The USD’s strength is due to the combined effects of high oil prices and cross-border deleveraging as the Fed raises interest rates and normalises its balance sheet. While the impact on emerging currencies were expected, the collapse of the euro and yen was due to their delay in tightening policy in line with the US. The USD upcycle will likely end once cross-border deleveraging is completed. The downcycle will be accompanied by demand destruction (national and global recession), low international demand for USD assets, impairment of US private sector balance sheets (crystallisation of investment losses for investors, corporations and households rather than banks) and high US trade and fiscal deficits. The extent of the USD decline depends on whether the Fed is more willing to tolerate a weaker currency or higher inflation and the ability of the government to control its deficit. The USD correction would be accompanied by a modest recovery in the euro and yen. The changeover to a USD downcycle will be marked by a shift from an inflationary phase to a deflationary phase.
- USD-yuan. This will become the most important forex relationship as it will reflect terms of trade between two currency areas. The current USD upcycle is driven by cross-border deleveraging and positive interest rate differentials. It will be interesting to see how PBOC reacts to the pressure on the yuan from the Fed’s interest rate hikes. In the downcycle, the USD depreciation will be driven by US deficits and falling global demand for the greenback. Generally, PBOC is positioning the yuan as a stable currency with relatively low volatility so that it will be accepted as a reliable store of value by Global South countries. One interesting event to watch is whether the Hong Kong USD peg would be maintained in the face of growing geopolitical tensions.
Establishing an alternative intermediation network
BRICS members appear keen to forge ahead to establish alternative intermediation networks. While this would put them on a head-on clash with the West, nonetheless they are keen to ensure a ready back-up to minimise disconnection risks from potential sanctions as well as to protect geopolitically sensitive data from US oversight. Towards this end, the GEW has created favourable conditions – the threat of secondary sanctions, high compliance and friction costs, and a reorientation in global production, trade and investment patterns towards re-circulating surpluses (savings) within spheres. The reshaping of the global monetary order thus depends on China and Russia’s progress in overcoming challenges to establishing an alternative intermediation network. In this regard, availability of capital is not a constraint because Russia and China enjoy large trade surpluses.
The impending fragmentation of the global economy into spheres implies that non-OECD MNCs and intermediaries are likely to diversify out of OECD into non-OECD currencies, assets and havens. There is potentially a large customer base for a range of financial services to support non-OECD cross-border trade and investments. There are risks from potential Western secondary sanctions and the untested reliability of new network. Nonetheless, there will be no shortage of non-OECD MNCs[10], intermediaries, tycoons and informal players enticed by the enormous growth and opportunities in a fledging intermediation network – in cross-border lending, insurance, clearing, settlement, custodian, information, legal, compliance, risk management and financial surveillance.
One major challenge is the establishment of a cross-border messaging[11] and clearing infrastructure. Barry Eichengreen notes “though China has been at work since 2015 building a parallel cross-border settlement system, it does not yet possess a viable alternative to SWIFT…to send instructions regarding cross-border interbank transactions; identifying financial counterparties other than Western banks with which to do international business and platforms other than Western clearinghouses through which to make payment; and finding a vehicle other than the dollar for denominating and executing transactions”. “If anything, China and SWIFT continue to grow closer…now supports Chinese characters, ensuring compatibility with messaging on China’s domestic payments system…SWIFT established a unit in Beijing in 2019 in order to provide local language services and meet local regulatory requirements”.
Barry Eichengreen points out “finding a way around these clearinghouses is more difficult than finding a way around SWIFT”. While “China is further along in developing an actual clearing or payments mechanism capable of transferring renminbi across borders”, “China remains leagues behind…the U.S. Clearing House Interbank Payments System (CHIPS) and its counterparts in other advanced countries”. “In 2015 the PBOC launched the Cross-Border Interbank Payments System (CIPS)…organized along similar lines as CHIPS, although it is a real-time gross settlement system as opposed to a netting engine. Financial institutions are divided into direct participants, which maintain an account with the system, and indirect participants, who deal with it via the direct participants. Direct participants must be incorporated in China so that the PBOC has oversight of their operations. At last count, there were 76 direct participants, mainly overseas branches of Chinese banks, located on every major continent except Latin America. This number is comparable to that of direct participants in CHIPS”. “CIPS’s website claims 1,304 indirect participants, about two-fifths in China and three-fifths abroad…Direct participants can message one another through SWIFT or through CIPS’s own messaging system. Indirect participants send and receive instructions through SWIFT…estimate that 80 percent of payments through CIPS use SWIFT messaging. The constraint does not appear to be the capacity of CIPS’s messaging system, but that many non-Chinese institutions have not installed translators for CIPS messaging. Participating banks are required to ensure that payments comply with China’s capital controls. This may obligate them, for example, to obtain prior approval for payments from the Chinese authorities”.
Barry Eichengreen thinks “for the moment, it is hard to argue that CIPS constitutes a serious challenge to Western clearinghouses. CHIPS has nearly 10 times as many participants: Whereas CHIPS is used by around 11,000 financial firms worldwide, CIPS is used by just over 1,300. CHIPS also processes 40 times as many transactions: In March 2022, daily volume on CIPS was 385 billion yuan ($45.6 billion), compared to $1.8 trillion on CHIPS. However, transactions using CIPS are growing…transaction value increased by 75 percent in 2021 and transaction volume by 50 percent. More banks around the world could plausibly join CIPS as a contingency plan. Even if they have little use for it for the moment, participation would provide a limited alternative in the event that CHIPS and SWIFT restrict access”. “Some observers imagine the creation of a joint Russian-Chinese clearinghouse or platform – or even the integration of China’s renminbi-based and Russia’s ruble-based systems. And those of other BRIC member countries. But interest is unclear as such a system…A system based on Chinese characters would have to add the capability of translating Cyrillic script (and vice versa). Governance challenges would be formidable. Western banks would have additional grounds for hesitating to participate…Would a Chinese central bank digital currency (CDBC) make a difference?”
Barry Eichengreen highlighted “China’s financial arrangements, such as CIPS, could weaken the effect of Western sanctions by offering targeted countries a hard-to-detect workaround”. “If China facilitated evasion of Western sanctions, then it would expose to the risk of imposing secondary sanctions on the Chinese government and specifically on the central bank. And any other participating financial institution…In the extreme scenario where relations between the United States and China break down, two self-contained monetary and financial systems might emerge: a Western system centered on the United States and utilizing the dollar and an Eastern system centered on China and utilizing the renminbi. In a less extreme scenario where there are no U.S. sanctions on China (or vice versa) and no outright military conflict between the two countries, there will be overlap. Western financial institutions will use the renminbi and CIPS for some transactions with their Chinese counterparts, and Chinese financial institutions will use CHIPS. Their respective national authorities have not opposed this in the past. The four big public Chinese banks are direct participants in CHIPS, while Citi is reportedly a direct participant in CIPS. To be sure, if the United States saw China as facilitating Russia’s evasion of sanctions, this permissive stance could change. Having Washington bar U.S. banks from participating in CIPS would be a further blow to U.S.-Chinese relations and accelerate the countries’ economic and financial decoupling. This would have far-reaching implications not just for the financial system but also for the fundamental organization of the respective economies”.
Global Times reports the PBOC is intensifying efforts “to improve yuan settlement-related policies for cross-border e-commerce platforms and other new trading scenarios, expand settlement services from goods and services trade to all sectors under the current account, strengthen supervision over payment institutions, and shore up risk prevention”. The “new forms of foreign trade include market procurement, offshore trade and overseas warehouses. Domestic banks may cooperate with non-bank payment institutions and clearing institutions with legal qualifications to provide cross-border yuan settlements under the current account for trading entities and individuals”. These initiatives are aimed at broadening the range of participants to “accelerate the development of new models of foreign trade and boost the yuan’s internationalization”.
More countries are seeking to participate in non-dollar payment systems. Global Times cites PBOC data showing “in 2021, cross-border yuan settlements totaled 36.6 trillion yuan ($5.4 trillion), up 29 percent year-on-year…Local banks have also ramped up efforts to serve firms’ cross-border businesses”. At the recent G20 meeting, “five countries in ASEAN – Malaysia, Indonesia, Thailand, Singapore and the Philippines – decided to connect their payment systems within the year to allow people to buy goods and services throughout the region using their own currencies”. Similarly, India’s central bank “had put in place a mechanism for international trade settlements in Indian rupees with immediate effect”.
China is already challenging Western dominance in banking. China’s commercial banks[12] – Industrial & Commercial Bank of China, China Construction Bank Corporation, Agricultural Bank of China and Bank of China – rank among the largest in the world. While their assets are mainly domestic, their foreign claims on developing economies are substantial. Emmanuel Mourlon-Druol and Aliénor Cameron notes “from 1970-1985, the well-known top five of the most famous IFCs including Tokyo, Paris, New York, London and Frankfurt topped the largest 15 banking centres…The 1986-1994 period showcased the continued strength of the same five banking centres”. “This highlights the strength of these places as financial centres, backed by the classic list of factors that support their functioning: a skilled workforce, the support of highly developed countries, and the stability of their institutional frameworks. These five centres represent the three most developed regions of the world economy, namely the United States, Japan and Europe”. “At the turn of the century, the emergence of China…as illustrated by the rise of Beijing, confirming the global shift in international economic relations towards Asia”. “Confirming the regional dynamism, the 2010s witnessed the emergence of Seoul, Shanghai and of India with Mumbai as its largest financial centre”. “Since 2020, Beijing is by far the world’s largest banking centre. Paris comes second and is followed by a close group of three cities: New York, London and Tokyo”. Frankfurt’s fall out of the top 5 contradicts “the claims made at the time of the creation of the European single currency that Frankfurt would become the leading European financial centre with the hosting of the European Central Bank”.
In contrast, a Bloomberg report notes “the global ambitions of both HSBC and Citigroup have been pared back, replaced by a narrower focus on core markets. HSBC has reduced the number of countries and territories in which it operates to 64 from 88. Its largest shareholder, China’s Ping An Insurance (Group) Co., has been agitating for a spinoff of its Asia operations. Last year, Citigroup announced its exit from 13 markets across Asia, Europe and the Middle East and is trying to sell its Mexican business, Banamex”. “As profitability in their outposts declined and the cost of managing far-flung organizations grew alongside stricter post-crisis regulations, the banks began to shed their global aspirations”.
The gap is not in traditional banking and payment services but rather in the creation of deep capital markets to rival those in US and Europe. Mona Ali notes “the largest cross-border financial flows are between Wall Street and the City of London…Much of the world’s money – from international debt securities to gold – is housed in New York and London…the world’s largest foreign currency markets, in key forms of dollar-financing such as derivatives, the City of London surpasses Wall Street. More than ninety percent of derivative contracts such as foreign exchange swaps – a key form of global funding – are dollar-based. New York and London also dominate the global legal profession. Half of dispute resolution across the world occurs in the courts of England and Wales and about a quarter occurs in New York State. Transnational law bears the insignia of American unilateralism. The US second circuit, which includes New York, leads in applying extraterritorial judicial rulings. Meanwhile, the US bristles against other sovereign states applying their laws extraterritorially against US residents. Lawyering through the sanctions has proven very lucrative for Anglo-America…this new cooperation is occurring alongside increases in the Australian and Canadian dollars in foreign exchange reserves. The coincidence of hard and soft power – Five Eyes and Fedwire – represents the integration of military, legal, and economic force”.
The establishment of an alternative intermediation network requires a robust cross-border architecture to support flows among participating countries. This requires establishing an acceptable regulatory and legal framework that facilitates and protects foreign ownership, an information infrastructure (disclosure rules, supervision, insurance and credit ratings) to underpin market integrity and policies to expand private intermediation capability to deepen market liquidity and accelerate product innovation. It is a time-consuming process to establish oversight, disciplinary, dispute and default resolution mechanisms and to build the non-bank financial and information intermediation capabilities. In tandem with this, there is a need to establish financial and macroeconomic surveillance to identify and address potential risks from persistent deficits and market misconduct among participating countries. These tasks have become easier as the Western templates for capital markets can be replicated while the costs and technological aspects of setting up a non-OECD payment infrastructure is no longer prohibitive.
Though the fledging alternative intermediation network may lack the advantages of the incumbent Western network, it can be competitive by offering several value propositions. First, it can offer anonymity from Western oversight. This can provide a home for “informal” finance as requests for information in relation to money-laundering and illegal activities can be ignored and there will probably be immunity from Western extraterritorial sanctions. Second, it can leapfrog legacy architecture and operate new highly-efficient digital models such as the digital yuan to reduce dependence on the inefficient USD-based correspondent banking network and reduce counterparty and settlement risks, costs and fees through greater efficiencies. Third, since Western intermediaries may not be allowed to participate in the alternative network, this creates a space to nurture non-Western intermediaries.
In this regard, the GEW is creating ample opportunities for the emergence of non-OECD wealth centres or safe havens that replicates the global service functionalities of international financial centres like London and New York. Some of these may be emerge in the BRIC hinterlands which is shielded from Western sanctions. Giacomo Tognini notes “in August 2018, four months after the U.S. Treasury Department imposed sanctions on seven Russian billionaires with alleged ties to Putin, that the Russian government quietly passed the law creating” two offshore zones, known as special administrative regions (SARs). SARs incentivised businesses to repatriate “their foreign companies to Russia provided a tax deal that was tough to beat: zero taxes on dividends and capital gains from the sale of shares in publicly traded companies, as long as the beneficiaries invested at least 50 million rubles – about $650,000 – in a Russian company within six months of transferring their firm to the SARs”. “SARs brought some of Russia’s largest firms back into Moscow’s orbit and blunted American sanctions. Since 2018, more than 70 companies have repatriated to Russian SARs from foreign jurisdictions, many of which were located in places that agreed to recognize the U.S. sanctions”.
The new havens are likely to model themselves after the Dubai International Financial Centre (DIFC)[13]. DIFC was established in 2004 and emerged as a financial hub for the Middle East, Africa and South Asia. DIFC has its own independent, internationally regulated regulator and judicial system, common law framework, and global financial exchange. It offers 100% foreign ownership, a zero-tax regime and has no restrictions on foreign exchange or capital repatriation. Dubai has invested heavily to build the infrastructure and is willing to tolerate to the consequences of internationalisation – including a foreign population density of 90%, and high living costs.
Initiatives were also launched to challenge the OECD price discovery hubs for energy and commodity products. Russia possesses sizeable amounts of collateral and will be able to anchor the formation of new trading hubs for energy, minerals and commodities. Chris MacIntosh notes Russia is proposing “a new international standard for trading in precious metals: the Moscow World Standard (MWS) which will become an alternative to the London Bullion Market Association (LBMA)…The basis of this new structure will be a new, specialized international precious metals brokerage headquartered in Moscow, which will rely on the MWS. Also proposed is a committee for fixing precious metals prices composed of central banks and largest banks of countries that are members of the Eurasian Economic Union (Armenia, Belarus, Kazakhstan, Kyrgyzstan and Russia) that currently have a presence on the precious metals market. According to the Russian Finance Ministry, precious metals prices will be fixed either in the national currencies of key member-countries or using new monetary units used in international trade – for instance, the new BRICS currency proposed by Putin. The Finance Ministry wants to make membership in this organization attractive to all market participants, especially China, India, Venezuela, Peru and other South American countries, as well as Africa. It aims to swiftly destroy the monopoly of LBMA and to provide for stable development of the precious metals sector. In essence, Russia proposes to create a market for gold, platinum, etc., which will be regulated by countries that control the resources for these metals”. “The production share of the US and other hostile nations produce a grand total of 22% of the world’s gold. Eurasian Economic Union, BRICS and Africa, together, produce 57% – already a controlling share. Now add Peru and Venezuela, and the number goes up to 62%”. “For starters, Russia has fixed the price of gold in rubles at 5000₽/g, which works out to $2,447.17 per troy ounce. This compares rather favorably to the current LBMA fix of $1737.84. The days of LBMA’s ability to drive down gold prices using paper gold manipulation appear be running out”. This market initiative is intended “to further the system of bilateral trade in national currencies that specifically excludes dollars, euros and pounds”. It is interesting to see how fragmentation of price discovery centers, intermediaries and clients will pan out. There are questions relating to how price differentials would be arbitraged, physical deliveries and storage, and the overall impact of fragmentation on Western intermediaries and the global markets.
Russia is also starting to tap China’s capital markets. Global Times report “Russia’s largest gold miner, PJSC Polyus, has completed the issuance of 4.6 billion yuan in bonds, less than one month after Russian aluminium company Rusal issued 4 billion yuan-denominated bonds in the Russian market”. China’s Special Administrative Regions (SAR), Hong Kong and Macao, have also begun to issue yuan-denominated treasury bonds.
The shifting of intermediation business out of New York and London to financial centers and havens outside the Western sphere will shrink the business of OECD intermediaries. The problem for the West is that it is conducting GEW in its backyard and is damaging its own network and intermediaries. The range of self-inflicted wounds include loss of space (scale) and connectivity, damage to currency, asset and collateral functionality, loss of liquidity and efficiency, and large frictions from compliance and legal risks. The lesson is that the maintenance of network dominance requires openness. Once a dominant network imposes conditionalities to restrict usage and increase costs, this would raise the probability of user deflection.
Conclusion
By forcing financial activities to shift outside of the OECD currency area, the West is inadvertently assisting the birth of an alternative international intermediation network. This will give rise to a fragmented global monetary order. Economic prospects will undoubtedly be adversely affected by the interactions, or lack of, between the two currency areas. What will be the implications of non-OECD countries not re-investing their surpluses in OECD currencies? How will transactions between different currency areas be settled and related information be shared? How will global coordination of monetary policies, regulatory and risk oversight and resolution of debt crises take place? Will MNCs and intermediaries be allowed to straddle between the two currency areas? The fragmentation of the global monetary order is likely to have severe effects that could lead to a global economic breakdown and monetary disorder.
References
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[1] See articles on monetary decoupling.
[2] See “Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)”.
[3] See Zoltan Pozsar for a detailed analysis of a commodity-based monetary order.
[4] The BRICS members are Brazil, Russia, India, China and South Africa.
[5] See Global Times.
[6] See Pepe Escobar.
[7] https://en.wikipedia.org/wiki/Sterling_area
[8] See articles on monetary decoupling.
[9] See “Global reset – Economic decoupling (Part 1: China’s socialism big bang)”.
[10] Scott Foster notes “a new Russian economy is likely to emerge as Indian, Turkish, Chinese and Russian companies move into markets vacated by Europeans, Americans, Japanese, South Koreans and others”.
[11] See Liana Wong and Rebecca M. Nelson (19 July 2021).
[12] See “Global reset – Monetary decoupling (Part 13: Intermediaries in the era of globalisation and decoupling)”.
[13] https://en.wikipedia.org/wiki/Dubai_International_Financial_Centre