Authors: Ross Buckley and Mia Trzecinski, UNSW
Since the invasion of Ukraine in February 2022, the United States, European Union and their allies have imposed extraordinary financial sanctions on Russia. They have frozen US$300 billion of Russia’s foreign currency reserves, removed Russian institutions from SWIFT — the messaging service that facilitates international payments — and banned most foreign investment into the country.
The impact of these sanctions — which have cut Russia off from the global financial system — has been severe. Inflation in Russia has increased to over 17 per cent and is likely to accelerate further. There are major shortages in food, drugs, medical gear and IT equipment. Over 750 companies have announced plans to suspend or end investments and operations in Russia. The rouble is no longer a convertible currency. The European Bank for Reconstruction and Development predicts that the war will cause Russia’s economy to contract by 10 per cent this year — a staggering fall in economic activity.
Such sanctions are able to wreak such havoc because of the United States’ present dominance of the global financial system. The US dollar is the principal currency used for international trade and global financial transactions, and the currency in which most central bank foreign exchange reserves are held. As the bulk of international payments are cleared by correspondent banks located in the United States, they are subject to US rules. The US also has significant influence over SWIFT and CHIPS, a clearing house system that processes US$1.8 trillion in payments daily.
The benefits the United States enjoys from the current system are massive and range from abundant capital inflows to the capacity to borrow cheaply overseas, and from having no foreign exchange cost or risk on most trade transactions to being able to use financial sanctions as a potent weapon against adversaries.
The United States views sanctions as effective and low-risk tools, given their capacity to severely damage the economy of another country without resorting to military intervention. Of late, United States sanctions have been directed at a wide range of targets, from foreign regimes to Swiss banks, and from Chinese tech firms to employees of the International Criminal Court charged with investigating whether US forces committed war crimes in Afghanistan.
But the sanctions on Russia are of another order and scale than anything ever seen before. By freezing some US$300 billion of Russian central bank foreign exchange reserves, the United States has trampled upon fundamental notions of national sovereignty and private property, however just the cause.
Imposing these unprecedented sanctions may prove to be a brave move by the United States, as it may in time reduce the extraordinary upsides for America of the centrality of the US dollar in the global financial system today. Some states may well seek to reduce their exposure to US sanctions by developing alternatives to the current US-dominated global financial system.
Russia and China have developed financial messaging services which they claim are alternatives to SWIFT and CHIPS, though uptake has so far been limited. In 2019, the two countries agreed to replace the dollar with their national currencies in cross-border settlements between them. China has also entered local currency swap agreements with many countries participating in its Belt and Road Initiative, including Russia. The development of central bank digital currencies could also be a step in the dethronement of the US dollar.
While the development of alternatives has so far been slow to take off, the unprecedented sanctions imposed on Russia will likely be an inflection point in the process.
These sanctions could have two significant consequences.
The first is the de-dollarisation of global currency reserves. There already is a clear push among states to reduce dependence on the US dollar in international reserves. The US dollar’s share of global reserves fell from 73 per cent in 2001 to 59 per cent in 2021. Around a quarter of the shift away from US dollars has gone into the Chinese renminbi, while the rest of the shift has been into a mix of other currencies.
While no other currency will fully displace the US dollar as the global reserve currency in the near to medium term, the trend towards a multiple reserve currency system is established and the extraordinary sanctions on Russia’s central bank will likely accelerate this shift.
The second consequence is fragmentation. Along with the diversification of global reserves, a renewed push for the development of an alternative financial system parallel to the US-dominated financial system is likely. This will lead to fragmentation as the world divides into blocs, de-stabilising global monetary relations. In a fragmented system, more transactions will take place outside of existing regulatory channels, causing regulators to lose visibility of, and control over, illicit transactions.
The sanctions on Russia send a powerful message that violating global norms as defined by the United States, its allies and partners will not be tolerated. But the West will also pay a price for these sanctions. Most likely, non-Western states and some Western states too will re-evaluate the risks of remaining dependent upon the US-dominated global financial system. The United States’ ability to leverage its economic power in the future, and the integrity of the global financial system, are at risk.
Ross P Buckley is the KPMG Law – KWM Professor of Disruptive Innovation at UNSW Sydney, and an ARC Laureate Fellow at UNSW Sydney.
Mia Trzecinski is a Research Fellow on the Laureate Project at UNSW Sydney.
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