Rubles, Renminbi and Other Weapons: How Emerging Markets Are Fighting Dollar Dominance

Going to the movies this weekend? We’re now approaching summer blockbuster season, which means it’s almost time to head to the cinema for a big-budget, two-hour disaster film. Hollywood studios know that nothing draws people to the multiplex like another Godzilla rampage through Tokyo, or an alien death ray vaporizing the Eiffel Tower. For reasons best known to psychiatrists, anything featuring zombies or marauding aliens – preferably both – always achieves record ticket sales. People just love this stuff.

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Courtesy: Entertainment Weekly

Financial news isn’t much different from the big-box studios; there is no shortage of forecasts and theories about the next imminent disaster facing today’s global economy. I’m well aware that Martin Scorsese probably won’t produce another finance film (though Wolf of Wall Street did quite well), but I find the subject no less riveting than the possibility of a plummeting asteroid, or a pathogen outbreak. Frankly the potential for disruption and general mayhem can be just as great.

I am particularly interested in the emerging — and generally disturbing — trend whereby governments have begun to use their currencies as offensive weapons. In the world of economics, of course, currency wars are nothing new. Governments have debased and manipulated their currencies since the Roman days. In general this has often involved intentional weakening of a country’s currency in order to narrow a trade imbalance, or to prolong a corrupt regime’s ability to spend profligately at the expense of savers. James Rickards’ book Currency Wars is an excellent and definitive historical account of this practice. Governments and central banks continue to employ currency manipulation as a key strategy — though, one may argue, more recklessly than at any time in recent history — but this has always been a defensive measure, intended to protect one’s own economy. The weakening of a trading partner’s position was always a consequence, but not necessarily the desired result.

Even that is changing now. In recent years the US government, and to a lesser extent the European Union, have begun to introduce what the Eurasia Group’s Ian Bremmer calls ‘the weaponization of finance’.

The Dollar As Both Carrot — And Very Big Stick

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After nearly fourteen years of uninterrupted combat operations in Iraq and Afghanistan – where columnist George Will recently pointed out that the US government spends over US$ 1.4 billion to fight each member of al-Qaeda on the ground there – Washington has realized that popular support for further military campaigns is unsustainable. However, DC still wants to assume a leading role with global security issues and has realized that the dollar — or, more specifically, the threat of lost access to it — is a significantly more potent weapon.

Having been the world’s lone superpower for over two decades now, the US retains a dominant grip over global trade flows not seen since the peak of the British Empire in the 19th century. The creation of the ‘petrodollar’ in the 1970s — where the US government persuaded Saudi Arabia to receive payment for oil exclusively in US dollars and invest excess profits into US Treasury securities — enabled the US dollar to dominate the global oil market, and ultimately become the world’s reserve currency. The Soviet Union’s demise in the early 90s enabled the dollar’s dominance over global trade to continue unchecked.

Until very recently the global banking network relied almost exclusively on the US financial system. Do you live in Manila, and want to import French wine? They don’t accept pesos in Bordeaux, so you’ll have to convert your payment into euros. Unfortunately there is no direct conversion between those two currencies (just as there isn’t with most of the other 150 currencies around the world) so your wire transfer will involve a two-step process. First your funds will have to go to what is called a correspondent bank, typically Bank of New York or Citigroup, where your pesos are converted into dollars. That bank will then route your funds to the French bank, which will convert your dollars into euros and close out the transaction.

This status as the financial world’s central routing station is an incredibly powerful position. It is why Washington can seek to prosecute almost anyone in the world it wishes to – even if the alleged culprit never sets foot in, or does business in, the US. In the Justice Department’s opinion, the fact that dollars were involved in the alleged crime gives them jurisdiction and prosecutorial rights. This practice made headlines last week when Austria refused to extradite a Ukrainian billionaire (and, unsurprisingly, a Yanukovych associate) whom the US had indicted on bribery charges. Because the oligarch had routed funds to India through a US correspondent bank, Washington pursued him as if he were just another corrupt politician from Chicago.

Expulsion from the US financial system can become a serious hardship for the target, since nearly every financial system on the planet requires access to the US dollar in order to operate. So, when Washington designates a particular oligarch or politician as persona non grata then that person’s access to the global financial system is essentially shut down.

Sanctions work just as well against financial institutions as they do against individuals. In recent years the US has markedly increased the number of banks that are subject to sanctions, or on the receiving end of enormous fines. Last year the US assessed a $9 billion fine against the French bank BNP Paribas for violating its sanctions against Iran and Sudan, a charge which was upheld even after French President François Hollande appealed directly to President Obama on behalf of BNP. It speaks to the strength of the dollar’s grip on global finance that the bank paid such an enormous sum of money, rather than refuse and risk becoming a sanctions target itself.

It therefore stands to reason that, on today’s geopolitical chessboard, Washington has realized that economic ‘soft power’ can be a much more potent force than its military ‘hard power’. It can even be applied against governments, as is currently being applied against Iran and, increasingly, against Russia.

The problem with this strategy – as we will shortly explore – is that its application is almost certainly prompting US adversaries to develop alternative financial systems as quickly as possible.

The Dollar As An Offensive Weapon

Relations with the US and Russia (as I have written about here, here and here) are now at their lowest point since the first Cold War, as the US and European Union attempt to check Russia’s influence in Ukraine and across eastern Europe. Though tensions remain high in eastern Ukraine, the Minsk II Protocol has created an uneasy truce – which tilts very much in Russia’s favor. The West is gradually coming to grips with the fact that the contested regions of Donetsk and Luhansk will remain in Moscow’s sphere of influence. (Reports that a parallel, ruble-based economy is quickly taking hold in Donetsk are only adding to that perception).

Last August the UK government began pressing an idea around Brussels — a proposal to expel Russian banks from the global SWIFT network in reprisal for its actions in Crimea and eastern Ukraine. A year ago, loss of access to SWIFT would have been catastrophic to the Russian economy. (It still would – but as we’re about to see, somewhat less so now). Cross-border banking between Russian businesses and their foreign clients, vendors and suppliers would grind to a halt and the economic impact would be instantaneous.

Rubles Renminbi China Russia Dollar Dominance Emerging Markets

What is the SWIFT network?

If you have sent an international wire transfer before, then you are probably familiar with SWIFT codes — the eight- or eleven-digit string of characters that identifies the bank to which you wish to remit funds. What you may not have realized, is that SWIFT (or the Society for Worldwide Interbank Financial Telecommunication) is an international organization based in Brussels that is privately owned by its member financial institutions.

Back in 2013, former NSA contractor Edward Snowden released thousands of classified US National Security Agency (NSA) documents to the public. Among those documents was confirmation that the US government considers SWIFT to be a ‘target’, and prioritized the collection of information about financial transactions on its network. While it is unclear whether SWIFT has been complicit in providing this information, it should come as no surprise that this revelation dealt a significant setback to its reputation in the eyes of other governments.

The SWIFT network claims to be impartial and independent of government influence. In the past it has successfully resisted efforts to be used as a political weapon, whether by pro-Palestinian groups who lobbied to disconnect Israeli banks or by the Brits in their attempt to expel the Russian institutions. But SWIFT does not have a spotless track record when it comes to neutrality — under orders from the EU, they have disconnected all Iranian banks from their network as part of Western-led sanctions. Most recently, Russian media has claimed that Western banks are rejecting any transfers via SWIFT that originate from the Crimean region of Ukraine.

Why Is This Important?

SWIFT has become a systemically important institution since its founding in 1973. Though most people know very little about the organization, its viability has become critical to the global financial system. Unfortunately, because it is based in Brussels, it has been co-opted by the European Union who have denied access to out-of-favor countries like Iran and North Korea. The network has resisted pressure to deny access to Russia and Israel, but its complicity in anti-Iranian sanctions demonstrate that it will never be a truly neutral entity.

Let’s imagine, for a second, that the global financial system’s critical infrastructure were run by a private organization out of Shanghai, or even Hong Kong. Now imagine what would happen if, in an escalation of the Senkaku/Diaoyu Islands dispute, the Chinese government coerced that organization into denying access to Japanese banks. Or that Chinese military intelligence was tracking and recording every transaction that passed through the network. Would the US and UK governments sit idly by and continue relying on that network to support their cross-border banking needs?

Of course not; politicians would be under intense political pressure to create an alternative. And this is exactly what Vladimir Putin and Xi Jinping intend to do.

China Russia Renminbi Rubles
“This vodka is excellent, Vlad — and so much cheaper now that I can pay with Renminbi.”

Last December the Central Bank of Russia announced that it intends to implement a parallel network to SWIFT. The new system will utilize the CBR as the central routing facility, and will accommodate both domestic and foreign banks “without restrictions”. That network, which has not yet been named or launched, was expected to be launched “within six months”; if accurate, then we can expect an update soon.

Not surprisingly, objective information on this issue is very difficult to find. Mainstream Western media has no interest in exploring the topic, and any inclusion of Russian sources will only be met with skepticism and claims of propaganda. Nonetheless, the CBR did announce earlier this year that they have built the foundation of a new framework that domestic Russian banks can use in lieu of SWIFT. As of February they reported that 91 Russian financial institutions were now corrected directly to the CBR’s new network, which has not yet been named (I’ll put my vote in now for “Bistro”, the Russian word for ‘fast’).

Further to the east, an even more potentially destabilizing project is under way. Reuters recently ran a great article on the China International Payments System (CIPS), a payments network that is intended to enable direct conversion into renminbi with financial institutions around the world. Interestingly, CIPS will use a messaging system that is identical to SWIFT — a telling indicator of its intent to compete for market share. This is just one tactic in China’s ongoing strategy to unseat the dollar as the world’s reserve currency (I could, and probably should, devote another article to this topic); as of this writing Beijing is lobbying the International Monetary Fund (IMF) for endorsement as one of the world’s five reserve currencies, and aggressively striking deals for direct currency conversion with other countries around the world. Its successful campaign to persuade 57 countries to join its Asian Infrastructure Investment Bank (AIIB) was a significant embarrassment (and most likely not the last at China’s hands) to Washington, who aggressively lobbied its allies to refuse Beijing’s offers of membership.

SWIFT is well aware that these developments pose a looming threat to its dominant market position, and has recently taken steps to increase Russian participation in its management. Last year, in spite of mounting UK and US pressure to expel Russia from the network, its leadership instead voted to extend an offer for Russia to sit on its board of directors.

No such foresight is being displayed by the US or EU, who continue to escalate the use of today’s financial system as an offensive weapon — while apparently giving no consideration to the long-term consequences of those actions. It remains to be seen whether Russia and/or China will succeed in launching a parallel system in the coming months as has been projected, but eventual competing systems are an inevitability.

No sovereign nation with the means to resist such naked aggression from Western countries will allow themselves to be permanently victimized by financial weapons such as sanctions, denial to SWIFT and the petrodollar. Direct convertibility between other currencies will ultimately deny Washington the ability to use its newest foreign policy incentive. How effective will economic sanctions against Iran be when Teheran can bypass the dollar completely and settle cross-border trades in Renminbi?

Someday a disaster film may indeed be created to document the momentous changes that are coming to the global financial system, but a happy ending — at least for the US and EU — is far from assured.

Homepage photo courtesy Getty Images

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