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Article 16/2022
Introduction
The sanctions imposed on financial institutions in Russia, including on its central bank, are likely to be a wake-up call for many emerging market economies (EMEs). Rising global powers like China and India will see the ability to impose crippling financial sanctions through payment networks controlled by western countries as a threat to their independence in pursuing global international relations.
Financial sanctions are a potent weapon at the disposal of the western countries because much of international trade is invoiced in US dollars. This translates in the economists jargon to the US dollar being a dominant currency. Because cross-border payments systems are routed through systems controlled by the west, blocking access to them cripples a country’s economy. Without a material shift in the invoicing pattern of international trade to include alternative currencies, the financial clout and privileges of western countries will not be easily broken.
This requires building financial security which has many common themes with energy security. The president of the European Commission recently criticised Russia for using fossil fuels to blackmail Europe. But America and its allies routinely use financial payment networks to blackmail countries. Just as Europe seeks to achieve energy independence from Russia, EMEs must strive to achieve financial independence from the western control of critical payment and settlement systems. Against this backdrop, this article raises the following question: What safeguards can central banks in EMEs build to ensure that their mandate to promote the welfare of their country’s citizens is not jeopardized through the geopolitical goals of some countries? This article goes about providing some suggestions as to what can be done.
Dominant currency and international trade
The dominance of a currency over others usually translates into the following attributes (Gopinath and Stein, 2018). (a) An overwhelming fraction of international trade is invoiced in this currency; (b) Foreign banks are able to raise deposits in the dominant currency and foreign firms are eager to borrow and issue bonds denominated in this currency; (c) It is cheaper to borrow for banks and firms in the dominant currency after adjusting for exchange rate movements, and (d) Central banks accumulate foreign exchange reserves predominantly in the dominant currency.
The US dollar has been the dominant currency for well over 50 years. The size and openness of the US economy, deep and liquid capital markets, and trust in the US institutions that regulate financial markets and set monetary policy have been the key anchors for the US dollars’ role as the dominant currency. The benefits to the US by ensuring that the US dollar remains the dominant currency are enormous. It reduces currency hedging costs for domestic corporations and helps to fund government deficits cheaply when countries invest their trade surplus in US securities. At the same time, it also helps to inflict economic pain on adversaries by preventing them from using US dollars to trade in international markets.
The rapid growth of the Chinese economy since early 2000 has raised hopes that renminbi could compete with the US dollar as an alternative currency for international transactions. However, the project to internationalize renminbi has not gathered momentum. Part of the reason for this is the reluctance of the Chinese authorities to fully liberalize the capital account. That is because experience from the Asian crisis showed that countries that did not fully liberalize their capital account had fewer adverse macroeconomic adjustments, and recovery was swift (Prasad et al, 2005). Experience during the global financial crisis was also similar.
From China’s perspective, an increase in the use of renminbi in international trade will have the added benefit of insulating domestic inflation from external shocks (Gopinath, 2015). Also, encouraging the use of renminbi in invoicing and settling trade is the first logical step in internationalizing the currency (Eichengreen, 2011). Still, a perceived shift in global invoicing patterns that embrace the renminbi or any other currency will not go down well in Washington. That is because foreign investment flows in the past have largely been flowing into US Treasuries, which in turn has helped lower the borrowing costs of the US government.
Lessons from the Ukrainian conflict
The US government has increasingly relied on financial sanctions to advance its foreign policy objectives (Wong and Nelson, 2021). In the ongoing Ukrainian conflict, several Russian banks were barred from accessing the SWIFT messaging network and the foreign currency assets of the Bank of Russia were frozen. The legality of such bans can be contested. But the lesson to be drawn is that by controlling critical Financial Market Infrastructures (FMIs), western countries have a powerful tool to inflict significant damage and suffering on citizens of independent nation-states. Those at the receiving end are likely to be the financially weaker sections of the population.
This action by G10 countries, unprecedented in nature, is likely to be interpreted by EMEs as a signal that the monetary system under Bretton Woods II is not to be trusted and that it may even cease to exist. However, its demise was already being speculated during the Trump presidency as trade sanctions against China took centre stage (The Economist, 2019). The defining element of Bretton Woods II is the notion that the flow of money from reserve accumulating economies to the US and from the American consumers back to the reserve accumulating economies will keep the global economy ticking. The actions of the G10 countries have called into question this assumption. Countries holding large foreign exchange (FX) reserves in US dollars and euros will be sensitive to this development. This action is likely to trigger a fundamental review of the reserve’s management operational framework.
Structural changes needed
In a globalized economy, inflicting collateral damage and economic pain on an adversary will be implemented through the control and ownership of critical FMIs. Relying on a single messaging platform to conduct international trade and facilitate cross-border financial flows is the biggest risk any mature economy faces in an interconnected world. Addressing this risk will require building an alternative FMI with a different oversight committee and governance mechanism to the SWIFT network to transmit and settle cross-border payments. However, for such a system to operate in a fail-safe mode and not be subject to sanctions of G10 countries, international trade invoicing should broaden to include non-G10 currencies or digital assets.
Privately issued cryptocurrencies and stablecoins have gained much attention in recent years as a possible substitute for fiat currencies. The attraction to cryptocurrencies has been driven by the hype that they are a better store of value, much like gold, compared to fiat currencies whose purchasing power can be eroded by pursuing extremely accommodative monetary policies. However, crypto-assets pose many risks stemming from the lack of an underlying claim, light-touch or no regulation, and the absence of a formal governance structure (Chimienti et al., 2019).
It is imperative that any currency used to settle cross-border trade should be available to a central bank to acquire and hold on its balance sheet. That effectively narrows the list down to renminbi, excluding the G10 currencies. Indeed, renminbi is the only viable alternative to US dollars and euros to settle international trade, given both the size of the Chinese economy and the inclusion of renminbi in the Special Drawing Rights (SDR) granting it the reserve currency status.
One would argue that the prerequisite to use renminbi as a currency for cross-border trade is the internationalization of renminbi. Capital account liberalization and currency convertibility are important elements of the internationalization of a currency. However, it also requires credible central bank policies that promote low inflation and stable exchange rates versus major currency pairs (Gao and Yu, 2011).
Lingering concerns about the potential negative macroeconomic consequences of large investment in- and out-flows against the backdrop of less deep capital markets in China have made full-scale liberalization of the capital account a challenge. That said the Chinese government has been actively promoting the internationalization of the renminbi as a safe and reliable currency with little geopolitical risk.
The attractiveness of renminbi in cross-border trade invoicing for critical commodities is likely to gather pace following the financial sanctions imposed on the Bank of Russia. Even a modest increase in the share of renminbi invoicing in energy markets can create a positive feedback loop to make renminbi invoicing also attractive in other commodity markets. This conclusion can be drawn if we follow the arguments of Gopinath and Stein (2018). Specifically, an increase in renminbi invoicing share in country m will tend to push up the renminbi invoicing share in country n through a safe asset demand-and-supply mechanism. That argument should extend to markets as countries export and import different goods.
Governance arrangements
The ability of an FMI to attract a significant volume of cross-border payments to be routed through it will depend on the users’ trust in the system. That trust is built through four mechanisms: an inclusive ownership structure; shared goals among participants who use it; principled and transparent governance arrangements; and a collective oversight responsibility under the stewardship of central banks.
Central banks have to start with the right governance arrangements to build trust in the new FMI. Governance is the set of relationships between an FMI’s owners, board of directors, and other relevant parties including participants and stakeholders. Governance provides the processes through which an organization sets its objectives, determines means for achieving those objectives, and monitors performance against those objectives. Specific guidance on the objectives and governance arrangements for an FMI drawing lessons from the global financial crisis has been set out in the report on principles for financial market infrastructures (CPSS, 2012).
Considering that SWIFT has been the core agent for implementing G10 executive decisions on financial sanctions, some may think setting up an alternative messaging network to SWIFT would be sufficient to build safeguards. However, that is a wrong conclusion. To the extent that the new messaging system attempts to facilitate the movement of funds denominated in euro or US dollar through an interbank payment system, that transaction can be blocked by G10 sanctions. Consequently, there is value-added only in cases where the messages of the new FMI are routed to interbank payment systems in non-G10 currencies. That helps establish what the objectives of the new FMI should be.
For the lack of a better name, one can call the new messaging system NAIMS (Non-Aligned Interbank Messaging System), which carries out similar functions as SWIFT but handles only EME currencies. NAIMS is not designed to move funds but only facilitates the secured flow of financial information across borders to actual payment and settlement systems.
Setting up the appropriate governance arrangements and participant rights to ensure fair and safe access to NAIMS would be the key step toward achieving financial independence from the executive actions of G10 countries. Specifically, participant access to NAIMS should not be constrained by geopolitics. That requirement can be met by restricting the oversight body to be from selected non-G10 countries. The oversight body should comprise about ten central banks with good geographical diversification. That will ensure the diversity of views and appropriate checks and balances in decision-making.
Developing an alternative messaging system to SWIFT has the advantage that cross-border trade denominated not just in renminbi but also in other EME currencies could be routed through it. For example, India will be able to make payments through this messaging system in roubles and receive payments in rupees. More importantly, these transactions can be executed independently of G10 countries’ decisions. That would give greater freedom and more financial security to the vulnerable sections of the world’s population who tend to suffer most from the financial sanctions. It is a mission worthy of pursuing and accomplishing before the end of this decade.
Concluding remarks
The dominance of the US dollar has remained uncontested over the last 70 years. However, the Ukrainian conflict has brought to the forefront the deeply rooted distrust in the international monetary system. This could increase the demand for renminbi as an alternative reserve currency asset and its use in invoicing cross-border trade. Still, the US dollar will have an important role to play in invoicing international trade, though it may have to compete for market share against the renminbi at some stage. From India’s perspective, influencing the governance arrangements and serving as a member of the oversight committee of a new financial messaging system will provide geopolitical clout and strengthen India’s financial security in conducting international trade. In the future, achieving the geopolitical goals of the US government by using the US dollar as a financial disrupter would face challenges as the renminbi, and perhaps a few other EME currencies could become an alternative for settling international trade.
(Srichander Ramaswamy, former EU high-level adviser on financial system governance to the Prime Minister’s Office, Republic of Moldova. This article draws on insights gained working closely with global central banks, initially with foreign exchange reserves managers after the 1997 Asian financial crisis and subsequently on building financial system safeguards after the 2008 global financial crisis. The views expressed are those of the author and do not reflect the views of C3S.)
References:
1. Chimienti, M. T., U. Kochanska and A. Pinna, 2019, “Understanding the crypto-asset phenomenon, its risks and measurement issues,” ECB Economic Bulletin, No. 5/2019, Frankfurt. 2. CPSS (Committee on Payment and Settlement Systems), 2012, “Principles for financial market infrastructures,” Bank for International Settlements, Basel. 3. Eichengreen, B., 2011, “The renminbi as an international currency,” Journal of Policy Modeling, Vol. 33, No. 5, pp. 723–30. Gao, H. and Y. Yu, 2011, “Internationalisation of the renminbi,” BIS Papers No. 61, pp. 105–24. 4. Gopinath, G., 2015, “The international price system,” NBER Working Paper No. 21646, National Bureau of Economic Research, Cambridge, MA. 5. Gopinath, G. and J.C. Stein, 2018, “Banking, trade, and the making of a dominant currency,” NBER Working Paper No. 24485, National Bureau of Economic Research, Cambridge, MA. 6. Prasad, E., T. Rumbaugh and Q. Wang, 2005, “Putting the cart before the horse? Capital account liberalization and exchange rate flexibility in China,” IMF Policy Discussion Paper PDP/05/1, Washington DC. 7. The Economist, 2019, “What comes after Bretton Woods II?”. Available from: https://www.economist.com/finance-and-economics/2019/08/15/what-comes-after-bretton-woods-ii. 8. Wong, L. and R. M. Nelson, 2021, “International financial messaging systems,” Congressional Research Service R46843. Available from: https://sgp.fas.org/crs/row/R46843.pdf.
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