By Nicolas Sargen, Darden School of Business
Russia’s invasion of Ukraine poses one of the greatest challenges to the post-World War II order, and it could portend further problems if the conflict drags on, as recently warned by the General Mark Milley.
Shortly after the invasion began, the United States and its NATO allies invoked sanctions against Russia that a report by VOX CEPR called “the most powerful and costly punishments imposed on a major economy at least since the Cold War”. The actions included the freezing of Russia’s foreign exchange reserves, which led to an initial drop in the ruble. They forced Russia to impose capital controls, raise the key central bank rate to 20% and shut down the stock market while Russia’s sovereign credit rating was downgraded to junk status.
As a result, the Russian economy is on the verge of a deep recession that could exceed what it experienced during the 2008 global financial crisis. But the sanctions have not deterred Russia from committing war crimes, as claimed by the US government and others.
Therefore, the United States and the European Union are now considering additional measures. Most impactful would be for European countries to reduce their purchases of Russian oil and natural gas, as Russia earns around $1 billion a day exporting energy. Achieving consensus on this issue is not easy, as European economies import around 40% of their oil and gas from Russia, and 55% of German gas came from Russia before the conflict. The dilemma is how much economic pain Europe is willing to accept to deter Russia.
Beyond that, some observers fear that the “weaponization of finance” will undermine the international financial system and the role of the dollar in it.
In an interview with the Financial Times, Gita Gopinath, the first deputy managing director of the IMF, indicated that financial sanctions against Russia could gradually dilute the dominance of the dollar and lead to a more fragmented international monetary system. Others go much further. In an Asia Times commentary, David P. Goldman writes: “Once, pessimism was reserved for money maniacs; now even Goldman Sachs is warning that the dollar will go the way of the pound.
Concerns about international trade have some validity, as pressures to reduce trade have intensified over the past four or five years. Former President Trump’s actions to impose tariffs not only on China but also on US allies have yet to be reversed by President Biden. Meanwhile, the coronavirus pandemic has disrupted links in the global supply chain and the fallout from the Russian invasion led to a 2.8% decline in global trade volume from February to March.
But fears that the sanctions will erode the dollar’s role in international trade and finance are overblown. As Sebastian Mallaby observes: “Russia, China and other American adversaries would love to escape Uncle Sam’s financial hegemony. But they have been trying for years and have little to show for it.
To understand why this is so, consider how the US dollar became the predominant currency after World War II.
As the most powerful country in the world with the strongest economy, the United States was widely seen as a safe haven, and there was a shortage of dollars in the 1950s. Even Soviet bloc countries sought to hold dollars but did so outside the United States, giving rise to the Eurocurrency market. It then took off when the US government enacted the Interest Equalization Tax (IET) in 1963, which levied a federal tax on the purchase of foreign stocks and bonds by Americans. During this process, multinational corporations obtained dollar financing from abroad, and the role of the dollar as a vehicle currency for trade and finance took root.
The main challenge for the dollar as the world’s main reserve currency came in the 1970s, when the United States abandoned convertibility between the dollar and gold. As US inflation rose, the Bretton Woods system of fixed exchange rates gave way to flexible exchange rates. Thereafter, the dollar steadily weakened against the West German deutsche mark, the Swiss franc and the Japanese yen. Throughout the decade, the question of whether the dollar could retain its status with high US inflation was debated in official circles.
In the end, the dollar prevailed for two reasons. First, the Federal Reserve restored confidence in the dollar when US inflation was brought under control from the mid-1980s. Second, Europe, Japan, and China lacked the breadth and depth of markets American financiers. Moreover, Japan and China have been reluctant to allow capital to flow in and out of their countries without restrictions, and they prefer trade surpluses.
Today, the dollar’s share in official foreign exchange reserves is around 60%. This compares to 21% for the European Union (EU), 6% for Japan and 5% for the United Kingdom. And while China encourages the use of its currency in international trade and as a reserve asset, the renminbi accounts for just 2% of global reserves.
From this perspective, there are two reasons why the role of the dollar could be questioned. The first is that the Federal Reserve could have difficulty bringing inflation back towards its average annual target of 2%. So far, however, investors have not lost faith in the dollar, which has appreciated against other key currencies since the start of the Russian-Ukrainian conflict.
The other is that the United States may use more frequent sanctions and/or tariffs in the future. In imposing sanctions on Russia, however, the United States has wisely done so with NATO members and Japan rather than acting unilaterally. Even Switzerland has embraced EU sanctions, and Sweden and Finland have announced plans to join NATO. It shows how egregious Russia’s actions are and why no democracy accuses the United States of acting irresponsibly.
Nicholas Sargen, Ph.D., is an economic consultant affiliated with Fort Washington Investment Advisors in Cincinnati and the Darden School of Business at the University of Virginia. He is the author of three books, including “Global Shocks: An Investing Guide for Turbulent Markets. »