The turn of the 21st century brought a fundamental reordering of how economic battles are waged. After 9/11, the US Treasury recognised that global dollar dominance gave Washington control over the critical plumbing of global finance. A new breed of financial sanctions emerged which could precisely cut individual targets – terrorists, foreign government officials, state institutions, firms – off from the dollar system. ‘Smart’ financial sanctions revolutionised economic warfare.
American presidents responded to the new tool with enthusiasm, deploying sanctions with increasing frequency over the past two decades. In 2000, just four countries were targeted under a US financial sanctions programme. By 2020, this had risen to 21, meaning roughly one in 10 sovereign states was facing some level of pressure from a financial sanctions programme. In several cases, foreign central banks were targeted. In Libya, Venezuela, Iran and most recently Russia, official money managers found their dollar reserves frozen as a result of sanctions. These acts have implications for official portfolio decisions.
In ‘Bucking the Buck: US Financial Sanctions and the International Backlash Against the Dollar’, I argue that Washington’s growing use of the dollar as a tool of economic coercion has generated political risk in the international currency system. Political risk, in this context, is the potential for a political act to raise the expected cost of using the dollar as a store of value or medium of exchange.
The US’s penchant for financial sanctions does not jeopardise dollar supremacy. The currency retains undeniable economic and political advantages over all rivals. US Treasury bonds will remain the fundamental component of most central bank portfolios for the foreseeable future. However, monetary authorities in states with adversarial relations with the US are exploring ways to hedge against the risk of asset freezes. That will intensify in the near term in the wake of the most recent sanctions against the Central Bank of Russia.
Monetary gold is a key beneficiary in the current environment. After two decades of declining popularity as a reserve asset in the 1990s and 2000s, gold has experienced a revival since 2010. Some of this relates to economic considerations. The metal is a popular hedge against dollar weakness. However, gold’s rising appeal has much to do with its emergent role as a hedge against sanctions risk.
Bullion held in a national vault cannot be seized by Washington short of a military invasion. Central banks in states that are targets of US sanctions as well as those that are at higher risk of facing sanctions purchased more gold on an annual basis between 2008-20 compared to unsanctioned states. Notably, central bank demand for gold in 2022 – following severe sanctions targeting Russia for its invasion of Ukraine – was the highest on record, with China as a major buyer.
Yet, there are limits to how much gold central banks will want to hold. Targeted and at-risk states are likely to make additional efforts to ‘sanction-proof’ their portfolios. Shifting the geographic distribution of reserve assets, including dollar reserves, out of the US is one such tactic. Russia did this in 2018 following a major tranche of US financial sanctions, cutting its share of reserves custodied at US institutions to about 5% that year, down from around 30%. Brad Setser, senior fellow at the Council on Foreign Relations, has pointed out that China has most likely moved some of its US Treasury holdings to places like Belgium in an effort to escape US legal jurisdiction and improve resilience to future sanctions.
Finally, among sanctioned and at-risk countries, there may be some marginal movement of official foreign exchange reserves into the renminbi. Beijing’s willingness to deepen its economic relationship with Russia signals to other states that the world’s second-largest economy can serve as an economic and financial lifeline to blacklisted economies. Though renminbi reserves are of limited usefulness, lacking full convertibility, they can be freely used in current account transactions with China.
As the shadow of geoeconomics looms ever larger over the world economy, expect political considerations to shape reserve manager decisions in new and meaningful ways even as the dollar’s fundamental position atop the global currency hierarchy remains stable.
Daniel McDowell is Associate Professor of Political Science at the Maxwell School of Citizenship and Public Affairs, Syracuse University.
This article was originally published in the OMFIF Global Public Investor 2023.