The US has been a global power since the second world war. But it was during the interval between the collapse of the USSR in 1991 and the rise of China in the 21st century that the US was perhaps the single global hegemon. 

Joseph Mariathasan

The US dollar remains the dominant reserve currency, contributing to the country’s dominance. The dollar’s status as a reserve currency benefits the US in many ways, including allowing it to achieve significantly lower yields on its debt issuance as global investors, including central banks, invest their dollars in US Treasury bonds. 

It has also allowed the US and its allies to impose effective financial sanctions on Russia after the Ukraine invasion, which represents another facet of what Gary Smith, managing director of Sovereign Focus Asset Management, refers to as the weaponisation of finance by the US – using financial policy to pursue foreign policy objectives. This has had ramifications for the currency make-up of central bank reserves across the globe and raises issues for investors on the geopolitical risks they face.

Sanctions power

America’s allies and its enemies have the common goal of reducing the dominance of the dollar and the ability of the US to impose sanctions not only on unfriendly states such as Iran and North Korea, but also on European companies that may be breaking no laws in their country of domicile or in the countries they trade with. 

The view that the US has an “exorbitant privilege” may hold some truth in that it can finance imports in its own currency. But the dollar’s dominance has been gradually eroding; global central bank reserves were 70% US dollar demoninated at the start of this century and have fallen to 60%, says Smith. 

Central banks and the weaponisation of finance

The euro was meant to be a challenge to the dollar’s supremacy, but the years of negative interest rates and bond yields following the global financial crisis reduced the attractiveness of the European currency.

Smith argues that the US weaponisation of finance began with the enactment of the 2001 US Patriot Act, following the 9/11 terrorist acts, that included strong provisions on preventing money laundering that could finance terrorism. The use of dollars to facilitate international trade meant that the US Treasury could track every dollar transacted in hostile nations such as Afghanistan or North Korea and back into the US banking system. It was very successful but gradually started to be used more widely against rogue states such as Iran and Sudan. 

However, it came as a massive shock to European banks when they discovered that US sanctions also applied to them in their dealings with Iran and the like, despite Europe not sanctioning those countries. This was most dramatically seen in 2014 when the US imposed a $8.9bn (€8.3bn) fine on French bank BNP Paribas for its dealings with Sudan. The US was able to do this because the transactions were in US dollars, which could be tracked. 

European law at the time did not prevent banks from transacting with Sudan, but as they were transacting in US dollars they found out, to their cost, that the US Treasury could sanction them for using dollars in transactions with states the US deems ‘rogue’. The US was using its laws to govern non-US entities doing transactions outside the US in dollars. Smith believes 2014 was a key date when central banks became aware of the implications of the weaponisation of finance. This has provided an impetus for them to diversify away from the dollar, which has benefitted smaller countries that trade with each other. 

Australia and South Korea have strong trading relationships but Smith points out that in 2008 neither country had the other’s currency in their reserves. Now they do. 

Russia’s invasion of Ukraine has led to financial sanctions not only by the US but also its allies in Europe and Asia, including Australia, which Smith sees as another key date in the weaponisation of finance. Some central banks responded by buying more gold, with the price of the precious metal hitting all-time highs in 2022 and 2023. According to Smith, these countries included Turkey, India, Egypt and Qatar. With the exception of Turkey, which has an uneasy relationship within NATO, they all abstained on the vote to remove Russia from the UN Human Rights Council. 

It is harder to put a control on gold transactions, except where the proceeds are in dollars through transactions in the US banking system. There has therefore been a trend for central banks to repatriate their gold reserves that had been stored with the Bank of England or the US Federal Reserve. Smith points out that doing so can have its disadvantages. Apart from the costs of transportation and security, gold stored at the Bank of England can be easily lent out or sold without physically moving it.

The China effect

Perhaps the most significant longer-term impact of the weaponisation of finance may be on China’s renminbi, which has been a quiet beneficiary of central banks’ anti-dollar sentiments. It is a Special Drawing Rights (SDR) currency, which is a currency reserve asset based on the value of a basket of five currencies – dollar, euro, Chinese renminbi, yen and sterling. 

China has been trying to encourage greater use of the renminbi as a reserve currency. Its share of global trade certainly justifies a much higher status in terms of its weightings in central bank reserves. However, geopolitical risks associated with China are coming to the fore and that will have repercussions for the suitability of the renminbi as a reserve. 

Will China invade Taiwan? As one military figure said to me, if a man approaches you waving a knife and says he is going to stab you, you generally assume he will try. China has declared publicly and repeatedly that it will retake Taiwan by force if need be. Such threats cannot be ignored as the Russian invasion of Ukraine has shown. The US has so far showed itself willing to stand up to China’s threats, but will President Xi Jinping take the gamble that if a full-scale invasion does take place in the next decade, the US public would not be willing to see a huge destruction of US military capabilities and loss of life to support Taiwan against mainland China? 

The alternative face-saving option for the US would be imposing financial sanctions. The weaponisation of finance has achieved some success but its capabilities may not be powerful enough to deter China’s ambitions regarding Taiwan. But for investors in China, it does represent a risk that cannot be ignored.

Joseph Mariathasan is a contributing editor to IPE and a director of GIST Advisory