Dollar power, exorbitant privilege, and financial sanctions

A headline in the Financial Times on 3 October 2018 read, ‘Can Russia stop using the US dollar?’ The subheading for the article was ‘After years of US sanctions, Moscow says it can de-dollarise its economy. But its rhetoric may be easier than reality’. These article headings raise a couple of questions to be addressed in this Transatlantic Puzzle piece. What does it mean to ‘de-dollarise’?  And why does this economic action matter? There is an historical transatlantic tension with the dominant role of the US dollar for international trade and investment. The effort by Russia to reduce its use of the dollar highlights two points involving this tension. First, it reminds us of the prominent role of the US dollar in the world economy since the end of World War II.  Second, it underscores the increased use of financial sanctions by the US government as a foreign policy tool in the 21st century.

In simple terms, de-dollarisation could be understood as a process of removing the dollar from use in a nation’s cross-border trade.  For some, it is a detox from dollar addiction, or a withdrawal from the excessive use of dollars in all forms of business. Thus, it serves to promote national financial independence from US economic and monetary policy.  For others, it is an act of resistance against Valéry Giscard d’Estaing‘s assertion of America’s ‘exorbitant privilege’ from dollar hegemony (cited by Ben S. Bernanke, 7 January 2016). To understand what this assertion means requires that we first reflect on how this situation of dollar hegemony came to be and then understand the critique of an exorbitant privilege arising from dollar hegemony as a by-product.  

Dollar hegemony emerged as part of the peace settlement for World War II and the creation of the Bretton Woods system of global financial governance.  The dollar was positioned as the anchor for a fixed exchange rate regime, with other currencies fixing their currency exchange rate against the dollar. In turn, the dollar was fixed in value against gold at $35 an ounce.  This system provided stability in the foreign exchange markets during post-war reconstruction. Moreover, it provided a stable means for pricing goods and services in international trade. President Nixon terminated this fixed exchange rate system in 1971, and progressively countries shifted to floating exchange rates against all other currencies.  Nonetheless, international trade in goods and services often continues to be priced in dollars, which is most prominently reflected by the global trade in oil, with its benchmark prices quoted in dollars/barrel. Similarly, many countries issue dollar-denominated sovereign debt targeted to foreign investors. It is a practice reflecting the ease of international finance using the dollar and its continued role as the leading international reserve currency.  The exorbitant privilege arising from this situation is that the US government manages its monetary policy to support its domestic policy with little regard for its impact on other currencies and national economies.

At the beginning of the 21st century, this exorbitant privilege was extended beyond monetary policy. Since the end of the Cold War, the US and EU have employed economic sanctions as a prominent foreign policy tool.  Economic sanctions are recognised as an action short of war, to effect change in a country’s domestic and foreign policy.  However, the imposition of economic sanctions to isolate a country from the world economy and thereby force compliance with Western governments’ desires may be just as violent as a war for that country.  The people of Iraq experienced this situation in the 1990s, and it led to a series of initiatives to refine the sanctions tool and create targeted sanctions.  Targeted sanctions focus on national leaders and decision-makers rather than on the population as a whole.  Targeted sanctions may be implemented by one government as part of its foreign policy. But in order to achieve more widespread enforcement of a targeted sanction, they should be imposed by the UN Security Council or by a group of like-minded governments.   One form of targeted sanctions are financial sanctions, which serve to restrict access to banks and other financial institutions. These targeted financial sanctions have become a prominent foreign policy instrument for the US.

Targeted financial sanctions first were employed in the aftermath of the September 2001 terrorist attacks by the US Treasury Department at the direction of President George W. Bush’s Executive Order 13224.  The objective behind freezing the bank accounts of named individuals and groups along with blocking their access to the global financial system was to prevent the financing of terrorism.  Depicted as the ‘lifeblood’ and ‘oxygen’ of terrorism, quick action against any potential source of money was justified in order to prevent future acts of terrorism.  The apparent success of this tool to help prevent additional terrorist attacks encouraged the use of targeted financial sanctions for other purposes, including the response of the US and European states against Russia following its annexation of Crimea in 2014.  However, rigorous enforcement of economic sanctions is necessary in order to ensure compliance.

Companies that do not comply with US targeted financial sanctions have been charged under the US laws that implement the sanctions, such as the International Emergency Economic Powers Act and the Trading with the Enemy Act.  For financial firms, the consequences may include substantial fines and suspension of their authorisation to clear, or exchange, dollars on behalf of customers.  A prominent example was BNP Paribas in 2014, which was fined close to $9 billion and received a one-year ban on dollar clearing transactions for violating US sanctions imposed on Cuba, Iran, and Sudan.  These enforcement actions and penalties imposed on foreign banks has improved compliance with US targeted financial sanctions. Targeted financial sanctions imposed against Russian citizens and companies now motivates the Russian government to ‘de-dollarise’ the economy.  Russian success in this endeavour undermines the application of targeted financial sanctions because it enables the national economy to operate without using dollars for cross-border trade. This situation in turn reduces the utility of targeted financial sanctions as a foreign policy tool because they are no longer able to influence or change Russian policy.  With the restoration of US targeted sanctions on Iran, European governments are also seeking to circumvent this US foreign policy tool.  The maintenance of European trade with Iran is contrary to US policy goals and helps Iran to resist US efforts to force a change in Iranian foreign policy.  

Ultimately, reducing the use of the dollar as an international reserve currency does provide a mechanism to evade US sanctions. However, it also has the potential to introduce more friction to international trade relations with more widespread consequences, such as increased foreign exchange costs or changing trade partners to avoid using the dollar.  This creates a dilemma. Past success with targeted financial sanctions, as an application of dollar power, may be leading to a diminution of that power as countries reduce their use of the dollar in cross-border trade.  Consequently, the reduction in its use will weaken the effectiveness of dollar power for future targeted financial sanctions.

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