2022 has been a year of dollar power—power that manifests itself in both overt and subtler forms.
In the spring, the financial sanctions slapped on Russia’s Central Bank following Russian President Vladimir Putin’s invasion of Ukraine demonstrated the extent of U.S. financial sway, especially when it is exerted in cooperation with America’s European partners. If you export far more than you import and thus hold really large foreign exchange reserves—like Russia’s $500 billion—there really is nowhere else to hold them other than dollars or euros. If it comes to a confrontation, that puts you at the mercy of the financial authorities of the United States and its alliance partners. NATO reveals itself to be a financial power.
Russia has, so far, ridden out the storm, but to do so it has had to close its financial system to the outside world. Its imports have been squeezed to barely more than half their pre-crisis level.
When the sanctions were applied, the shock to Russia provoked the question of whether a monetary system that conferred such one-sided power on the United States could possibly be sustainable. Surely Russia, China, and India would look to build an alternative currency system. This might perhaps be denominated in China’s renminbi and would be centered on the exchange of key commodities. One model might be the kind of deal recently brokered by a leading Indian cement producer, which paid for imports of Russian coal in Chinese currency. To secure funding, you could borrow in the so-called dim sum bond market in Hong Kong, where issuers from around the world issue offshore renminbi debts.
Such a system would secure independence from the United States. But it would take years, if not decades, to reach substantial scale. It also depends on the continuing shortage of key raw materials, which makes it interesting to lock in privileged customer-supplier relations, and the continuing growth of the Chinese economy, which makes it look like the economic champion of the future.
Those trends were never guaranteed to continue. From our current vantage, six months on from the start of the war, a future beyond the dollar seems more remote than ever. As the world economy slows down, commodity prices are far off their peaks. There is still excess demand for oil, gas, and coal, but other commodities such as iron ore are going cheap. China, rather than asserting its dominance as an alternative center of the world economy, is seeing a hemorrhage of foreign capital at a rate faster even than that during the crisis period of 2015-2016.
With talk of rivals to the dollar system on the wane, what dominates the global economic news cycle in mid-2022 is another face of U.S. financial power: the tightening of Federal Reserve policy in response to inflation and a surging U.S. dollar. This changes the conditions under which the entire world economy operates, not through legal or geopolitical interventions but through currency values, interest rates, and the demand and supply of credit. It is on this all-pervasive presence of the dollar that the more overt leverage of financial sanctions ultimately rests.
First and foremost, the dollar system is a commercial and financial network. Political and military power plays a part in anchoring the global dominance of the dollar. It is hard to imagine U.S. Treasury debt having the status that it does in the world economy if it were not ultimately backed by the world’s preeminent military power. But the more prosaic motive for the dollar’s adoption as the main currency of trade and finance is that dollar liquidity is abundant and cheap, and the currency is universally accepted. That is the reason that close to 90 percent of all currency trades—a daily turnover of $6 trillion before the COVID-19 pandemic—involve the dollar as one of the currencies in the pair. Whether there is a new cold war with China or Russia or not, an unanticipated, sudden increase in U.S. interest rates—which tightens credit conditions and strengthens the dollar—sends a shuddering shock through this entire network of commercial transactions.
Of course, a rising dollar creates both winners and losers. It means that other currencies are falling in relative terms. One might expect that the effects of a rising dollar would be offset by the effects of the falling value of other currencies. But because of the dollar’s ubiquity, this is not the case. If the dollar rises, anyone who has borrowed in dollars—and there are trillions of dollar debts outstanding all around the world—faces more painful debt service charges. A surging dollar also raises the global cost of exports priced in dollars, making them less competitive. Overall, a 1 percent rise in the dollar is thought to knock around 0.7 percent off global trade within a year.
It is bad news, therefore, that since the middle of 2021 as the Fed has pushed up rates, the dollar has surged by 15 percent against a basket of currencies. The euro and yen have both been reduced to record lows. So too have the currencies of emerging markets ranging from Chile to Turkey to Egypt. The relative devaluations of their currencies as a result of the dollar’s rise amplify the inflationary pressure radiating from the dollar-zone. If these countries want to avoid a devaluation and a consequent surge in the price of imports, they have no option but to match the Fed’s rate rises. As a result, in 2022 we are seeing an unprecedented synchronized tightening of central bank policy across both advanced economies and emerging-market economies.
As in the case of financial sanctions, there is always a risk that as credit conditions tighten, the links that make up the dollar-based financial system will snap. For those economies in the worst shape, this risk is very immediate. A Fed tightening cycle is not a sanctions regime, of course, but it has the predictable effect of cutting off weaker economies in the dollar system from access to vital imports, forcing the rationing of fuel and electric power, and tightening their access to credit in an unbearable way.
Sri Lanka has tipped over the edge into default and political crisis. Argentina faces surging inflation and crushing energy import bills. In both cases, their economies were already weak and their debt unsustainable before the current surge in commodity prices, interest rates, and the dollar. But the new conditions contributed to making their situation evidently unsustainable, helping to trigger an open crisis.
All told, the World Bank estimates that nearly 60 percent of low-income borrowers are at danger of debt distress or already in it. It doesn’t help that following the success of the worldwide debt jubilee campaign in the early 2000s that slashed the debts of the lowest-income countries, many of them have availed themselves of market-based finance, including borrowing at variable interest rates. By 2020, more than 30 percent of their debt was on a variable interest rate basis, which is attractive when rates are low but far more dangerous in an environment, like today, of rising rates.
Given the drama in Sri Lanka and Argentina and the precarity of low-income countries, one might imagine that 2022 has the makings of a comprehensive debt crisis like that in the 1980s. Economic and financial hardship is already afflicting tens of millions of people and will in due course likely affect hundreds of millions. A half-dozen debtor countries or more may find themselves navigating the uncertainties of debt restructuring and sovereign default. In all likelihood, however, we will avoid a systemic crisis of the dollar-based global financial system. The acute pain will be confined largely to the weakest and poorest economies, where local resources are scant and dependence on the dollar is most manifest.
We will avoid a comprehensive crisis not because the dollar system is inherently stable or immune to shocks but because since the 1990s it has evolved to cope with these stresses, and the more important nodes in the network have become far better at protecting themselves.
What has changed is how businesses and governments around the world avail themselves of the possibilities of the dollar-based international financial system. Unsurprisingly, those with moderate debt levels and steady income flows will do better. But how acute the pressure is depends also on how dollar and local currency liabilities and assets are balanced.
Insofar as the dollar system is literally the dollar system, it is extremely fragile. Countries that have pegged their currencies to the dollar or have borrowed in dollars without protection against exchange rate and interest rate fluctuations, particularly if it is governments or households that have borrowed, are likely to be in serious trouble.
But that kind of reliance on the dollar is increasingly rare. Since the 1990s, what has made the global financial system more robust is a toolkit of devices for moderating dependence on the dollar and managing the risks attendant on financial globalization. Big emerging-market economies like Brazil and Thailand have learned that it is better, if you are going to take money from foreign lenders, to borrow from them only in your own currency. In a crisis, that may still leave the value of your currency in danger—as foreign investors sell out their stakes, you will likely suffer a devaluation—but at least part of the risk is then borne by the lender, and you can at least ensure you have enough local funds to service the debts.
If there is foreign currency borrowing, let it be private and corporate and not by households or governments. In the 2008 crisis, many Eastern European economies discovered at their cost the dangers inherent in mortgages or car loans being financed in foreign currencies.
It is also true, however, that in a crisis, foreign-currency debts run up by corporations or the household sector will likely be too big to fail from the perspective of local governments, which will be under pressure both for the sake of their international credibility and for the survival of the national economy to bail them out. De facto, they constitute claims on the government budget that will need to be monitored, contained, and accounted for. It was with this in mind that the United States, United Kingdom, and European Union agreed at last year’s United Nations climate conference to provide financial support to South Africa in the financial restructuring of Eskom, its ailing power utility. This was both an energy transition strategy and a way of relieving the pressure on the South African government account arising from its implicit responsibility for Eskom’s debts.
What 2022 has revealed is that the dollar system has the resilience and strength that it does because it is deeply entrenched and buttressed by both commercial and geopolitical interests. Not for nothing the economist Daniela Gabor has coined the phrase “the Wall Street consensus” to highlight the role of investment bankers, fund managers, and their client borrowers in maintaining the dollar-based global financial network. In major crises this system becomes an overt public-private partnership secured from the top down by the liquidity swap lines extended by the Fed to the major central banks of Europe, Latin America, and Asia. In geopolitical confrontations, its reach is expanded by close cooperation between the United States and its security policy partners in Europe and East Asia. But most of the time the de-risking provided by public authorities for dollar-centered global finance remains in the background. The system appears to sustain itself based above all on the resilience of the U.S. economy and its dynamic financial markets.
In general, a strong U.S. economy promotes growth and secures the prosperity of American capital and the centrality of U.S. equity markets to global capital accumulation. It also, however, requires a tighter stance from U.S. monetary policy. Right now, it is the latter point that is critical. How severe the tension in the global economy becomes over the coming months will depend above all on how far the Fed’s tightening goes, and that depends on how rapidly American inflation cools down. If the U.S. economy remains robust, then the Fed will have to resort to higher interest rates, redoubling the squeeze. In that regard, news of a slowing U.S. economy is good news for the dollar system, because it means that the Fed may be able to ease off further interest rate increases later this year. The best case would be a mild U.S. recession with inflation coming down rapidly—the so-called soft-landing scenario. As far as the dollar system is concerned, it is still a “heads I win, tails you lose” world.