Until the weekend, Russia’s $630 billion stockpile of central bank reserves was supposed to protect it from sanctions. If the Western powers refused to lend Russia euros or dollars, the state had enough to continue paying off existing debts and paying for imports. If financial traders abandoned the rouble, Russia’s central back could support the currency’s value by using foreign exchange reserves to buy it.
These assumptions are now dead. With Western institutions refusing to deal with the Russian central bank, around half of its reserves were crippled. The result is panic. The central bank was stripped of its credibility as a defender of the ruble, so the currency fell sharply against the dollar. Russian authorities retaliated by raising interest rates to 20%, imposing austerity on ordinary Russians to slow the flow of currency. Fearing that the financial system is on the verge of collapse, citizens line up at ATMs. President Vladimir Putin’s claim to champion economic stability has been shredded.
This shredding prolongs a profound change in geoeconomics. Until a few years ago, creditors were supposed to have the upper hand over debtors. The US-led international financial institutions – the World Bank, the International Monetary Fund – have used the power of creditors to impose political conditions on borrowers. Japan’s position as a huge buyer of US Treasury securities was thought to give it leverage during the US-Japan trade wars of the 1980s and 1990s. What could happen, strategists wondered, if the Japanese were dumping their Treasury holdings, causing US borrowing costs to spike and Wall Street to crash?
Later, as China became a massive creditor, the same fear returned with a vengeance. As a military ally of the United States, Japan was unlikely to have a big enough dispute with Washington to resort to a financial attack, but China was another story. My former colleague at the Council on Foreign Relations, Brad Setser, wrote brilliantly about the circumstances in which China could use its creditor status as an offensive weapon.
Setser turned out to be wrong, but not for the reasons his critics expected. The standard objection was that by starting to sell off its Treasuries, China would destroy the value of the rest of its holdings – harming its own interests. Russia’s invasion of Ukraine is the latest illustration of the naïveté of this objection. In times of war, nations regularly damage each other in hopes of inflicting greater damage on their opponents.
The real reason Setser got it wrong emerged in 2008. The financial crisis prompted the Federal Reserve to improvise quantitative easing, another maneuver that had always been possible in theory but untested in practice. When the Fed’s QE experiment succeeded, the geoeconomics changed. Debtors now had a superpower and the influence of creditors had been broken.
Quantitative easing was above all a tool to manage the economic repercussions of the crisis on Wall Street. But there was also a Chinese angle. The Chinese state had heaps of treasury bills and mortgage bonds, and it was determined to get its money back. Quantitative easing showed how the Fed could respond to these demands: it could print money and buy the bonds that China wanted to sell. This buried the idea that a future Chinese threat to sell US bonds could function as a weapon.
With its sanctions against Russia, the West is taking the impotence of creditors to a new level. Not only does Russia’s status as a major official creditor give it no clout with the West, it also has little defensive value. It turns out being a creditor isn’t a source of power after all. What matters is to have a financial system that inspires global confidence, based on an independent central bank and an independent legal system.
Autocratic creditors, first and foremost China, are not going to like this. But as long as democratic nations remain open and fair, they have the upper hand in geoeconomic competition. They will issue the most popular and stable currencies in the world, so savers everywhere will want to hold them. They will host the most efficient and least politicized financial markets, attracting lenders and borrowers. This will give the West the ability to freeze enemy assets and block enemy payments, just as it does now – provided, of course, it has the courage to do so.
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