christopher smart, a former deputy assistant secretary of the U.S. Treasury, is chief global strategist and head of the Barings Investment Institute, the research arm of Barings LLC.
illustrations by rocco baviera
Published July 26, 2021
Friends and foes alike decry expansive U.S. financial sanctions as self-defeating and ineffective. Punishing Venezuelan dictators and Chinese hackers, the argument runs, does little to defend democracy in Latin America or to protect American digital networks. Meanwhile, the expanding web of restrictions fuels demand for renminbi and bitcoin as media for international transactions.
Yet even as the sanctions list grew and trust in U.S. leadership ebbed in the Trump years, the dollar remained the overwhelming choice for purposes of holding international reserves and for clearing international transactions. Last year, as the pandemic triggered yet another global financial crisis, the rush to safety was (as usual) straight to the dollar.
Broader and Subtler
The dollar’s true power is often misunderstood, though. On the one hand, financial sanctions alone seldom force significant government policy retreats. On the other, the clout of America’s currency is both broader and more subtle than the ways that sanctions can directly damage transgressing regimes. The greater influence lies in a web of standards adhered to by the world’s largest banks and businesses.
A dictator will rarely reverse a policy that successfully whips up popular support simply because they have been threatened with a bank account freeze. But few commercial enterprises with global ambitions in any country willingly risk exclusion from the world’s deepest and most sophisticated financial markets.
The leverage that dollar sanctions bring to the table has made it easier to track down drug lords, nuclear proliferators and terrorists while also encouraging greater data exchange on taxes. The Biden administration — and its successors — should exploit this potential with fresh efforts to crack down on tax evasion, with regulatory oversight that encourages banks to address climate risks and with focused efforts to create convergent international standards on data privacy and security.
But progress won’t come easily. In particular, we should tread softly to avoid cutting off developing market countries that need dollar access to weather the pandemic. Still, persistently strong global dollar demand remains a powerful tool for advancing U.S. interests when it is deployed patiently and targeted carefully at a time when the country’s toolbox otherwise looks bare.
Deep in the World’s Bloodstream
Fundamentally, ongoing reliance of the dollar reflects enduring confidence in the strength of U.S. institutions, the resilience of its economy and, to some degree, the commitment of its military — despite the reality that all three have recently been called into question. The dollar’s status is no more guaranteed than that of the British pound a century ago. But America’s currency runs deep in the bloodstream of the world economy: While the United States represents about a quarter of global GDP, roughly two-thirds of all government foreign exchange reserves are held in dollars.
This dominance is mirrored in the private economy. Since the onset of the Great Recession in 2008, the value of bonds denominated in dollars that were issued by foreign firms has nearly tripled. And, apart from its role as a store of value, the dollar remains a centerpiece of global trade. More than 40 percent of global payments are in dollars even when the transactions are between foreigners. If a firm sources parts from different jurisdictions, it’s much easier when everyone quotes prices and settles invoices in the same currency.
The simplest test of a safe haven remains this: if you had to put all your money in a single currency and leave it untouched for 25 years, can you think of a better choice than dollars?
America’s money also benefits from the relative weakness of the alternatives, which other governments have tried to offer amid rising resentment toward dollar sanctions. Europe’s struggles with cohesion hardly make the euro a certain long-term bet, while its capital markets remain smaller and less developed than Wall Street. Chinese efforts to boost the renminbi will continue to gain traction from a very low base. But even without the capital controls that limit the utility of the currency, China’s legal and regulatory infrastructure raise doubts. Meanwhile, the cryptocurrency (bitcoin, ethereum, litecoin, etc.) or global digital alternatives still look distant. The simplest test of a safe haven remains this: if you had to put all your money in a single currency and leave it untouched for 25 years, can you think of a better choice than dollars?
Safe as Safe Can Be
Even well into the Trump years, when the president took pride in disrupting expectations and opting for unilateral action, the dollar’s allure proved irresistible. The administration’s most unsettling actions included the withdrawal from a multilateral agreement to contain Iran’s nuclear program, the recall of U.S. troops protecting Kurdish partners in Syria and a series of steel and aluminum tariffs targeting close allies. Yet when trouble struck last year — this time as a global pandemic — liquid asset flows went straight into the dollar as usual. And, much as in the financial crisis in 2008, the Fed’s decision to enhance or extend swap lines to 14 key central banks helped avoid calamity. The European Central Bank and People’s Bank of China offered swap lines, too, but the euro and the renminbi just weren’t in much demand.
The Fed’s further innovation this last time was to offer repurchase facilities to central banks sitting on substantial quantities of U.S. Treasuries, including India, Taiwan and China. Their holdings might have otherwise been sold into commercial markets to meet liquidity needs, hampering the Fed’s efforts to keep borrowing rates low. By the same token, a rush to buy dollars for domestic needs might have driven the dollar exchange rate still higher, damaging U.S. trade competitiveness in a period of declining demand for U.S. exports.
The rush to dollar assets eased by the spring of 2020 as the markets shifted their concerns from the sudden stops in capital flows to management of the grinding recession ahead. But the Fed’s ongoing purchases of dollar securities was ample evidence of its commitment to providing global liquidity. For any sensible finance minister or central bank governor, the lesson was clear: you can’t really have too many dollar assets when the next crisis hits.
This will reinforce an economic and political cycle that some will call virtuous and some will find vicious. All else equal, global demand for dollars probably makes the dollar exchange rate stronger and hurts U.S. export competitiveness, even if it makes America’s borrowing cheaper and, as a practical matter, unconstrained. Other governments may resent America’s political leverage through its currency dominance, not to mention their own economies’ excessive sensitivity to Fed monetary policy. But markets surely prefer the presence of a single reliable central bank that can provide unlimited liquidity when confidence evaporates.
How Dollar Leverage Does (and Doesn’t) Work
Meanwhile, the dollar’s power as a political tool endures as long as it is deployed patiently, and on behalf of realistic, shared goals. Dollar markets remain an obvious and powerful mechanism for law enforcement to track and constrict the financial resources of international criminal and terrorist organizations.
Ending South African apartheid and limiting Iran’s nuclear program took many years of multilateral pressure and negotiation, but ultimately trade and financial sanctions contributed to changing their governments’ behavior. Clearly, such pressures have done little to slow Kim Jong-un’s missile tests or to return Crimea to Ukraine, although in conjunction with similar measures by other countries they can serve a powerful purpose as symbols to highlight and isolate rogue behavior.
More important, the dollar’s power extends well beyond financial sanctions that formally freeze assets or block transactions. The Financial Action Task Force (FATF) sets standards and coordinates efforts to combat money laundering, terrorist finance and other financial crimes. Established by the G-7 in 1989, the group issues recommendations on improving enforcement and maintains “gray” and “black” lists of jurisdictions that fall short, warning banks away from doing business with risky clients without needing to threaten specific sanctions.
There are real risks that good money is scared away by bad in poor countries. And policymakers must take great care to avoid excessive “de-risking” in vulnerable markets, especially those highly dependent on remittances from their diaspora. But FATF’s dwindling gray and black lists bear witness to improving compliance.
Even foreign commercial banks have effectively become tools of U.S. policy under the 2010 Foreign Account Tax Compliance Act (FATCA), which requires them to report all clients who might owe U.S. taxes — or risk stiff penalties. After much outrage and foot-dragging, even Russian and Chinese banks now comply. European officials still complain about FATCA’s conflicts with EU privacy rules, but the law also inspired the OECD to develop common standards on tax reporting and information exchange.
Even foreign commercial banks have effectively become tools of U.S. policy under the 2010 Foreign Account Tax Compliance Act, which requires them to report all clients who might owe U.S. taxes — or risk stiff penalties.
Finally, the full power of the dollar’s leverage may be most revealing in how the need for access to dollar transactions-clearing forces foreign firms to ignore the policies of their own governments. When the Trump administration withdrew from the Joint and Comprehensive Plan of Action to limit Iran’s nuclear aspirations, European governments struggled to preserve a remnant of the deal by promising to deliver more foreign investment and trade to Iran. Their central problem was that no major European firm — let alone commercial bank — could risk the threat of U.S. sanctions. Instinex, a convoluted mechanism designed to facilitate transactions that skirt dollar sanctions, proved so disappointing that even Iran has denounced it as useless.
Access to the dollar will not magically turn enemies into friends or rush the spread of Jeffersonian democracy. Nor will dollar dominance survive long if the dollar’s leverage is viewed exclusively as a tool of Washington’s political interests that few allies support or as giving advantage to U.S. firms over foreign competitors. Rather, it is most effective when the dollar’s power — at least notionally — advances common agendas.
It’s a lot easier to agree to a shared approach to terrorists and criminals than to tax cheats, but FATF’s success in cracking down on money laundering does offer hope that more is possible in the way of taxes. The OECD has been closing in on a global agreement for a fairer means to share and enforce corporate tax obligations at a time when digital commerce and intellectual property are so hard to link to any single jurisdiction (or to apportion among many). If codified, the governments themselves will implement and enforce the legislation. But the global banking system, and especially those banks that wish to maintain access to dollar markets, will do much of the heavy lifting to improve reporting standards and transparency.
Meanwhile, the dollar’s leverage may soon provide fresh substantive encouragement for banks to do more to tackle climate change. In December 2020, the Fed announced its application to join the Network of Central Banks and Supervisors for Greening the Financial System, an effort launched in 2017 that encourages financial regulators to include rising waters and raging wildfires among the many risks they monitor. These regulators have also been cheering on the development of new forms of finance to support transition to a more environmentally sustainable economy. The Fed’s presence in the network will turn a lot more heads within global financial circles. With time, an expanding web of engagement by banks that touch dollar markets may prove as powerful to the cause of climate stabilization as any legislation.
Finally, one of the thorniest questions facing the global economy in the next decade is the handling of personal and business data that is increasingly driving economic growth and innovation. In the absence of alternatives, the European Union’s General Data Protection Regulation has become a de facto global standard, though cooperation with the United States has hit a significant snag over recent European court decisions. Yet even partial agreement will benefit from the backing of euro and dollar regulators, who can enlist the world’s most important financial institutions and businesses to implement new standards. Once a deal is struck, they can together move mountains.
If the United States were actually trying to undermine confidence in the dollar, it would behave much the way it has for the last 50 years. It would close the gold window (the convertibility of gold to dollars), run up vast government debts, shut down government operations from time to time amid political gridlock and generally treat access to the world’s reserve currency as a tool to gain national advantage. And yet, demand for dollars remains high for borrowing, commerce and especially as a refuge when trouble strikes.
This doesn’t mean the dollar is bulletproof. Abusing the dollar’s dominant role will surely erode it over time, but the recent past suggests that any challenge is many years away. Meanwhile, the value of the dollar as a political or economic tool lies less in the ability to freeze the assets of dictators than in steadily raising standards of global business and finance. This influence does not work quickly or automatically, but its potential is undeniable.