The forces of good have found courage. From ordinary Ukrainians preparing molotov cocktails to Germany’s leader proclaiming an end to his nation’s geopolitical passivity, the shifts have been extraordinary. But the Ukraine war has brought another development.
Until the weekend, Russia’s stockpile of $630 billion in central bank reserves was assumed to protect it against sanctions. If Western powers refused to lend Russia euros or dollars, the state had enough on hand to keep servicing existing debts and pay for imports. If financial traders dumped the ruble, Russia’s central bank could support the currency’s value by using foreign reserves to buy it.
These assumptions are now dead. With Western institutions refusing to deal with Russia’s central bank, roughly half of its reserves have been paralyzed. The result is panic. The central bank has been stripped of its credibility as a defender of the ruble, so the currency has fallen sharply against the dollar. Russian authorities have fought back by hiking interest rates to 20 percent, imposing austerity on ordinary Russians to slow the flow of currency out. Fearing that the financial system is on the brink of collapse, citizens are lining up at ATMs. President Vladimir Putin’s claim to stand for economic stability has been shredded.
This shredding extends a profound shift in geoeconomics. Until a few years ago, creditors were assumed to have the upper hand over debtors. U.S.-led international financial institutions — the World Bank, the International Monetary Fund — used creditor power to impose policy conditions on borrowers. Japan’s position as a huge purchaser of U.S. Treasury securities was thought to give it leverage during the U.S.-Japan trade wars of the 1980s and 1990s. What might happen, strategists wondered, if the Japanese dumped their Treasury holdings, causing a jump in U.S. borrowing costs and a meltdown on Wall Street?
Later, as China grew to be a massive creditor, the same fear returned with a vengeance. As a U.S. military ally, Japan was unlikely to have a big enough beef with Washington to resort to a financial attack, but China was a different story. My former Council on Foreign Relations colleague Brad Setser wrote brilliantly about the circumstances under which China might use its creditor status as an offensive weapon.
Setser turned out to be wrong, but not for the reasons his critics had expected. The standard objection was that, by starting to sell its Treasury securities, China would destroy the value of the rest of its holdings — damaging its own interests. Russia’s invasion of Ukraine is the latest illustration of why this objection was naive. In wartime, nations routinely damage themselves in the hope of inflicting greater damage on their adversaries.
The real reason Setser was wrong emerged in 2008. The financial crisis drove the Federal Reserve to improvise quantitative easing, another maneuver that had always been possible in theory but untried in practice. When the Fed’s QE experiment succeeded, geoeconomics changed. Debtors now had a superpower, and creditors’ leverage had been broken.
Quantitative easing was primarily a tool to manage the economic aftershocks from the crisis on Wall Street. But there was a China angle, too. The Chinese state owned oodles of Treasury and mortgage bonds, and it was determined to get its money back. Quantitative easing demonstrated how the Fed could deal with these demands: It could print money and buy the bonds that China wanted to sell. That buried the idea that a future Chinese threat to dump U.S. bonds could work as a weapon.
With its sanctions on Russia, the West is driving creditor impotence to the next level. Russia’s status as a large official creditor not only fails to give it leverage over the West, it also has little defensive value. It turns out that being a creditor is not a source of power after all. What matters is having a financial system that commands global trust, based on an independent central bank and an independent legal system.
Autocratic creditors, China foremost among them, are not going to like this. But so long as democratic nations remain open and fair, they stand to have the upper hand in geoeconomic competition. They will issue the world’s most popular and stable currencies, 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 is doing now — provided, of course, that it has the courage to do so.