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The most interesting geopolitical risk of 2015

People gather near a currency exchange office in Moscow on Dec. 17.  (Reuters/Maxim Zmeyev)

As the first work week of 2015 commences, it’s worth remembering that geopolitical risk remains on the minds of many investors (though its actual impact on markets is debatable). Fortunately, every January the Eurasia Group publishes its top 10 geopolitical risks for the rest of the calendar year. Not all of the predictions come true, and a lot of the usual suspects (the Middle East, Russia, China) get mentioned. This year’s list, however, contained an interesting and seldom-discussed-in-polite-circles item:

Weaponization of Finance
For the Obama administration (and indeed, many of its critics), “boots on the ground” is a 20th-century concept. The American public has had enough of wars and occupations. But on core security issues, the United States still wants significant influence over global outcomes. That means less reliance on traditional elements of America’s security advantage — its nuclear weapons arsenals, its carrier groups, or other conventional assets. And more reliance on the dollar, which is now actually more strongly imbalanced in America’s favor than it was before the financial crisis. Access to the US marketplace and US banks, and Washington’s ability and willingness to use them, are becoming more important as instruments of foreign and security policy. There is no better example of this trend than the weaponization of finance — the systematic use of carrots (access to capital markets) and sticks (varied types of sanctions) as tools of coercive diplomacy….
Of critical importance, the weaponization of finance is a tool that can be used with minimal cooperation from other governments. The most important near-term challenge is the damage inflicted on transatlantic relations. Europe will become more frustrated with an American unilateralism that Europe (and European banks) must pay for. Also, the US could well slap new sanctions on Russia and/or Iran, eliciting a backlash in 2015. Over the longer term, though, others will diversify away from reliance on the dollar and US-dominated institutions, particularly in East Asia, where China has the muscle and the motive to create its own institutions, and where there is less dollar-denominated debt to complicate the process. The Asia infrastructure investment bank, the BRICS bank, and the Silk Route Maritime and Overland initiatives are all steps in that direction. These projects, combined with Beijing’s determination to broaden and deepen commercial and investment relations across the region, will eventually undermine Washington’s ability to use these tools to lean on financially weak states.

Now this is interesting, because the savvier foreign policy wonks I know genuinely do fret about the possible blowback from this use of financial statecraft. At the same time, however, they’ve been fretting about this possibility for the past 15 years or so, and there’s zero evidence that there has been or will be any blowback.

As the Eurasia Group report notes obliquely, and as The System Worked noted less obliquely, the dollar and U.S. capital markets have become more and not less central to global finance in the years since 2008. Recent trend lines show an increase in reserve holdings of the dollar, not to mention an appreciating currency. Given that, in 2015, the U.S. economy looks set to outperform every other great power, even Financial Times curmudgeons would have to acknowledge that there’s little reason to believe that 2015 is the year U.S. financial statecraft jumps the shark.

Why isn’t there more blowback? One reason is that despite what Eurasia Group says, most of these financial sanctions have not been unilateral in nature. While not sharing the exact preferences, the European Union has largely been on board with sanctioning Russia and Iran for their various transgressions.

Another reason is that there is no alternative. At present, the only entity that could even approach the United States in the depth and liquidity of its capital markets is the European Union. The less said about the current viability of that option, the better. Sure, China is starting to gear up some nascent financial substitutes, but at present these structures show far more promise than substance.

So going forward, I’d tweak the Eurasia Group’s warning just a wee bit. The geopolitical risk isn’t really the United States’ use of financial statecraft, it’s the possible abuse of its preeminent position. And in 2015, this abuse could come in one of two forms.

The first would be if the United States grew too enamored of financial sanctions as a tool of regime change rather than a tool of bargaining leverage. There’s been an ongoing debate inside the beltway about the power of these new sanctions, and the new GOP majority in Congress will be very enthusiastic about sanctioning Russia and Iran even more. If either Moscow or Tehran offers deals that are amenable to American allies but not to the United States, that would be… problematic.

The second is if the United States continues to stymie IMF reforms that the United States itself advocated. In 2014 Congress had two chances to approve these reforms and yet did not. Until Congress approves a deal that was made more than a few years ago, the international financial institutions remain frozen in an outdated set of rules. This paralysis, more than anything else, has prompted the creation of the BRICS Development Bank.

There’s a theme buried within these two concerns: The problem isn’t exactly the unilateral U.S. use of financial statecraft — it’s the unilateral U.S. congressional use of financial statecraft. So as new Senate Majority Leader Mitch McConnell (R-Ky.) talks about not being scary, one hopes that this is an area where his rhetoric turns into reality.

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