Geopolitics in Focus #3: Are political shocks reshaping the global financial system?

Jeff, you’ve been teaching a course on international financial order in the TRIUM program for well over a decade, and it’s one of our most popular courses. How would you describe the international financial order, and why is it important for business leaders to understand how it works? So the international financial order provides, I think, for business leaders, both an opportunity to think about the blessings and the curses involved in sort of global financial integration.

In terms of the blessings for financial integration it offers business leaders to think about the allocated efficiency benefits that they get in terms of how financial markets can allocate savings more efficiently across borders in terms of stirring greater innovation, productivity, opportunities for risk sharing across borders, and also lifting people in terms of their prosperity.

But, you know, you mentioned also the curse, which is essentially that integration also brings rising risks in terms of instability, in terms of volatility, in terms of financial crises, which is obviously one of the more sexier things that we talk about in the course. And so we sort of focus on that in terms of how business leaders should think about volatility in terms of responding to it, in terms of understanding the sources of this volatility, about the changing contours of the global financial system, but also thinking about it in terms of the changes that have occurred over the past, say, 20 years or so.

For some years now, the United States and China have been locked into a deep and deepening geopolitical rift. Some of that is spilling over into the economic and financial world, too. There’s talk about economic decoupling between the US and China. How is that playing out in the international financial system?

The US sort of growing tendency towards weaponizing the dollar or using the dollar as an instrument of foreign policy, or to put it more broadly, is conditioning usage of the dollar on adherence to US foreign policy objectives has caused growing sort of concern amongst Chinese policymakers, but also others in terms of the reliability of the US dollar as a store of value as a reserve asset, as an invoicing currency. And this is where we think of in terms of potential for a growing rupture between the two countries, which is essentially that China is becoming increasingly reluctant to expose itself to the whims of U.S. foreign policy with regard to the usage of the dollar.

How are other countries likely to react to that kind of weaponization of the dollar’s dominant position? Because is it not to be expected that countries like China, Russia certainly will want to search for an alternative international payment system and thereby undermine the dollar’s dominance and America’s reach with its financial clout?

The way to understand the payment system in the international financial system is to think of it as a sewer, where all most of the of the pipes of the sewer run through New York. And so this enables the United States to basically have some sort of claim on entities there using the US dollar. Even when these entities are not located within the United States or entities are interacting with other US entities.

And this network is something that has caused other countries growing concern, as you mentioned, because it enables the US to essentially cut off access to these payment system and the death that these firms or these entities experience is much more rapid than technological constraints or trade constraints.

It’s instantaneous by causing a massive liquidity shock, which enables which prevents these entities rather from gaining access to payments or making payments. And so what this does is it creates a strong incentives for these countries to begin to develop alternatives. It creates a strong incentive also for business leaders to seek out these alternatives, because they are also susceptible to US leverage.

The problem, of course, are the challenge rather for these countries or the other entities is the startup costs from creating a new payment network are enormous. These payment networks centered around the US dollar, have these huge incumbency advantages. Those are very difficult to disrupt. So if you are the leader of a global company that’s having to transact in a lot of different locations, if you have a lot of supply chains that you need to finance, you’re facing increased uncertainty.

You need to watch out for how you’re exposed to these kind of acts of weaponizing global payment systems, but we shouldn’t expect a radical change overnight if that’s going to change, it’s going to change very slowly. Is that the right prediction to make at this point? I would say that, you know, there’s sort of two possibilities here.

One is a gradual erosion in the position of the US dollar as the principal national international reserve currency, the international payments currency or payments medium towards a more multi-polar or multi-currency world centered around, say, the US dollar, the euro, renminbi and potentially other assets or currencies.

And that’s sort of one scenario. Another one is a much more worrying one, perhaps, where we see this abrupt, disorderly shift away from US dollar assets, away from US dollar hegemony that’s triggered by some shock, some adverse market reaction. And this could come about from a political shock emanating from, say, inside the US. It could come from the rollout, for instance, of, you know, somewhat incoherent trade policies. It could come about from some geopolitical event that leads to a rapid change in market sentiment that leads to moving away from the dollar. You know, in our discussions thus far, we’ve focused a lot on China and a lot of other large holders of US dollar – government holders – of US dollar assets. But there’s also a massive amount of US dollar assets – the largest amount – that’s held by private market actors who are less susceptible, less vulnerable to US policy or US political persuasion.

These actors are looking more at the types of things that the business leaders are, which is predictability, certainty, credibility of US policy. And what we’ve seen in the recent past is that, you know, US foreign policy, as a result of it moved towards a much more transactional nature has given rise to increasing concerns about the long term predictability of U.S. policy.

And so one problem that the US will face is how do you you re-cultivate or ensure that actors can once again trust the US to be much more predictable? And financial market actors may have may have lost that trust. And we’ve seen a little bit of that, for instance, in the reaction of market actors to the US implementation of much more aggressive and unilateral trade policies in the opening months of the Trump administration.

So, in a sense, the disruption that the trade war is causing is also then playing itself out in the financial order, in the financial system, and is actually being aggravated by these financial flows and by the reactions to the trade disruption. So there is, in a sense, a kind of a feedback mechanism here that could create more instability and should be worrying, therefore, for future economic growth.