"The real losers from this emerging schism will be international corporates operating across multiple financial systems, especially banks. Not only will they need to incur additional costs to navigate this fragmentation, but the risk is that geopolitics will, at some stage, force them to choose between the dollar framework and a rival yuan system."
The risks of a global financial schism are mounting
Precedent set by Russian sanctions dramatically increases geopolitical instability
William Bratton is the author of "China's Rise, Asia's Decline." He was previously head of equity research, Asia-Pacific, at HSBC.
The unprecedented ferocity of sanctions against Russia is frequently seen as demonstrating the West's continued financial power.
But such hubris overlooks emerging geographical divisions in the equity and foreign exchange markets, which suggest that Western reach is waning and that recent events may, in fact, prove to be the last hurrah of its global financial hegemony.
The first is the growing fracture in global equity markets. This has been an issue for some time, with both the U.S. and China using national security fears to create barriers for international investors.
The U.S., for example, continues to expand the list of Chinese companies which its domestic investors are prohibited from owning. It will also delist Chinese stocks from the New York exchanges if they fail U.S. auditing requirements. At the same time, China has made it more difficult for its companies to list overseas, citing data security concerns, and is encouraging those already trading in the U.S. to come home.
But more problematically for international equity investors, the precedent set by the Russian sanctions has dramatically increased their geopolitical risks. If bilateral relations between China and the West deteriorate further, the fear is that any investments in the Asian economic superpower could one day be rendered either frozen or worthless.
A month ago, such concerns would have been dismissed as idle scaremongering. But as China's foreign policy more openly conflicts with the West's and as Taiwan becomes more of an issue, it could face similar sanctions at some stage. It is perhaps no surprise, then, that many American investors now view Chinese companies as un-investible, not because of the underlying fundamentals but because of the broader geopolitical environment.
Although this fracture between the world's two largest equity markets will be very visible, its impact will be contained. U.S. investors will be unable to benefit from China's growth, while Chinese corporates will be shut out of America's deep capital pools.
In contrast, however, the developments in the global foreign exchange markets will have far more significant and irreversible global consequences.
The West's moves to exclude Russia from foreign exchange markets and to freeze its foreign exchange reserves may have been seen by policymakers in Brussels, London and Washington D.C. as an appropriate and proportionate tool to punish Russia. But like many decisions driven by geopolitics, these sanctions will have unintended outcomes and derivative impacts.
Not only do they raise profound questions about the financing of trade and the management of foreign exchange reserves, but their scale and severity must be ringing alarm bells in any country not completely aligned with the Western view of the world. And nowhere will the bells be ringing louder than in the corridors of power in Beijing.
China has always held long-term ambitions to reduce its reliance on the dollar and internationalize the yuan, although progress toward this objective has been slower than expected. But the sanctions imposed by the West on Russia have highlighted the dangers it incurs by remaining dependent on its rival's currency and will inject greater urgency to its attempts to reduce this vulnerability.
This is seen in its efforts to convert payments for imported commodities to yuan instead of dollars. Although this has had mixed success in recent years, the news that Saudi Arabia is now considering accepting yuan as payment for some of its oil shipments to China suggests that the impetus to de-dollarize such trade flows is gaining momentum.
Clearly, this will be a gradual and multi-decade effort, as it was with the dollar's rise. After all, a substantial proportion of China's foreign exchange reserves are still dollar-denominated and it is unclear what other assets offer the scale and liquidity needed. But importantly, it is not alone in such efforts to switch away from the dollar. India is also apparently exploring whether Russian oil could be purchased using rupees and by means independent of Western financial mechanisms.
Of course, Russia's aggression had to be punished. But the fear is that Western policymakers have failed to understand the derivative longer-term impacts of their actions. Instead, the sanctions were imposed with the self-assured belief that the world's continued reliance on the existing Western financial mechanisms was sacrosanct.
But by sanctioning the world's fourth-largest foreign exchange reserves, they have triggered shock waves that will reverberate around global finance for many years to come, create new risks, instabilities and vulnerabilities, and ultimately reduce the role and influence of Western financial systems.
The consequences of this approaching schism will be complicated.
The U.S., and more broadly, the West, will lose geopolitical influence while China will gain, although the extent of China's gain will depend on its ability to persuade others of the merits of a yuan bloc. The U.S. will lose the substantial economic benefits it derives from having the world's dominant currency. But conversely, some countries will benefit from the emergence of an alternative financial system more closely aligned with their stage of economic development.
The real losers from this emerging schism will be international corporates operating across multiple financial systems, especially banks. Not only will they need to incur additional costs to navigate this fragmentation, but the risk is that geopolitics will, at some stage, force them to choose between the dollar framework and a rival yuan system.
This will be a difficult decision to make given the comparable economic sizes of China and the U.S. But if the geopolitical environment continues to deteriorate, which appears inevitable given current trajectories, we may not be as far from that point as some would like to think, especially if current events do prove to be the last hurrah of Western global financial hegemony.