Financial sanctions and the US-dollar

Hefeker, Carsten Article Financial sanctions and the US-dollar Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung (VAW) Provided in Cooperation with: Institut Arbeit und Wirtschaft (IAW), Universität Bremen / Arbeitnehmerkammer Bremen Suggested Citation: Hefeker, Carsten (2025) : Financial sanctions and the US-dollar, Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung (VAW), ISSN 2942-1470, Duncker & Humblot, Berlin, Vol. 2, Iss. 2, pp. 197-212, https://doi.org/10.3790/vaw.2025.1457704 This Version is available at: https://hdl.handle.net/10419/317913 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Duncker & Humblot · Berlin Financial Sanctions and the US-Dollar By Carsten Hefeker* Summary The paper discusses whether US dollar based financial sanctions will undermine the dollar’s dominant international role. Despite long-standing attempts to reduce the role of the dollar, these have had limited success so far. I discuss why this is the case and why alternatives to the dollar are unlikely to challenge its position at present. However, a fractionalization of the global financial system may happen in the longer run. An important step to avoid such a fractionalization will be to make the use of financial sanctions less unilateral and arbitrary. Zusammenfassung Der Aufsatz diskutiert, ob Finanzsanktionen die internationale Bedeutung des USDollars schwächen werden. Obwohl es seit längerem Versuche gibt, den Einfluss des Dollars zu verringern, sind diese bislang weitgehend erfolglos geblieben. Es wird beschrieben, warum dies der Fall ist und warum es auch auf absehbare Zeit so bleiben wird. Langfristig kann es allerdings durchaus zu einer Fragmentierung des globalen Währungsund Finanzsystems kommen. Um eine Fragmentierung zu verhindern, sollten Finanzsanktionen künftig stärker koordiniert und weniger einseitig und arbiträr verhängt werden. Keywords: Financial sanctions, international financial system, dollar, renminbi JEL classification: F2, F3, F5, G2 1. Introduction The swift and comprehensive reaction of Europe and the United States to the Russian attack on Ukraine in February 2022 surprised most observers. It took only a few days to impose the first of a series of sanction programs (reaching 14 at the time of writing) on Russia, which had been coordinated and prepared in advance among the United States, the European Union, the United Kingdom, * Carsten Hefeker, Department of Economics, University of Siegen, Unteres Schloss3, 57072 Siegen, Germany, email: carsten.hefek[email protected] I am grateful to the anonymous referees for helpful and constructive comments and suggestions. Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung 2 (2025) 2: 197 – 212 https://doi.org/10.3790/vaw.2025.1457704 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 198 Carsten Hefeker Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 Japan, Canada, Switzerland and Australia (Baker 2024). They targeted around eighteen-thousand individuals and firms, freezing and confiscating their assets, banning technology exports and certain imports, and put a (largely ineffective) price ceiling on Russia’s oil exports. The alliance also decided to freeze Russian currency reserves and central bank assets in the amount of 300 billion US dollars, about half of the Russian central bank’s total currency reserves of 630 billion. Given the size and international importance of the Russian economy, the extent of sanctions is exceptional in modern times and goes further than sanctions following the occupation of Crimea in 2014, when the reaction was less united and comprehensive.1 It also intensified an ongoing debate about the long-term consequences of financial sanctions for the international financial system (Demarais 2022; Weiss 2022). While financial sanctions in general are nothing new, the seizure of central bank assets is different. If currency reserves, which were so far considered immune to sanctions, are seized, countries around the world might reconsider to continue using the US dollar. Using currencies not aligned with the Western coalition against Russia would make them less exposed to be sanctioned in future conflicts. The financial sanctions are a reminder of how far-reaching the power of the United States is in obstructing other countries’ use of the US dollar. Russia and China had already earlier begun diversifying away from using the dollar as a reserve currency to reduce their vulnerability and looking for alternatives to the US-dollar before the recent sanctions (McDowell 2023). The discussion has, however, intensified and become part of a broader discussion about “fragmentation” between economic blocs in trade policy, industrial policy and access to critical technology and resources. The International Monetary Fund, for instance, warns of such a fragmentation and even draws comparisons to the Cold War (Aiyar et al. 2023; Catalán et al. 2024; Gopinath et al. 2024). The present paper asks what the consequences of financial sanctions for the global financial system will be. It begins by discussing the importance of the US dollar for international financial transactions and whether the increasing use of financial sanctions may undermine the dollar’s role. Despite long-standing attempts of many countries, including American allies, to reduce the dominant role of the dollar, these have had only limited success so far. I therefore discuss next why this is the case and why alternatives to the dollar will not challenge the dollar soon. However, this does not preclude that, going hand in hand with a 1 Sanctions imposed on Iran are similarly comprehensive but target a smaller economy less integrated into the world economy than Russia. Iran accounts for less than onepercent of world GDP, Russia for about threepercent (Krahnke et al. 2024). For a comprehensive account of the design and implementation of sanctions against Russia since 2014, see Baker (2024). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 Financial Sanctions and the US-Dollar 199 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 fractionalization of the trading system, a fractionalization of the global financial system may happen in the longer run. In conclusion, I discuss possible ways to avoid such a fractionalization. An important step will be to make the use of financial sanctions less unilateral and arbitrary. A regulatory framework that conditions the use and scope of permissible financial sanctions, or at least stronger coordination between countries, could lower incentives to reduce the use of the dollar, which is ultimately also in the interest of the United States. 2. The Use of Financial Sanctions Imposing sanctions and embargoes against the trade of individual countries is a standard policy measure in international conflicts and wars (Blackwell and Harris 2016; Felbermayr et al. 2020; Krahnke et al. 2024; Mulder 2022). Blocking trade obstructs access to important goods and, even if sanctions are not watertight, they increase costs. Over time, however, sanctions and embargoes become porous and lose effectiveness. This can also be seen with trade sanctions against Russia where states like China, Turkey or Kazakhstan either directly or through re-exports provide access to all kinds of goods, including weapons and technologies needed for war related purposes (Hilgenstock et al. 2024). Given the higher centralization of the international financial system, however, it is more difficult to bypass financial sanctions. Financial sanctions are more effective due to the dominant role of the US dollar in international financial transactions, which gives the United States unique power of punishing enemies, and sometimes friends, that it does not have with other forms of sanctions. Since September 11, 2001, the United States and its allies make abundant and increasing use of unilateral and multilateral financial sanctions against countries such as Iran, Afghanistan, Burma, Libya, Syria or Venezuela (see Cipriani et al. 2022; Krahnke et al. 2024).2 While less often used, there have also been cases of central bank asset freezes in Syria, Iran and Afghanistan before those imposed on Russia. Krahnke et al. (2024) report ten cases of asset freezes for the 2000s alone. The dominant role of the US dollar becomes apparent first in the fact that it is used in about 90percent of all foreign exchange transactions.3 Moreover, around 50percent of international loans and more than 60percent of international debt are denominated in dollars.4 The dollar makes up nearly 60percent of officially 2 The United States Office of Foreign Assets Control (OFAC) provides details for each case. See https://home.treasury.gov/policy-issues/office-of-foreign-assets-control-sanc tions-programs-and-information. 3 Out of a total of 200percent since each transaction involves two countries. 4 The importance of the dollar may be even larger than shown in statistics because of “FX swaps”, forward transactions with dollars that can create undocumented dollar obligations. Estimates of these swaps run up to 39trillion US-dollars (Borio et al. 2022). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 200 Carsten Hefeker Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 declared international currency reserves (ECB 2024), down from around 70percent twenty years ago as the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) database shows.5 Concerning the composition of currency reserves, Laser et al. (2024) develop a new dataset, based on official data and national central bank reports. They show that over the last five years the dollar’s share has dropped in Europe, South America and Asia, but increased in Africa, Australia and Oceania. The renminbi’s share in contrast has risen in all regions with exception of the eurozone. Nontraditional reserve currencies like the Australian and Canadian dollars and currencies collected in the “other currencies” category increased in all regions other than Australia and Oceania, hinting at a gradual reduction of the importance of dollar and euro (see also Arslanalap et al. 2022). Recent press reports, in contrast, suggest that central banks are actually planning to increase their dollar reserves, particularly in Asia (McDougall 2024). This is in line with Goldberg and Hannaoui (2024) who show a significant reduction of Russian and Chinese holdings of the dollar but do not see this as a general phenomenon. In their view, the decline in dollar shares can be mainly attributed to a strong increase in overall reserves (mainly by Switzerland) not denominated in dollars. While the exact composition of currency reserves may be disputed, it is not disputed that central banks have increased their gold reserves in recent years so that gold makes up about tenpercent of total reserve holdings now. While gold purchases have been 400 and 600tons over the 2010s, in 2022 and 2023 they jumped to over 1000 tons, with China alone increasing its gold holdings by 225tons (ECB 2024). But even as central banks diversify their reserve holdings, the dollar’s dominant role in currency reserves remains. The second factor that gives the United States unique power is its control over the global financial infrastructure. International financial flows usually consists of two parts: there is first a notification between banks that a payment will follow, before in a second step the actual execution of the payment takes place. Communication between banks mostly takes place via the Society for Worldwide Interbank Financial Telecommunication (SWIFT) located in Belgium. Before the creation of SWIFT by private banks in 1973, banks notified each other by Telephone or Fax and so the creation of the network has reduced transaction costs and made verifiability much easier. Because SWIFT is not based in the United States, it is not subject to American legal oversight. But threatening SWIFT with losing access to the United States financial network has been enough in the past to force the organization to implement also unilateral sanctions of the US government. In the case of Iran, for instance, the organization decided to exclude Iranian banks from the network without a formal European 5 See https://betadata.imf.org/Datasets/COFER. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 Financial Sanctions and the US-Dollar 201 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 legal requirement, based on the mere threat of US sanctions (Cipriani et al. 2023). While exchanging information is possible without using SWIFT, the actual execution of a significant payment involving dollars needs an American bank. Clearing of dollar payments among banks takes place through the Clearing House Interbank Payment Systems (CHIPS), created by private banks in 1970. Today it comprises about 50 American banks or US branches of foreign banks, including Chinese (but not Russian) banks. CHIPS directly clears payments among member banks or on behalf of third banks that have access to member banks. Payments are netted once a day, and funds at CHIPS are prefunded by participating banks through Fedwire, the Federal Reserve Bank’s gross-settlement system, to transfer money from their Fed accounts to CHIPS. Consequently, banks that are part of an international financial transactions in dollars either need to be a direct member of CHIPS or use a correspondent bank that transfers dollars to the receiving bank or its partner bank. An American bank wishing to transfer money to a foreign individual will first transfer the payment to a domestic bank participating in CHIPS which then transfers it to the CHIPS account of a foreign bank. The latter then transfers the payment to its customer abroad or another bank located in the respective country. The US government can forbid American banks to interact with certain foreign banks and a bank excluded from CHIPS has no longer access to the clearing system and the necessary dollar funds for a transaction. The same applies to similar clearing networks in other countries such as the Clearing House Automated Payment System (CHAPS) in the United Kingdom or the payment systems operated by the European Banking Association in the European Union (EBA Clearing). While banks might find ways around SWIFT by using less efficient technologies, it is much more difficult to work around clearing systems. Even if banks would consider doing transaction with dollar funds located in offshore markets such as Singapore or Hong Kong, the threat of exclusion from the network against individual banks or countries has so far been enough to making them comply. The threat of secondary sanctions is legally contested, but it can be very powerful nevertheless. The United States often extends sanctions to all payments which are somehow connected to a sanctioned entity or individual. A correspondent bank may not be involved directly in a sanctioned payment but as long as it needs dollars to refinance itself, this exposes it to sanctions and therefore offshore markets are not outside secondary sanctions. This extension of sanction reach is considered “unlawful” and criticized as extraterritorial jurisdiction not only by foes but friends of the United States as well (Emmenegger and Zuber 2022). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 202 Carsten Hefeker Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 3. Reducing Vulnerability Given their exposure to dollar sanctions, several countries have tried to reduce their vulnerability. Starting with the occupation of Crimea in 2014 this is most obvious in Russia and China, but there are also longer-standing attempts by oil and gas producing Arab states to move away from denominating energy in dollars. Even allies of the United States, like the European Union, have declared their intention to reduce the role of the dollar and their exposure to unilateral sanctions by setting up an alternative system. Before the invasion of Ukraine, close to 80percent of Russia’s imports were invoiced in dollars or euros, but after the invasion of Ukraine its imports became increasingly invoiced in renminbi. By the end of 2022, renminbi payments accounted for 20percent of Russia’s imports, up from 3percent a year earlier, while the share of dollar and euro declined to less than 70percent. Partly this reflects more trade with China and other non-sanctioning countries. Renminbi invoices of imports from China increased from 23 to 63percent between 2021 and 2022 and in trade with third countries the share of renminbi increased from less than 1percent to more than 5percent during 2022 (Chupilkin et al. 2023). Russia also restructured its currency reserve holdings. Following the first round of sanctions in 2014, the Russian central bank started to convert part of its reserves to gold and declared in 2022 that its entire gold holdings had been moved to Russia (Corsetti et al. 2024). Russia does not disclose the composition of its currency reserves anymore since the invasion of Ukraine, but even before it had shifted its reserves away from the dollar, holding about a third of them in renminbi (Eichengreen 2024). Not expecting that currency reserves would be frozen by European countries, however, it continued to hold part of its reserves in Europe which explains why almost half of them could be frozen. While Russia had reduced the share of its reserves down to 6.6percent in the United States in 2021, it continued to hold around 25percent in France, Germany, the UK and Austria (Kamminga 2023). After 2014 Russia also started to develop its own financial communication system, the System for Transfer of Financial Messages (SPFS), as an alternative to SWIFT. According to Cipriani et al. (2023) more than 400 banks, mostly from Russia, but also from Germany, Switzerland, France, Japan, Turkey, Sweden and Cuba, joined SPFS. As of April 2022, banks from 52 countries were connected to the system, whose participants Russia no longer discloses. In 2021, however, only about 20percent of intra-Russian transfers used SPFS. China as well has taken steps to promote the use of its own currency instead of the dollar. While this has been China’s strategy for more than a decade now (Prasad 2014), it has accelerated since the Russian invasion. China has concluded a number of clearing agreements with Pakistan, Argentina and Saudi Arabia OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 Financial Sanctions and the US-Dollar 203 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 since 2022. Moreover, new clearing banks for renminbi payments have been established in Laos, Kazakhstan, Pakistan, Brazil and Serbia (Sandlund 2024). There have also been negotiations and agreements with the Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) to pay in renminbi for its oil and gas imports. Also, Iraq and Bolivia agreed to settle their trade with China in renminbi (Eichengreen 2024). Overall, around 30percent of China’s trade in goods is now settled in its own currency, up from around 7percent in 2012 (ECB 2024). Despite these initiatives, however, the international role of the renminbi is still a minor one. In late 2023, only 2.4percent of official currency reserves were held in renminbi and it accounted for only 5.1percent of global trade payments and only 5percent of currency turnover (Eichengreen 2024). Given the importance of a clearing system, and the vulnerability to being excluded from it, the Chinese central bank, the People’s Bank of China, as well launched its own clearing system in 2015, the Cross-Border Interbank Payment System (CIPS). It is in principle organized similarly to CHIPS but works as a gross-settlement system as compared to a netting system like CHIPS. There are also direct participants and indirect ones which go via a member bank located in China (two-fifths) and abroad (three-fifths). CIPS also has its own messaging system which banks use besides communicating through SWIFT. In comparative size, however, CIPS is clearly dwarfed by CHIPS. The latter has 11,000 participating banks as compared to 1,300, it has 10 times more transactions, and a daily volume of close to 2 trillion USD as compared to an equivalent of only 46billion (Eichengreen 2022). Presently, most banks continue to prefer SWIFT for messaging because they do not have access to a separate CIPS terminal (Cipriani et al. 2023). In April 2022, Russian Minister of Finance Siluanov suggested linking the Russian and Chinese payment system and including other BRICS members as well (Eichengreen 2022).6 At the October 2024 BRICS meeting in Kazan, Russia, President Putin again promoted the idea of an own clearing system for the organization, called BRICS Bridge, but the response of other members was not enthusiastic (Clover and Mosolova 2024). This is not surprising: A clearing system with nonconvertible, or only partly convertible, currencies is not attractive. Current account surpluses with a country whose currency cannot be used to pay for imports from other sources are not desirable and so members will aim at balanced trade. Only the renminbi may be more widely accepted as a means of payment because of China’s importance as a global exporter. Given the control of China over its currency and the political risk involved, however, it is unlikely 6 Members of BRICS are Brazil, Russia, India, China and South-Africa; Egypt, Ethiopia, Iran and the UAE joined this year. The group has association agreements with 13states, and around 40 more countries have expressed their intention of joining. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 204 Carsten Hefeker Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 that BRICS members like India, South Africa or Brazil have a strong incentive to switch from dollar to renminbi on a larger scale, including their currency reserves. Presently, it can therefore not be expected that a BRICS clearing mechanism will find widespread support beyond Russia. There is also a long-standing discussion about the intention of Gulf Cooperation Council countries to move the denomination of oil trade away from the dollar (Momani 2008). One initial reason behind the consideration was the American invasion of Iraq in 2003 and the advocacy of Iran to move away from the dollar in international oil trade. The euro was initially seen as a possible alternative but the euro-crisis after 2010 shelved this plan. There is now a new discussion about the possibility of denominating at least part of oil trade in renminbi which is actively promoted by China, and since 2018 renminbi denominated oil futures are traded in the Shanghai International Exchange (Kamel and Wang 2019). A second factor is that the incentive to keep currency reserves in dollars has declined in Gulf countries. There was allegedly an agreement since the early 1970s between the United States and Saudi-Arabia, that the former would provide a military security umbrella for the region. In exchange, dollar revenues from oil trade would be recycled into US treasury papers by Saudi Arabia (Spiro 1999). That has reportedly ended some while ago and Gulf states slowly diversify their investments away from the United States (Momani 2008; The Economist 2023). The diversification incentive is supported by the fact that the dollar exchange rate and the price of oil have become positively correlated in recent years (Hofmann et al. 2023). Pegging to the dollar and holding dollar reserves serves as a stabilizer when oil and dollar are negatively correlated but procyclical when the correlation is positive. Risk aspects suggest that diversification away from the dollar will continue. Finally, even the European Union has taken measures to reduce its vulnerability to dollar sanctions. In response to the 2018 unilateral and uncoordinated reimposition of sanctions by the United States against Iran, France, Germany and the United Kingdom created their own clearinghouse for trade with Iran, the Instrument in Support of Trade Exchanges (INSTEX). Their attempt to bypass the dollar payment system entirely was joined by other countries and finally the system was opened to all EU countries (Cipriani et al. 2023). INSTEX was designed not only as a messaging system but as a clearinghouse that would manage payments between Europe and Iran. Payments should be netted within the system, and payments between Iran and the European Union would only occur to settle import-export imbalances. The system, however, was a failure. Although it still exists, there was only one transaction in 2020, covering the import of medical equipment by Iran. The system was declared as being useless by the Iranian central bank in 2021 (Corsetti et al. 2024). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05 Financial Sanctions and the US-Dollar 211 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 2 (2025) 2 Eichengreen, B. (2022): Sanctions, SWIFT, and China’s Cross-Border Interbank Payments System, Center for Strategic and International Studies Brief. Eichengreen, B. (2024): Globalization and Growth in a Bipolar World, Journal of Policy Modeling, 46, 714 – 722. Emmenegger, S. and Zuber, F. (2022): To Infinity and Beyond. 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OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2025.1457704 | Generated on 2025-05-19 12:47:05