War by Other Means

by Robert D Blackwill

  When it comes to understanding how having a large global footprint for a country’s currency can bring geopolitical benefits, beyond the euro there is only really one other present case, only one other truly global currency, from which to draw. To be sure, the United States enjoys a number of strategic benefits arising from the dollar’s global role.171 It serves as “disaster insurance”—in times of international financial or geopolitical turmoil, money flees to dollars, boosting U.S. buying power and hence the nation’s capacity to respond effectively.172 It affords the United States the unique ability to run sizeable fiscal and current account deficits while borrowing in its own currency.173 And it enables the sort of financial sanctions that—whether leveled against particular banks or companies or meant to isolate entire countries, as with Iran—now seem a fixture of U.S. foreign policy. After more than sixty years, these geoeconomic “privileges” have so permeated American thinking as to become implicitly assumed.

  Yet doubts are growing about how long the dollar’s unrivaled status will last.174 Reserve holders have been diversifying—the share of minor monies in global reserves has tripled over the last six years.175 Calls to replace the dollar’s global role, stoked by the 2008–2009 financial crisis and more recently by the string of fiscal and debt ceiling domestic political stand-offs in Washington, are now standard refrains in the yearly BRICS summitry—and can also be heard in friendlier capitals, including Paris and Brussels.176 “Among Chinese officials and scholars,” explains Financial Times journalist Geoff Dyer, “there is a widely held view that the U.S. has been abusing its position as controller of the main reserve currency by pursuing irresponsible economic policies. Nor do they hide the underlying geopolitical objective of the currency push—to place limits on the role of the dollar in the international monetary system.”177 In its commentary amid the October 2013 U.S. debt ceiling debates, the official Chinese press agency, Xinhua, strengthened its call for a new reserve currency with “a scathing indictment of the United States’ broader role in the world,” calling for a “de-Americanized world” and criticizing the United States on a series of political and security issues well beyond the realm of monetary or economic policy.178

  If present trends continue, the next decade may see the largest changes to the world’s monetary architecture since 1945 and (equally important to China) since the reforms of Deng Xiaoping.179 Chapter 4 outlines China’s long-term strategy for the renminbi in more detail; at this stage, just two points are worth noting. One, an internationalizing RMB comes with several economic and geopolitical implications, some of which are in tension with one another, at least in terms of U.S. interests. Sanctions are made harder, even as certain U.S. economic interests (a market-determined exchange rate for the RMB, for example) are helped. Because reconciling these tensions would require trade-offs across U.S. national interests, these issues tend to defy Washington’s ability to consider them in any comprehensive way.

  Second, little is known about the ability of the global monetary system to accommodate an additional reserve currency.180 The world already has two reserve currencies, the dollar and the euro, and beyond general assumptions, the effects of accommodating a third are largely unknown and untested.181 History provides little precedent for the world’s ability to operate with multiple “fiat” reserve currencies (previous such eras of floating exchange rates among major currencies all ultimately linked back to gold), and it remains an open question as to whether the United States can retain enough of the economic advantages of reserve currency status while accommodating the emergence of the RMB as a reserve currency.182 Further, the world has no modern precedent for a global reserve currency that is not administered by a democratic country.183

  Even if the United States can retain enough of these economic advantages, there are geopolitical considerations to weigh, including dampened effectiveness for U.S. economic sanctions and diminished regional influence in Asia and beyond. In today’s financial world, it is difficult to know whether these American “privileges” reside on a spectrum or are more binary in nature. What is clear is that losing these advantages would force the United States to confront new trade-offs between foreign policy objectives and the higher domestic economic costs required to support those objectives.

  Such uncertainty comes at an interesting time. Questions of reserve currency status matter more today than in previous eras because reserves are now at far greater levels than in previous eras (ten times what they were fifteen years ago), with much of this reserve buildup in developing Asia.184 Some argue that Asia’s acquisition of reserves is a function of its security environment.185 Further, these reserve stockpiles tend to be far more opaque than in decades past, creating more uncertainty and potential for reverberations into geopolitics. In March 2014, for example, the U.S. Federal Reserve saw the sharpest-ever weekly drop in U.S. government debt held on behalf of official foreign institutions—$105 billion in a single week. While it was officially unclear which country was responsible for the drop, all sides were virtually certain that it was Russia, withdrawing its U.S. holdings in response to tensions and threats of sanctions over Ukraine.186

  These concerns pale against those posed by the size and opacity of Beijing’s holdings. Because China uses intermediaries, typically based in Europe, to mask large portions of its holdings, neither global markets nor U.S. officials have a clear understanding of exactly how much U.S. debt China holds.187 By February 2014, for example, Belgium had vaulted past countries known for their financial centers, as well as major oil-exporting nations, to become the third-largest foreign holder of U.S. government debt behind China and Japan, with $341.2 billion (up from $166.8 billion just six months earlier, in August 2013)—this in a country of 11 million people with an annual gross domestic product of $484 billion.188

  The curious climb in Belgium’s U.S. Treasury holdings merely reflects the secret buying of top-rated sovereign debt by other countries using intermediaries to mask their purchases. “We know it’s not Belgium buying, it’s way too much. We need to look at that country’s custody services,” said Marc Chandler, chief currency strategist at Brown Brothers Harriman.189 Others in the financial blogosphere were more direct: “In summary: someone, unclear who, operating through Belgium and most likely the Euroclear service (possible but unconfirmed), has added a record $141 billion in Treasury holdings since December, or the month in which Bernanke announced the start of the Taper, bringing the host’s total to an unprecedented $341 billion!”190 Others eventually traced the mysterious Belgian purchases back to Beijing.191

  Beyond the size of a currency’s footprint in global markets, a second channel through which monetary policy can translate into geoeconomic influence is the extent to which a country can raise funds at low cost. This is mostly a story of how a nation’s domestic economic housekeeping can determine its ability to mobilize and sustain financing for wars and other less extreme security contests. Certainly this channel can be related to the first, insofar as the ability to borrow cheaply in one’s own currency, especially at times of political or economic uncertainty, undoubtedly constitutes one of the biggest perks of reserve currency status. But the point is also broader. For example, countries where debt is primarily domestically held tend to be somewhat better insulated in times of crisis—as with Japan after the 2011 earthquake and Fukushima nuclear disaster.192

  There are plenty of examples attesting to how one state’s ability to impact another’s borrowing costs can confer geopolitical leverage—often when states are at their most vulnerable. “Weak currencies make for timid states,” as Cornell’s Jonathan Kirshner has put it, referring to the geopolitical headaches that precarious borrowing positions can create for countries.193 Here the 1956 Suez Canal crisis again enters as the paradigmatic case. The U.S. use of loan guarantees to force Israel to the negotiating table with the Palestinians in 1991 is equally instructive.194 When Israel requested $10 billion in loan guarantees from Washington to finance the resettlement of Soviet Jews in la
te 1990, President George H. W. Bush asked Congress to delay action on the loan guarantee while he worked to arrange an Arab-Israeli peace conference. Only after Israeli prime minister Yitzhak Rabin announced a settlement freeze was the loan guarantee program approved.195

  More recently, in response to the EU’s April 2013 proposed bailout for Cyprus (which would have entailed losses for Russian investors), the Kremlin threatened to review the euro’s share in Russia’s €537 billion of foreign exchange reserves, while the Russian finance minister issued unspecified warnings of retaliation. Few took the Kremlin’s threats seriously. But, coming as they did amid a flaring of the eurozone crisis, portents of this sort did not necessarily need to stand up to individual scrutiny in order to register effect. Investors’ nerves were frayed, and threats, even seemingly minor ones, had a way of compounding in self-reinforcing and unpredictable ways.

  Alongside cases like this, where a state brandishes but does not act on threats to manipulate another state’s borrowing costs, there are also opposite cases: states that actually follow through on what are almost certainly geoeconomic gestures involving another state’s borrowing costs, all without any official acknowledgment of what is afoot. Qatar tripled its holdings of Egyptian treasury bills in the third quarter of 2013—immediately after President Morsi was ousted, and right as Egypt’s new military rulers were in the process of giving back billions in Qatari assistance that Doha had lavished on President Morsi’s administration. Given Doha’s newly limited options for leverage in a post-Morsi Egypt now hostile to its attempts at influence, Egyptian treasuries were not merely a cost-effective alternative but were arguably among Doha’s only options.

  And not least, some geoeconomic attempts to capitalize on a state’s borrowing costs in moments of crisis are just that: neither threats nor denials, merely attempts. Take Russia’s November 2013 bailout package to Ukraine. In its initial proffering, the package stood out as an example of how Russia, by meeting Ukraine’s pressing financing needs at rates Ukraine could afford (well below what the market would have commanded and without any of the difficult reforms the IMF would have demanded), managed to bend the course of Ukraine’s foreign policy toward Moscow’s preferences at a critical juncture. But within months, the package, or at least the $3 billion in euro-denominated bonds that Moscow actually delivered before halting the remaining portions, came to stand for the leverage that a sovereign creditor can have over a sovereign debtor.196 “Ukraine has two debt problems,” as Anna Gelpern put it. “First, it faces shrinking revenues, rising costs, and a spike in foreign debt payments over the next two years. This is a common problem, easily managed with familiar market tools and international institutions. Ukraine’s other debt problem is neither common nor manageable: its leading bond holder is annexing parts of its territory and stoking militant separatists from within.”197

  Together Ukraine’s two debt problems expose an awkward oversight in the world’s financial architecture. “The system is set up as if market finance and political patronage were distinct,” adds Gelpern. “When governments participate as debtors or creditors in the global capital markets, they are expected to use private deal technology, and abide by the rules and incentives of these markets. When governments put on their power-political hats, they are expected to retreat to political fora, removed from the markets. Being sovereign, they do not have to.”198

  Russia can be counted on to act crudely in its geoeconomics more often than not. But in many respects, the more powerful examples here are the more subtle ones. China’s decision not to devalue its currency during the 1997–1998 Asian financial crisis earned Beijing gratitude across the region that lingers today and provided Beijing an opportunity to buoy up its neighbors, especially newly repatriated Hong Kong.199 The U.S. handling of the 1994 Mexican peso crisis also reaped significant geopolitical returns. After President Bill Clinton failed to pass a stabilization act in Congress, he went to a fallback option, authorizing U.S. financial assistance through the Treasury’s Exchange Stabilization Fund (ESF). The ESF allowed the provision of funds to Mexico without legislative approval; unilaterally drawing upon $20 billion to stabilize America’s southern neighbor was, in the words of Treasury secretary Robert Rubin, the “largest nonmilitary international commitment by the U.S. government since the Marshall plan.”200 Largely thanks to U.S. assistance, the Mexican economy averted disaster.201 And, of course, a stable Mexico is essential to U.S. power projection in the world.

  The most powerful present-day example is that of Germany and its handling of the eurozone.202 Harnessing the power of bond markets, as Helmut Schmidt anticipated in 1978, Germany has done more to remake Europe in its likeness in the past four years than it had accomplished in the past century.203 Through forging the eurozone, German has also realized its century-long quest for a pliant European market for German manufacturing.204 Both of these were things it had previously tried (and failed) to accomplish by force. Further underscoring the growing extent to which market realities are shaping geopolitical outcomes, Germany is effectively dictating the terms on which foreign capital into the eurozone is solicited.205 Often this occurs in ways that impinge on U.S. leverage.206

  Obviously, the degree to which a state depends on external creditors for financing determines the degree of vulnerability. Japan has for more than a decade managed with debt that was predicted to hit 230 percent of GDP by late 2014—a level that for most other countries would be considered as risking saturation among bondholders.207 But, again, a far greater share of Japan’s debt is domestically held. For other nations, a much higher percentage of debt is externally held. In particular, this is true of the United States, where one creditor, China, possesses more than half of all outstanding debts at certain maturities.208 Reserving the specifics of this China-U.S. case for Chapter 4, there are, generally speaking, three points worth keeping in mind when it comes to sizing up the potential geopolitical leverage that might come from the ability to influence another country’s sovereign borrowing costs.

  The first point is that, from a geopolitical standpoint, it matters whether a country’s external debt is in mostly private or sovereign hands. Returning to the British Empire, one lesson that William III’s successors failed to appreciate is how the Bank of England’s investors would also become supporters of the revolutionary settlements, their financial fates intertwined. But if King George misjudged just how easily creditors’ investment portfolios can come to dictate their foreign policy preferences, America’s early founders made no such mistake. This, after all, is exactly what Alexander Hamilton had in mind with the Bank of the United States and the assumption of state debts. The bank’s creation meant that creditors of the United States, wealthy elites in all thirteen colonies, now had a vested interest in the success of the Union.

  The second point is that there is still a good deal of domestic bias in most sovereign debt markets, meaning that a sizeable portion of a country’s sovereign debt is still domestically held; the United States and Europe are no exception. But with this sharp rise in official reserves and the corresponding preference for “safe” assets, reserve managers can and do account for a large share of some markets (in recent years foreign official investors have held around 55 percent of the one-to-five year segment of the U.S. Treasury curve, with China likely accounting for more than 20 percent of the outstanding $10 trillion stock of marketable U.S. government debt).209 This in turn creates the risk of large and destabilizing portfolio shifts. The prospect of such a sudden shift is remote—to be sure, the U.S. Federal Reserve has proven its ability as a purchaser of resort—but it is not zero.

  The third general point is that there is at least the potential—again, albeit remote—that foreign official purchasers could marshal these assets to make a geopolitical statement. Evidence to this effect is scant and generally not well supported. After leaving public office, former Treasury secretary Hank Paulson claimed that Moscow had approached China in 2008, urging that their governments execute a coordinat
ed shorting of U.S. government-sponsored enterprises (GSEs), including Fannie Mae and Freddie Mac, in an apparent effort to put financial pressure on the U.S. government.210 As noted earlier, Moscow more recently signaled its displeasure with the EU’s handling of the Cyprus bailout by threatening to review the euro’s share in Russia’s €537 billion of foreign exchange reserves (the outsized Cypriot banking sector serves as an offshore hub for substantial Russian savings).211 Similarly, during tensions between the West and Russia over Ukraine, Moscow threatened to dump its holdings of U.S. sovereign debt (a feat that would go well beyond simply moving these holdings so as to remove them from any risk of sanctions) and not so subtly withdrew more than $100 billion in custodial holdings from the U.S. Federal Reserve.212

  Still, most of today’s large external creditor states have so far largely shied away from overt attempts to exercise the geoeconomic power implied by their respective official savings—Costa Rican bond purchases for repudiating recognition of Taiwan are the exception, not the rule. Nor, in the case of China, is there any evidence that observed portfolio shifts in Chinese official holdings have been driven by anything other than loss aversion; at worst, certain shifts have been accompanied by official statements meant to help punctuate policy positions and messages to Washington that Chinese officials had long sought to underscore.