LONDON (Project Syndicate) – The savage fighting in Ukraine has led many to wonder if Russian President Vladimir Putin’s so-called strategic genius is all it was made out to be.

Although Putin foresaw that NATO would not respond militarily to his war, he seems to have underestimated the West’s capacity for solidarity. The United States and its allies and partners have already implemented unprecedented economic and financial sanctions against the Putin regime, and the decision to block the Russian central bank from international financial markets (thereby freezing the country’s foreign exchange reserves) is undoubtedly a masterstroke.

Insufficient funds

True, Russia has diversified its reserves away from the BUXX dollar,
+0.13%
during the last years. But judging by the scale of the international response and its immediate impact on the Russian economy, this strategy appears to have been insufficient to maintain access to the financing it needs. Even Switzerland announced that it would participate in the new sanctions regime by freezing Russian assets.

You don’t have to be a deep thinker to understand that China must be alarmed and unhappy with Russia’s war daring and Western reaction to it. If China were to pursue military action against Taiwan, it too could expect to lose much of its access to the global financial system.

Unless Russia has considerable reserves held in Chinese renminbi CNHUSD,
-0.06
or currencies issued by other countries that still support it, the compression of its economy will be inevitable.

Whatever Russia’s response, the question now is what these moves by the West – and by almost every financial center in the world – will mean for future monetary affairs and the international monetary system. Are we seeing a further consolidation of American power through the dollar-dominated system, or will this episode set the stage for the kind of monetary and financial fragmentation that some analysts have long anticipated?

Russian airstrikes continued, hitting government and university buildings in Ukraine’s second-largest city, Kharkiv; Ukrainian President Zelensky has called on Vladimir Putin to stop attacks ahead of talks; The Ukrainians built roadblocks to slow down the Russian troops. Photo: Sergei Bobok/AFP/Getty Images

Raise the stakes

Having written about the future of the dollar myself, I can’t recall a previous policy announcement that raised the global monetary stakes as much as this one.

The immediate effect of the sanctions against Russia has been to highlight the continued dominance of the United States. But it may also force many emerging economies to reconsider the traditional approach of building up foreign exchange reserves to protect against economic crises.

The need for such self-insurance was the big lesson of the 1997-98 Asian financial crisis. But now that the Russian central bank has lost the ability to convert its foreign currencies into rubles RUBUSD,
+3.41%,
the strategy seems to involve new risks.

This is especially true for countries whose aspirations might run counter to the prevailing norms of the western democratic world – as threatening and then invading a smaller neighbor obviously does.

You don’t have to be a deep thinker to understand that China must be alarmed and unhappy with Russia’s war daring and Western reaction to it. If China were to pursue military action against Taiwan, it too could expect to lose much of its access to the global financial system.

unlikely scenario

One can understand why escaping this deep dependence on the Western-controlled monetary system might now become a top priority for some countries. If Renminbi, Rubles, USDINR Indian Rupees,
-0.21%,
and that other currencies were more convertible for other countries, a fundamentally different international monetary system might emerge – one in which the kinds of sanctions imposed on Russia would not be as effective.

But this scenario remains unlikely, for two related reasons.

First, there’s a reason China hasn’t done more to raise the renminbi as an international currency. At the many conferences on the world monetary order that I have attended, the message of Chinese scholars has long been clear: their preferred method of improving the current system is to expand the role of special drawing rights, the asset of reserve of the International Monetary Fund.

This makes sense considering what the internationalization of the renminbi would entail. Because China should allow greater freedom in the use of its currency abroad, it should give up its ability to maintain capital controls. So far, he hasn’t wanted to. Yet, without capital account liberalization, no other country – not even one as financially desperate as Russia – would want to hold its renminbi reserves.

Second, even if a great power like China were to respond to today’s changing circumstances by pursuing major financial reforms, it would still have to offer credible assurances regarding the safety and liquidity of reserves held outside Western currencies. Otherwise, why would anyone take the risk?

Again, it seems unlikely that China will pursue reforms that would require sweeping changes to its own economic and regulatory model. If China were to bite the bullet and open up its financial system, structural changes in the global monetary order would almost certainly follow. But, even then, the changes would not come in time to spare Russia the consequences of the appalling behavior of its president.

Jim O’Neill, former Chairman of Goldman Sachs Asset Management and former UK Treasury Secretary, is a member of the Pan-European Commission on Health and Sustainable Development.

This commentary is courtesy of Project Syndicate — Will sanctioning Russia upset the monetary system?

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