The dangers of a global financial schism are growing

Russian sanctions have created a dangerous precedent for international instability.

The West's enduring financial power is commonly perceived as demonstrated by the unparalleled fury of sanctions against Russia.

However, such arrogance ignores developing geographical splits in the equities and foreign exchange markets, which indicate that Western power is weakening and that recent events may represent the last gasp of its global financial dominion.

The first is the global equity markets' deepening schism. This has been a problem for a long time, with both the US and China exploiting national security concerns to erect hurdles to foreign investment.

For example, the United States continues to add to the list of Chinese companies that domestic investors are barred from owning. If Chinese equities fail to meet US auditing criteria, they will be delisted from New York markets. At the same time, China has made it more difficult for Chinese companies to list outside, citing data security concerns, and is encouraging those currently doing business in the United States to return home.

However, the precedent created by the Russian sanctions has drastically increased geopolitical risks for foreign equity investors. The danger is that if bilateral relations between China and the West deteriorate further, any investments in the Asian economic behemoth will be blocked or declared useless.

Such concerns would have been disregarded a month ago as irrational scaremongering. However, as China's foreign policy becomes more openly at odds with the West's, and as Taiwan becomes a bigger concern, it may face similar sanctions in the future. It's perhaps no surprise, however, that many American investors now regard Chinese companies as uninvestible, owing to the broader geopolitical context rather than the underlying fundamentals.

Despite the fact that the split between the world's two major equities markets will be obvious, its impact will be limited. Investors in the United States will be unable to profit from China's rise, while Chinese corporations will be denied access to America's vast finance markets.

The developments in global foreign exchange markets, on the other hand, will have considerably more substantial and irrevocable global implications.

Policymakers in Brussels, London, and Washington D.C. may have viewed the West's attempts to ban Russia from foreign exchange markets and freeze its foreign exchange reserves as an appropriate and reasonable instrument to punish Russia. However, like with many geopolitical decisions, these penalties will have unforeseen consequences and consequences.

Not only do they pose serious concerns regarding trade finance and the management of foreign exchange reserves, but their magnitude and severity must trigger alarm bells in any country that is not totally aligned with the Western worldview. The bells will ring louder in Beijing's power corridors than everywhere else.

Although progress toward this goal has been slower than expected, China has always had long-term objectives to minimize its reliance on the dollar and internationalize the yuan. However, the sanctions placed by the West on Russia have underlined the risks it faces by remaining reliant on its adversary's currency, making efforts to remove this vulnerability even more urgent.

 
A screen at a local bank branch shows the currency exchange rates of dollar and euro to ruble in Moscow on Mar. 9: the sanctions imposed by the West have highlighted the dangers it incurs by remaining dependent on its rival's currency   © Getty Images
 

This may be observed in its efforts to change payments for imported goods from dollars to yuan. Despite mixed results in previous years, news that Saudi Arabia is considering accepting yuan as payment for part of its oil supplies to China implies that the push to de-dollarize such trade flows is gaining traction.

Clearly, like with the rise of the dollar, this will be a gradual and multi-decade effort. After all, a large percentage of China's foreign currency reserves is still denominated in dollars, and it's uncertain whether alternative assets can provide the scale and liquidity that are required. However, it is vital to note that it is not alone in its efforts to move away from the dollar. India appears to be investigating if Russian oil may be purchased with rupees and without need to Western financial processes.

Naturally, Russia's actions has to be retaliated against. However, there is concern that Western officials are unaware of the long-term consequences of their actions. Instead, the sanctions were implemented with the firm conviction that the world's continued dependence on existing Western financial mechanisms was unassailable.

However, by punishing the world's fourth-largest foreign exchange reserves, they have sent shockwaves across global banking, creating new risks, instabilities, and vulnerabilities, and ultimately reducing the role and influence of Western financial systems.

The ramifications of this impending schism will be complex.

The United States, and the West more broadly, will lose geopolitical clout, while China will gain, however the level of China's gain will be determined by its ability to persuade others of the benefits of a yuan bloc. The United States will lose the significant economic gains that come with owning the world's most powerful currency. However, the establishment of an alternative financial system that is more closely matched with their stage of economic growth would benefit some countries.

International corporations that operate across different financial systems, particularly banks, will be the main losers from this rising rift. Not only will they have to pay more to negotiate this fragmentation, but geopolitics may force them to choose between the dollar framework and a competing yuan system at some point.

Given the similar economic sizes of China and the United States, this will be a difficult decision to make. However, if the geopolitical situation continues to deteriorate, which looks to be unavoidable given current trends, we may not be as far away from that point as some might believe, especially if current events prove to be the final hurrah of Western global financial hegemony.

About author: William Bratton is the author of "China's Rise, Asia's Decline." He was previously head of equity research, Asia-Pacific, at HSBC.

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