March 3, 2015 | The Wall Street Journal

The Fragility of the Global Financial Order

The U.S. Treasury has, over the past decade, been at the forefront of waging economic warfare against rogue actors. President Barack Obama has used sanctions to combat Iran’s nuclear program, punish Russian aggression against Ukraine, squeeze the Assad regime in Syria and prevent the flow of funds to terror groups such as the Islamic State and al Qaeda.

U.S. financial-warfare capability reached its height in 2012 when Congress forced the Obama administration and European Union regulators to expel Iranian banks from the Swift system, the primary messaging mode by which financial institutions move funds electronically. As a result, Tehran lost its most important global-banking entry point to finance its overseas trade, impelling the mullahs to negotiate with the West over its illicit nuclear program.

Watching from the sidelines, however, Washington’s adversaries have been developing economic weapons of their own. In 2010 China banned exports of rare-earth minerals critical to Japan’s electronic industry, and Beijing has frequently used economic and diplomatic pressure to challenge the international recognition of Taiwan. Soon China may complement its naval maneuvers in the South China Sea with economic coercion to pressure Vietnam, the Philippines and other Asian nations over ownership of the massive oil and gas reserves in the disputed waters.

As former U.S. Treasury Secretary Henry Paulson describes in his book, “On the Brink,” the Kremlin amid the Great Recession tried to persuade China to dump their massive holdings in Fannie Mae and Freddie Mac . This would have forced an intervention by the U.S. government to save the two institutions and dramatically exacerbated the already-serious economic crisis. The two powers ultimately balked, likely over fears that they had just as much to lose if they were to dump their investments.

In short, America and its allies are vulnerable, and while mutual economic dependence may have made the West’s adversaries cautious, this could change if countries such as China, Russia and Brazil decide to challenge U.S. global economic dominance.

For now, U.S. dominance means that it sets the rules and penalties in the financial sector. That dominance and coercion hinges on the strength of the U.S. dollar. As long as global finance is structured as it is—with the dollar as the currency of choice and U.S. Treasurys seen as the safest investment even during a financial crisis—Washington will continue to enjoy a strong advantage. Thankfully, 87% of international trade is still conducted in dollars and 61% of global foreign-exchange reserves is denominated in dollars.

But this won’t last forever. A number of countries and institutions are already looking at nondollar options. As global-finance expert James Rickards describes in his book “The Death of Money,” the International Monetary Fund is working to establish an alternative global-reserve asset, known as Special Drawing Rights, linked to a basket of currencies that would reduce the weight of the greenback and increase the weight of the yuan.

Other attempts are underway to circumvent the dollar-dominated system, primarily to evade U.S. penalties. One popular workaround is China’s UnionPay, an interbank credit-card association like Link or Interac that also issues credit cards. UnionPay accounts for 45% of all credit and debit cards in circulation and is now accepted in 135 countries. It can also be delinked from New York, providing an alternative for countries like Russia to skirt U.S. sanctions.

Meanwhile, Russian officials, with Chinese cooperation, are creating an alternative to Swift, according to Andrei Kostin, head of Russia’s state-owned VTB Bank and a close adviser to Vladimir Putin . With the Ukraine crisis escalating, the Kremlin knows that more U.S. sanctions are coming. U.S. legislators and British officials have even contemplated expelling Russian banks from Swift—a move Mr. Kostin has warned would be tantamount to a declaration of war. This system lacks the credibility of Swift, and therefore lacks customers—for now. But the combination of an alternative global-reserve asset, a Chinese global credit card, an alternative Swift system backed by Russia and China, and a number of banks willing to defy the global financial order, could represent a significant challenge to U.S. interests.

U.S. allies will also feel the pain. In 2014, pro-Palestinian organizations petitioned Swift to disconnect Israeli financial institutions from its financial-messaging system. Swift rejected the pressure, explaining that it wouldn’t take action without direction from EU regulators. Swift, however, would presumably comply, as it did in the case of Iran, if Brussels gave the order.

The U.S. and its allies must prepare for a growing and dangerous era. It will be marked by cyberwarfare, by abuses of the international legal system to disrupt national security, and by attempts to undermine the integrity of the U.S.-backed global system. Led by Washington’s sanctions architects, who have turned financial power into a significant instrument of offensive coercion, the West must now turn our punitive system into one that also provides a shield of defense.

Mr. Dubowitz is executive director of the Foundation for Defense of Democracies and its Center on Sanctions and Illicit Finance, where Mr. Schanzer, a former Treasury terrorism analyst, is vice president of research.

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