A New Era of Financial Warfare Has Begun

Washington and the West have begun a new phase of financial warfare against Russia and China—a powerful but also potentially risky escalation that, if people aren’t careful, could eventually give Moscow and Beijing exactly the outcome they are believed to be looking for.

How so? Because the unprecedented actions taken at the G-7 summit in June to hand over to Ukraine billions of dollars in profits earned on frozen Russian assets—along with new actions taken against Chinese banks—could begin to undermine the legitimacy of the U.S.-dominated international financial system, some experts say. And that could make Russian President Vladimir Putin and especially Chinese President Xi Jinping, who is said to want to create an alternative renminbi-based financial system, very happy in the end.

At a time when many nations are unsure about whether to do business with Russia and are falling into the debt-enforced embrace of China, the G-7 action sends a message: What was once sacrosanct in international finance may be no longer. A number of sovereign wealth funds, central banks, corporations, and private investors—especially from the smaller countries of the global south that are most vulnerable to sanctions—may well want to hedge against full investment in dollar- and euro-based holdings.

“This decision crosses the Rubicon,” said Ryan Martínez Mitchell, a law professor at the Chinese University of Hong Kong, by “weakening the norm of sovereign immunity for foreign central banks.”

“Any shift away from a U.S. dollar-based global financial system is not a near-term prospect, but decisions like these do probably add to the constituency that would welcome that kind of future,” Mitchell said. Others agree. “There were many forces pushing for a search for alternatives to [the U.S.] dollar, and this move will give an additional push to those efforts,” said Harold James, a financial historian at Princeton University. “I believe we are at a tipping point in which two worries coincide: one about the likely fiscal path of the U.S. and an unsustainably large burden; the second about seizure of assets, with secondary sanctions possibly being applied to countries that are in a supply chain with China and then indirectly with Russia.”

The “tipping point,” James warns, could come in the form of many countries, even U.S. allies, beginning to move their assets away from the dollar and euro. According to Raghuram Rajan of the University of Chicago, a former governor of the Reserve Bank of India, nations are disturbed by the idea that Russia’s $300 billion in central bank reserves have been inaccessible for more than two years. “Some central banks have started diversifying reserves a little more as a result, including into gold,” Rajan said.

James added: “One sign that I find very telling is how Central European countries, the Czech Republic and Poland, both of which feel very close to the U.S. and who weren’t interested in gold reserves when they felt secure—indeed, the Czech Republic sold its gold reserves the day they entered NATO in March 1999—are now buying large amounts of gold.”

Putin himself spoke triumphantly of this trend in his notorious interview with renegade U.S. newscaster Tucker Carlson in February. Washington’s decision “to use the dollar as a tool of the foreign-policy struggle is one of the biggest strategic mistakes made by the U.S. political leadership,” Putin said, pointing to America’s fiscal profligacy. “Even the U.S. allies are now downsizing their dollar reserves.” At another point, Putin warned other countries that they “could be next in line for expropriation by the United States and the West.”

Wary of the risks of sending a destabilizing message, the G-7 did stop short of actually seizing the Russian assets at its summit in Italy. Instead, it adopted a complex scheme to transfer so-called windfall profits on earnings from frozen Russian central bank securities—the earnings of some $3 billion to $4 billion a year come from investments by Euroclear, the financial services company in Belgium that holds the Russian assets—to supply finance to Ukraine.

It was unprecedented all the same. As a senior Biden administration official described it: “Never before in history has a multilateral coalition immobilized the sovereign assets of an aggressor country and then found a way to unlock the value of those assets for the benefit of the aggrieved party as it fights for its freedom. That’s what happened at this G-7.”

However it’s done, making money off other nations’ assets—even aggressor nations, such as Russia, in total violation of global norms—is a risky precedent. “Once a new sanction becomes seen as effective, its usage tends to proliferate,” said Jon Bateman, a senior fellow at the Carnegie Endowment for International Peace. “In recent years, creative new uses of export control powers—such as the Entity List and the Foreign Direct Product Rule—have ping-ponged between Chinese and Russian targets, with each country serving as a proving ground for actions later taken against the other.”

Nor did the G-7 leaders stop there. They also indicated that new measures were being considered that might gradually cut Beijing out of the international financial system. While saying in a communiqué that they “recognize the importance of China in global trade” and affirming that they “are not trying to harm China or thwart its economic development,” the leaders obliquely threatened Chinese banks “and other entities in China” with measures to “restrict access to our financial systems.” That could ratchet up the war—and the risks to the system—dramatically.

China has already been quietly insulating itself from financial retaliation over its support of Russia in the past two years, said Hung Tran, a former deputy director at the International Monetary Fund, in a June 21 interview. “The major Chinese banks have been very cautious even in reducing their exposure and dealings with Russia. In place of that, smaller institutions not having any business with any U.S. entity have been set up to handle trade with Russia so that basically Russia-China trade is settled in renminbi and rubles.”

The senior administration official justified the decision to increase pressure on China by saying that “some of China’s actions to support the Russian war machine are now not just threatening Ukraine’s existence but European security and trans-Atlantic security.” The official added that among other “unrivaled policy distortions coming out of China”—meaning its unfair trade practices—Beijing was now openly supplying dual-use components and other economic aid to Russia. “There was unanimous agreement that the Russian military has been sustained by transforming its entire economy into a war machine and because China and other countries have been willing to serve” that effort, the official said.

In a blunt statement during his visit to Beijing in April, Secretary of State Antony Blinken reiterated these accusations, declaring that China was “powering Russia’s brutal war of aggression against Ukraine” as “the top supplier of machine tools, microelectronics, nitrocellulose, which is critical to making munitions and rocket propellants, and other dual-use items that Moscow is using to ramp up its defense industrial base.”

The actions taken at the G-7 summit may well have been necessary. Nearly two and a half years into the war, support for aid from the United States and Europe is flagging, Kyiv’s forces are exhausted, Russia’s economy is still looking fairly robust, and a new anti-Western alignment is hardening between Moscow, Beijing, Tehran, and most recently North Korea. “We are stepping up our collective efforts to disarm and defund Russia’s military industrial complex,” the G-7 leaders said in their communiqué.

This latest approach to squeezing Russia started slowly, even painfully, amid a great deal of tension between the United States and European governments about just how tough to get with Moscow. Immediately following Putin’s invasion of Ukraine in February 2022, none of those governments had a problem imposing the usual economic sanctions—import and export restrictions and the like—and quickly. They took a major step further when they froze Russia’s central bank assets—an unprecedented move against such a large country—in addition to real estate properties, stocks, bonds, and various investments held by Russian oligarchs.

But actually seizing those bank assets was seen as a step too far, especially by the Europeans, who fought off an effort led by the U.S. Congress, and ultimately backed by the Biden administration, to pursue full seizure. That meant tampering with the international financial system itself—the complex postwar network of norms, codes, and laws that has underwritten the greatest surge of prosperity in recorded history and enriched the West. That felt a little too much like playing with elemental fire because it meant threatening the idea of sovereign immunity that is central to the system and because it meant posing increased risks to the holding of dollar- and euro-denominated assets. And having established this precedent, what about China? What effect will the G-7’s warnings have on Xi?

The shot fired in the communiqué could deter Xi from doing even more to isolate China’s ailing economy than he already has—specifically by invading or blockading Taiwan. Or, alternatively, it could mean the beginning of the end of the postwar global economic system if Xi decides to move against Taiwan anyway. Indeed, he could easily gamble that the United States wouldn’t dare do to China what it’s doing to Russia for exactly that reason.

If the United States and West were to respond to an invasion or blockade of Taiwan by freezing and leveraging Chinese assets, the result could be a freeze-up of the whole financial system and a devastating blow to the global economy. In the case of Russia, Washington needed to undergo many months of negotiation with the European Union because the vast majority of Russian assets are held in Europe and there was only about $300 billion or so to freeze. The same is not true of Chinese assets, which are huge and spread all over the world. Under the International Emergency Economic Powers Act, Washington would be able to freeze some $800 billion in Chinese Treasury bill holdings entirely on its own, which is only a portion of some $3 trillion in Chinese-owned sovereign assets overseas. But Beijing could easily retaliate against that nearly $6 trillion in Western investment in China.

As Tran argues, the threat of a kind of financial MAD, or mutual assured destruction, is far too great. In “terms of balance sheet exposures, China has about $3.4 trillion of identifiable international assets at risk of possible sanctions and up to $5.8 trillion of liabilities to, or assets in China of, international investors and companies largely from Western countries. China therefore has plenty of room to take retaliatory actions,” Tran wrote in a 2022 post for the Atlantic Council titled “Wargaming a Western Freeze of China’s Foreign Reserves.”

The deep cross-integration between China and the West is what has led both sides to avoid a complete decoupling of economies, reflecting what former U.S. Treasury Secretary Larry Summers once called a “financial balance of terror.” As a result, “there will be more resistance to imposing the scope of sanctions we have imposed on Russia because Western economies are far more intertwined with China’s than they were with Russia’s,” said William Reinsch, a former U.S. commerce undersecretary now at the Center for Strategic and International Studies.

Reinsch notes there is an important “qualitative difference” as well: “The Russian assets being used are those seized from oligarchs who have supported/enabled Putin. There are some Chinese oligarchs, but their relationship with their own government is much different, as is their role in the economy. If you go beyond oligarchs, you get very quickly to seizing sovereign assets, which I doubt the West would do and for which the consequences would be significant.”

But according to some China experts, the latest moves might only spur Xi to further decouple his economy. The “dimmer” that peaceful reunification with Taiwan seems, “the more incentives Beijing would have to reduce vulnerabilities to sanctions in case of a militarized conflict,” said Zongyuan Zoe Liu, a fellow at the Council on Foreign Relations and columnist for Foreign Policy. “China has been diversifying its foreign exchange reserves since the 2000s. While previously the primary motivation was to search for higher returns and strategic assets, now it is also to reduce vulnerabilities to sanctions.”

And while Xi’s dream of a renminbi-based system still “has a long way to go”—the yuan is a distant fifth in global reserve currency holdings—escalating Western moves “may ultimately weaken international law protections for everyone, not only their intended targets,” Mitchell wrote recently for the Quincy Institute. As a result, “intensified weaponization of Western currencies could indeed boost China’s yuan efforts, and, more significantly, provide a major stimulus to plans for a BRICS basket reserve currency. The move would simultaneously improve Beijing’s reputation as an apparently more responsible actor with respect to foreign assets, while also perversely incentivizing it to further experiment with its own nascent unilateral sanctions regime.”

Russia is much more willing than China to blow up the international system. But that doesn’t mean Xi won’t decide he can afford to see that happen as well. As Tran argues, Beijing has been pursuing a “dual-track” strategy of working within the current Western-led trading system “but also wanting to find alternative ways to do this trade without being exposed to dollar sanctions.” Further sanctions could only push Xi further in the radical direction of trying to set up an alternative renminbi-based financial trading system.

“Both sides are kind of upping their ante,” Tran said.