The second battlefront has been over the distribution of wealth within countries. The billionaire Warren Buffett candidly told a CNN reporter in 2011 that “there’s been class warfare going on for the last 20 years, and my class has won”. He was right. Structural overvaluation of the dollar has disproportionately benefited the wealthy, as corporate profits have been boosted by outsourcing to lower-cost countries, while US workers have paid the price. This is not just a matter of monetary policy, however. Since the 1980s, extreme ideological leanings towards “free market” policies have led to more regressive tax policies, less rigorous antitrust enforcement, and soaring executive compensation.
China’s rapid growth over the past four decades and the consequent improvement in the country’s living standards have insulated it to an extent from this second battlefront. As the events of 1989 bore witness, however, market-oriented reforms generated considerable social tensions. Further, the government’s suppression of domestic consumption to drive infrastructure and other investment, while successful in achieving rapid economic growth in earlier years, is now contributing to soaring inequality and exacerbating structural imbalances. In the face of the country’s rapidly aging demographics, continued dependence on its top-down investment-led economic model runs the risk of growing resource misallocation. Attempts to export its excess industrial capacity through the Belt and Road Initiative (BRI) have created international frictions. Meanwhile, the stunted development of China’s domestic financial markets means that the rising social welfare burden will weigh considerably on national finances.
In the face of growing domestic social tensions, political elites in both countries have resorted to populist nationalism. The result has been escalating Sino-US tensions, with the Financial Cold War heating up in the form of a widening geo-economic clash.
Since the Trump Administration launched its trade war with China in January 2018, the scope of the conflict has been extended far beyond trade tariffs. Sanctions have been applied against Chinese technology companies. US allies have been pressured to remove Chinese manufactured components from their telecommunications networks. Further, Chinese companies from sensitive sectors have been denied access to US capital markets. Officials from both countries have hurled incendiary accusations at each other and engaged in an unseemly war of words over the origins of the Covid-19 pandemic and interference in Hong Kong affairs. As the geo-economic clash between the China and the US unfolds, there is a substantial risk that this will spill over into broader conflicts that could result in disaster for both nations and the rest of the world.
In practice, the most potent weapon that the US has in its geo-economic arsenal is its influence over the dollar and dollar payment systems. In recent years, Washington has wielded this forcefully in the pursuit of unilateralist agendas. Continued abuses of this geo-economic endowment, however, could precipitate its own downfall, as even traditional US allies have been looking to reduce their dependence on the dollar-based system. One example was the decision by Britain, France and Germany to create the Instrument in Support of Trade Exchanges (INSTEX) in the wake of Trump’s withdrawal from the UN-backed Iran nuclear deal.
In the face of rising threats of US sanctions, China has also sought to reduce its vulnerability. This has included setting up the Cross-Border Interbank Payment System (CIPS) as an alternative to the established SWIFT bank-messaging network and developing its central bank digital currency. These steps are intended to support a more international role for the renminbi in trade settlements. The major factor preventing the renminbi from becoming more widely accepted in global trade, however, is the difficulty international investors have in investing yuan-denominated proceeds. Programs that have channeled investment through Hong Kong have helped increase international appetite for Chinese domestic securities but, to truly internationalize the renminbi, it will be necessary to expand significantly the pool of renminbi securities offshore and to loosen the government’s tight control over China’s financial system.
There are good reasons for Chinese policymakers to proceed cautiously, though. They are acutely aware of the enormous costs the US has borne due to the dollar’s global role and are wary of the volatility associated with liberalizing cross-border capital flows. Unlike the US, China also has limited ability to enforce its anti-tax evasion laws overseas. Further, given America’s control over major international custody and depository infrastructures, greater outbound securities investments by Chinese corporations and individuals would expose China to further risks of the type of financial sanctions that have been applied against Russia. This standoff is ironic, as both countries would benefit from greater outbound investment by China’s savers and a more international renminbi.
Worryingly, the cracks in the dollar-based global monetary system were starkly highlighted by the extraordinary drying up of liquidity in the US Treasury market in March 2020, amid global panic over the economic impact of Covid-19. Financial collapse was averted when the Federal Reserve stepped in to buy up US government and other securities. Since then, US government spending on pandemic relief and stimulus measures has soared; however, this is no longer being funded by international demand for US sovereign debt, but by an unprecedented expansion in the Federal Reserve’s balance sheet.
Concerns over currency debasement have contributed to a surge in interest in cryptocurrencies. Whether such novel challengers to the dollar will pose a serious long-term threat remains to be seen. Growing financial imbalances, however, risk exacerbating both domestic social tensions and international conflicts, and soaring public debt threatens today’s younger generation with unsustainable burdens that will imperil future prosperity and stability.