How crises reshaped the world financial system

Writing wistfully in 1919, John Maynard Keynes reflected on how the first world war had brought the first great age of financial globalisation to a crashing end. A few years earlier a Londoner sipping tea in bed could, with just a phone call, “adventure his wealth in the natural resources and new enterprises of any quarter of the world”. If government bonds were more to his fancy than commodities or startups, he could “couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend”. This ability to share “without exertion or even trouble” in the world’s wealth creation was part of “this economic Eldorado…this economic Utopia” in which Keynes had come of age—and which had been shattered by the war that broke out in 1914.

More than a century on, financial globalisation’s second age has given the day trader tapping at her phone a menu of options that would put Keynes’s imaginary gentleman to shame. Though war has returned to Europe, few financial channels have truly been closed. There has been no repeat of the wholesale shuttering of stock and bond markets that took place amid the first world war. The Londoner of 2024 can pick any of dozens of stockmarkets around the world in which to place his money without exertion.

Yet the global financial system is being refashioned once again. Recurrent crises, and the West’s failure to contain their effects, have pushed middle-income countries to deepen their domestic capital markets, strengthen their institutions and insulate themselves from the volatility of international capital flows. American-led financial warfare has incentivised the creation of parallel systems whose chokepoints are beyond Uncle Sam’s reach. Both of these trends have produced a system that is more distributed than the old hub-and-spoke model, one in which countries have options to turn to besides America. A third trend, America’s growing economic conflict with China, may one day force some countries to choose sides. The looming threat is that the entire system fractures.
Start with the countries that have marched determinedly towards self-sufficiency, rather than rely on the vagaries of global capital. The most important such bloc comprises the victims of the Asian financial crisis of 1997-98. What began with a speculative attack on Thailand’s baht, then pegged unsustainably to the American dollar, quickly became a financial and economic typhoon that swept through much of South-East Asia, South Korea and Hong Kong.

The crisis was so damaging in part because corporate and financial-sector debt had risen rapidly in the years beforehand. Much was borrowed from overseas, at short-term maturities and in foreign currency. When Thailand’s exchange-rate peg splintered in July 1997, it quickly became apparent just how risky this was. The central bank was forced to devalue the baht, causing the local-currency value of dollar debt to soar—a pattern which was then repeated in Malaysia, the Philippines and Indonesia. That alone would have been enough to send highly leveraged firms into distress or bankruptcy. But then global investors fled the region en masse, pulling out of positions indiscriminately. The result was a funding crisis in which short-term foreign debt could not be rolled over, leading to more defaults and the deepening of a multi-country economic slump.

In subsequent years, notes Clifford Lee, who runs the investment-banking division of dbs, South-East Asia’s biggest bank, policymakers in the region began to impose more controls on inbound investment. This limited firms’ access to capital, and hence their growth, but also prevented similar vulnerabilities from building up again. At the same time, notes Art Karoonyavanich, also of dbs, Asian governments were busy privatising and listing state-owned firms.

The combination of capital controls, high savings rates and a series of “crown jewel” assets being listed, as Mr Karoonyavanich puts it, breathed life into the region’s own capital markets. Then, as much of the rest of the world fell into the financial crisis of 2007-09 and South-East Asia emerged relatively unscathed, governments started issuing big tranches of sovereign debt in their own currencies rather than in dollars. Now, says Mr Lee, bonds issued by Asian firms tend to be bought up regionally, as deep-pocketed domestic investors outbid counterparts in London and New York.
Meanwhile, in middle-income countries across the world, financial and economic institutions have grown stronger and better able to insulate themselves from the global financial cycle. Many have stockpiled foreign-exchange reserves, enabling them to defend their currencies from speculative attacks or crises. Central banks have become more independent, often adopting inflation-targeting mandates long favoured in the rich world. During the most recent global inflationary surge, monetary guardians in Brazil, Chile, Hungary, Peru, Poland and South Korea started raising interest rates well before the Federal Reserve and European Central Bank—and successfully cooled rising prices.

These developments have steadily chipped away at the West’s dominant role in the financial system, and that has been largely for the good. Stronger institutions are an obvious boon. South-East Asian capital controls have helped stave off instability caused by volatile inflows and forced domestic markets to mature, providing a natural source of patient capital for the region’s fast-growing firms. And they have done so without cutting the region off from international finance. The skyscrapers thronging Singapore’s financial district are still adorned with the logos of multinational banks; foreign capital still flows in and out.

Less benign, though, is the second force reshaping the global financial system: its growing use as a weapon by America and its allies. Economic warfare is not novel. It dates back at least as far as an Athenian ban on trade with Megara, its neighbour, in 432bc. But its 21st-century incarnation, involving not just trade embargoes but the weaponisation of the financial system itself, has taken it to a new level. Trackable electronic payments, together with the dollar’s preponderance in global finance and the centrality of American banks, have granted America’s government an unprecedented level of influence. It has gained the ability to cut banks, or entire jurisdictions, out of the financial system. The inevitable result is that many are seeking alternatives to American-controlled levers of finance.

The long arm of Uncle Sam

America tightened its grip over foreign finance in the wake of the terrorist attacks of September 11th 2001. As the Treasury department searched for ways to prevent future attackers from accessing funding, it alighted on swift, a global financial co-operative whose messaging services facilitate large cross-border payments. Its data could be used to track transactions and uncover links between terrorists and financiers. The same sort of financial mapping helped the Treasury find other ties, too—between foreign banks and countries under American sanctions. The Patriot Act, another product of the 9/11 attacks, then gave the Treasury the power to drive such banks out of business.

This weapon was notably deployed in September 2005, against Macau’s Banco Delta Asia (bda), and then again in February 2018, against Latvia’s ablv Bank. Both times the real target was North Korea. The Treasury accused the banks of enabling the regime to break international law, in part by helping to fund its nuclear-weapons programme, and announced it was considering designating each bank a “prime money-laundering concern”. Under the Patriot Act, this step could lead to American banks being banned from providing “correspondent accounts” to bda and ablv, meaning they could no longer move dollars through America’s banking system. This would stop them from executing dollar transactions for their clients, effectively shutting them out of international finance. For other banks around the world, to continue doing business with bda and ablv would have been to risk designation as money launderers themselves.

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The effect in each case was immediate and dramatic. Global banks withdrew funds from both en masse. Within weeks of the Treasury’s announcements, each faced a liquidity crisis and had its management seized by its regulator. The collapses came so quickly that the Treasury’s accusations could not be challenged in court until it was too late. Now, with the help of an executive order signed by President Joe Biden in December 2023, the Treasury can dole out the same treatment to any foreign financial institutions deemed to be supporting Russia’s military-industrial base.

America and its allies have other ways of excising their enemies from vital parts of the financial system. Since 2008 American banks have been banned from facilitating dollar clearing on behalf of Iranian banks, even for transactions beginning and ending outside America (such as a foreign firm buying oil priced in dollars). Sanctions imposed by the West on Russia’s biggest banks after the invasion of Crimea in 2014 prevent them from raising equity or debt capital in America and Europe; those introduced in 2022 forbid a far greater array of transactions and have cut them off from swift. Such bans have significant knock-on effects beyond America’s borders. A study by Deloitte, a consultancy, in 2009 found that more than half of financial institutions used America’s sanctions list as a guide to which firms they could do business with.

All such sanctions incentivise those that might fall victim to them to devise workarounds, which means reducing their reliance on the parts of the financial system the West controls. For Iran, that means selling oil to privately owned refiners willing to risk America’s ire, and probably doing so in yuan or dirhams rather than dollars. For Russia it has entailed the construction of Mir, a card network run by its central bank to facilitate domestic payments in the absence of Western card companies. The question for China is whether any workaround is even possible to parry the sort of sanction America imposed on Russia in 2022, immobilising a central bank’s foreign-exchange reserves. This in turn raises another question: what effect would taking such action against China have on America?

The increasingly tense economic rivalry between America and China is the third force reshaping the global financial system. Like Russia, China has set up its own payments networks that are shut off from the West, in part to defang any future sanctions levelled against it. But for the more wide-ranging impact of Sino-American sabre-rattling, look to its effects on capital flows around the world.

The most obvious barriers raised by the two countries are in their cross-border investment-screening programmes. America’s Committee on Foreign Investment in the United States (cfius) has long scrutinised inbound investments related to national security. But it has recently become much busier. In 2022, even as deal volumes fell, cfius reviewed 286 transactions, two-and-a-half times the number from a decade previously. Its powers have expanded, too, with Mr Biden directing it to focus on supply-chain security and technological leadership. Britain kick-started its own investment-screening regime in 2022, again for national security purposes, and reviewed 866 transactions in its first reporting year. Last year Japan added nine sectors, including semiconductors, to its screening regime for foreign investments. The eu too is contemplating beefing up its own screening rules.

More novel is America’s approach to outbound investment, which is to crimp citizens’ ability to adventure their wealth in new enterprises in at least one of the world’s quarters. An executive order signed last August directs the Treasury to vet investments in “sensitive technologies” (meaning advanced chips, quantum computing and artificial intelligence) in “countries of concern” (meaning China). The justification is that national security trumps investment returns, and that in any case the Treasury will only screen a narrow range of sectors. They just happen to be the sectors about which investors are most excited. And domestic political calculations may well ratchet up the level of vetting. cfius is reviewing a proposed takeover of us Steel, the holder of not-so-sensitive technology, by a company in Japan, a security ally. Robert Lighthizer, Donald Trump’s trade representative, has proposed widening cfius’s remit to include investments that would inflict “long-term economic harm” on America.

Hedging their bets

In the face of all this, it is hardly surprising that international firms and investors are taking action to avoid being caught on either side of the Sino-American divide. Sequoia, one of the world’s most successful venture-capital outfits, announced last June that it would split into separate American, Chinese and Indian businesses. Singaporean bankers talk of hordes of companies moving from China to redomicile in their own, more neutral territory—and even of firms choosing to list there rather than in Hong Kong, despite an expectation that doing so will yield a lower valuation.
A couple of years ago, says a Singaporean banker, the proliferation of cross-border screening rules might have prompted Chinese firms to think twice about whom to solicit as major investors. After all, there would be little value in getting a big chunk of supposedly patient capital from a Western outfit that was then forced to abandon ship by its government. But today that is less of a concern, since the mood has shifted so far that only those already affiliated with China would be likely to invest anyway.

The long-term implications of such fragmentation are worrying for the world economy. Free capital flows give investors more opportunities and firms more funding sources. What is more, the reversal of these flows amid geopolitical strife can cause all manner of problems. The sudden withdrawal of foreign capital can trigger crashes in asset prices, threatening financial stability. It can also make countries more prone to shocks, by removing the ability to diversify risk internationally. So far, that tipping point is some way off. But it is getting nearer: cross-border capital flows have fallen precipitously, and those which remain are increasingly oriented along geopolitical lines.
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