Trans-Pacific View | Economy

With China Sanctions, America Pushes the Limits of Its Financial Power

U.S. diplomacy has developed an unhealthy dependence on sanctions.

By Andrew Rennemo for
With China Sanctions, America Pushes the Limits of Its Financial Power
Credit: PxHere

“Never waste the opportunity offered by a good crisis.” The quote, first attributed to Renaissance philosopher Niccolo Machiavelli, clearly has adherents among the U.S. political class. With COVID-19 driving anti-China sentiment in the United States to a 15-year high in March and nationwide unemployment nearing 15 percent in April, the resurgence in coercive diplomacy against Beijing that ensued shouldn’t have come as a surprise.

The offensive began on May 15, when the U.S. Commerce Department tightened sanctions on iconic Chinese technology firm Huawei. The company and 114 of its international affiliates already faced a U.S. export ban, implemented in May 2019 and followed by months of aggressive diplomacy intended to isolate the firm from Western markets. The new restrictions prohibit companies operating outside the United States from using U.S.-made designs or inputs to produce the semiconductors that Huawei needs for its smart phones and tablets.

Days later, Washington added a further 33 Chinese entities to an export control blacklist for alleged complicity in human rights violations or ties to the Chinese military. Concurrently, U.S. legislators tabled bills that would restrict a federal pension fund from investing in Chinese stocks, limit the ability of Chinese companies to raise capital in the U.S., and sanction Chinese officials responsible for repressing the Uyghur Muslim minority. President Donald Trump subsequently ordered his administration on May 29 to revoke Hong Kong’s preferential treatment as a separate customs and travel territory from mainland China in response to Chinese legislation that undercuts Hong Kong’s system of self-governance.

Media and analyst reactions to those measures have stressed the growing number of issues that now divide Washington and Beijing, prompting questions of whether the two powers are edging toward a new type of cold war. In fact, the moves reveal just as much about the current state of U.S. diplomacy and its unhealthy dependence on sanctions. After years of weaponizing its currency and economy for foreign policy influence, Washington is pushing the limits of America’s financial power.

Punitive Diplomacy

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U.S. overreliance on financial power began after the 9/11 terror attacks, when Washington leveraged the dollar’s role as a global trade and reserve currency to make sanctions a key component of national security. From 2001 through 2019, the U.S. Departments of Treasury, Commerce, and State together designated more than 14,200 individuals and entities under various national security statutes. The Treasury fined the private sector more than $5.7 billion during that time for violating its sanctions programs, which have nearly tripled in number since 2005 as Washington has relied on sanctions to confront an increasingly wide array of foreign policy problems.

Under the Trump administration, this long-term trend has reached record scale. During Trump’s first three years in office, the U.S. Treasury issued over 3,000 sanctions, including more than 1,400 in 2018 alone, the highest single-year total since the department started publishing sanctions data 20 years ago. And those measures, supposedly targeted in scope, have become less so with time. Current population estimates and U.S. government data suggest that nearly 10 percent of the world’s population now lives in countries covered by the U.S. Treasury’s active sanctions programs.

Washington has also projected financial power abroad by more subtle means. The Federal Reserve provides banking and custody services to nearly 180 foreign central banks, relationships that rarely make news but enable monetary cooperation and liquidity during crises like the COVID-19 pandemic and the Lehman Brothers collapse. Yet, those accounts also serve as a source of financial intelligence on America’s strategic competitors and have been used for leverage over foreign governments, most notably to pressure Baghdad into severing ties to Iranian banks and continuing to host U.S. troops in Iraq.

To complement the financial muscle, export controls harness the power of U.S. technology against adversaries and allies alike. Trump’s Commerce Department has specialized in denying tech inputs to the favored firms of geopolitical rivals. The department has also conducted more investigations into the effect of imports on national security over the past two years than it did in the preceding 20, including probes that placed tariffs on aluminum and steel from formerly strategic partners like Japan, Taiwan, and the European Union.

Diminishing Returns

As these technical levers of state for finance and trade have been pulled more often, they have been used in more nakedly political ways. For example, the U.S. Treasury’s Specially Designated Nationals blacklist, long known as a methodically assembled rogue’s gallery of terrorists and traffickers, has been expanded to include several heads of state, foreign diplomats, and even, for a time, the world’s second largest aluminum producer.

Similarly, Washington named China a currency manipulator last August amid heated negotiations over the so-called “Phase One” trade deal. The designation came years after Beijing had abandoned its policy of an artificially weak currency and lasted only five months. It was reversed shortly before the trade deal was signed.

Such tactics make America’s regulatory leadership seem less rigorous and credible to a global audience. This is particularly true in the case of sanctions, which historically have been most potent when they are aimed at apolitical targets and put companies and countries to a clear choice: you can transact with known criminals or the U.S. economy, but not both.

For the international private sector, choosing between ties to a sanctioned front company and access to a $20 trillion knowledge economy couldn’t be easier. The specter of nine-figure fines for even inadvertent exposure to the former hammers home the point. And when sanctions have targeted activity so objectionable that opposition to it transcends politics – drug trafficking, nuclear proliferation, and Islamic State-style extremism – Washington has often found foreign partners willing to adopt its restrictions as their own.

Yet, the U.S. case against Huawei stretches this calculus to the breaking point. The company is the world leader in 5G patents and contracts and regularly undercuts competitors on price. As such, the opportunity cost to countries and companies of foregoing Huawei’s equipment and knowhow is considerable. Washington implicitly acknowledged as much on June 15, when it loosened restrictions on Huawei – just a month after it had tightened them – in order to allow collaboration with the company on 5G technical standards.

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Why China Is Different

More broadly, China’s size and integration with the world economy, while highly imperfect, is too advanced for purely punitive diplomacy to work. A Connectedness Index developed by McKinsey, which considers flows of goods, services, finance, people, and data, assessed China to be the ninth-most connected country in the world in 2017.

Moreover, McKinsey estimates that between $22 trillion and $37 trillion of economic value, or as much as 26 percent of global GDP by 2040, could depend on the degree of engagement between China and the rest of the world economy. With potentially so much value at stake, the United States risks harm to its sanctions tool, longstanding alliances, and ultimately its geopolitical position if its posture remains one dimensional and overly coercive.

The reticence among some of America’s closest allies to adopt a hard line against China underscores the point. Despite U.S. warnings, Israel is participating in Beijing’s Belt and Road Initiative and has allowed more than $600 million in Chinese investments in Israeli start-ups since 2018. Meanwhile, heated debate continues in London over Huawei’s role in developing Britain’s 5G mobile networks and the broader national strategy for engaging China. While neither U.S. ally is in danger of choosing commerce with China over strategic ties to the United States, their refusal to reflexively bandwagon with Washington highlights the growing geopolitical leverage that Beijing derives from its economic size and technology.

Outlook

Over the long term, serious overreach with allies and trading partners has the potential to degrade the dollar’s role as the world’s trade and reserve currency. At first glance, its dominance in global commerce might seem unassailable. The dollar features in 88 percent of foreign exchange transactions, well ahead of the 32 percent market share of its closest competitor, the euro, and the 4.3 percent held by the Chinese renminbi. Central banks similarly keep roughly 62 percent of their reserves in dollars, compared with 20 percent in Euros and fewer than 2 percent in renminbi.

Yet, the dollar’s position is not pre-ordained, and from Beijing to Brussels there is no shortage of ambition to cultivate a global currency. To safeguard its privileged position, Washington needs to be a more careful steward of its currency and economy, and that means being more discerning in its use of coercive diplomacy, particularly where the world’s second largest economy is concerned. Otherwise, even its allies might one day conclude that they neither love nor fear the United States, and that trading under its rules is no longer worth the political cost.

Andrew Rennemo is a member of Chatham House. He has held roles in U.S. government focused on transnational threats and as a management consultant with PwC for risk and compliance and forensic investigation.