Are US sanctions on Russia harming USD supremacy? Ever since the US announced its unprecedented package of financial sanctions on Russia, a growing contingent of analysts and economists have warned that the measures risk undermining the greenback’s reserve currency status and balkanizing the global monetary order. The US Treasury’s ‘shock and awe’ move to sanction the central bank, something never attempted on an economy of Russia’s size, could have unintended consequences by causing other countries to rethink their relationship with the USD, they say.

The IMF is voicing concern: The IMF’s deputy managing director, Gita Gopinath, said just that last month. “The USD would remain the major global currency even in that landscape but fragmentation at a smaller level is certainly quite possible,” she told the Financial Times in an interview last month. “We are already seeing that with some countries renegotiating the currency in which they get paid for trade.”

The USD is the world’s reserve currency. Central banks across the world store most of their reserves in USD or in USD-denominated assets such as treasuries, and the bulk of international trade and financial transactions are performed using the greenback. How much of global reserves are in USD? The most recent data from the IMF shows that the currency makes up around 55% of the world’s foreign exchange reserves. In comparison, the next most-popular FX currency is the EUR, which accounts for less than 20% of the global total.

Crucially, foreign currency reserves are hardly ever held physically by the central bank, making them vulnerable to appropriation by other countries. Most of the world’s reserves are held as securities, which are stored in central securities depositories (CSDs) either in the host country or with a major international CSD such as Euroclear. For more information on this: Read monetary economist and payments specialist Ousmane Mandeng’s piece in the FT where he explains the financial plumbing of international reserves.

The USD as a weapon: In recent years, the US has used its control of the global financial system as a coercive foreign policy tool with increasing regularity. Iran, Venezuela and most controversially Afghanistan have all had their reserves frozen and been excommunicated from the USD system.

Moscow thought it had itself covered: Since dragging itself out of its financial crisis in 1998, Russia has been busy accumulating a vast stockpile of reserves which is now worth more than USD 630 bn. This, policymakers thought, would hand the central bank more than enough firepower to support the RUB should the US intensify its trade and financial sanctions. It had also worked to reduce its holdings of USD assets to less than 7% of its total reserves in a bid to reduce its exposure to the greenback.

So much for that warchest…: Prior to the conflict, few genuinely expected the US to go straight for the Russian central bank and most held up Russia’s huge reserve stockpile as a powerful  buffer against future financial crises. But just four days into the invasion, Washington went for the jugular. Together with the EU and Japan — which together hold more than 40% of Russia’s reserves ⁠— the US confiscated some USD 300 bn from the Russian central bank. The measure blindsided the Russians, with Foreign Minister Sergei Lavrov admitting last month that no-one in Moscow had predicted that the G7 would go for its reserves.

Other countries are watching: For countries holding a substantial portion of their reserves in USD assets, the sanctions on Russia have been instructive on how Washington is able to leverage the dominance of the greenback to mount financial warfare against hostile countries. Importantly, most countries outside of the G7 are not on board with sanctions. Major emerging economies such as China, India, Brazil, Indonesia and Mexico have refused to embargo Russia and are eager to continue business.

A “major break” in the system: For these countries, the sanctions are a potential watershed moment that could push them to reduce their exposure to the USD and transition to new bilateral and regional financial relationships. Economist Kenneth Rogoff called the decision “absolutely historic.” It will “probably accelerate moves in the international financial system” to compete with the USD, he said earlier this month. Shahin Vallee, economist at Soros Fund Management, called it a “major break” in the international financial system. “Central bank reserves are now worth as much as the dominant reserve currencies issuing them want. This could have profound long-term consequences.”

And that’s not all: There are also question marks over the integrity of international payment mechanisms after the US and Europe disconnected a large part of Russia’s financial system from Swift, the interbank messaging service used to facilitate most of the world’s cross-border payments. This makes it harder for many banks to process USD- and EUR-denominated payments, and though carve-outs do currently exist — notably for institutions processing oil and gas transactions — most Russian businesses now need to rely on channels such as encrypted telegrams and emails to continue trading overseas. It was a big move and one that will “likely fundamentally change the geopolitics of cross-border payments,” writes Robert Greene, a nonresident scholar at the Carnegie Endowment for International Peace.

Russia + India are moving to drop the USD: Russia and India are on the way to dropping the USD in bilateral trade and replace it with RUB and INR, a move that would allow the two countries to skirt sanctions and maintain their trading relationship. Indian exporters are reportedly waiting on USD 500 mn of payments that Russian banks have been unable to process, forcing Moscow and New Delhi to explore new payment mechanisms including Russia’s SPFS messaging system.

And China is accelerating its move to build an alternative financial system: China has been building its RMB-based answer to Swift — the Cross-Border Interbank Payments System (CIPS) — for a number of years, and though it remains small by comparison, the recent moves against Russia seem to have stirred policymakers into action. China’s central bank recently announced that it would limit the country’s use of Swift and ramp up the usage of the RMB in cross-border trade. The head of the country’s central bank has said it will provide support to countries in Southeast Asia to reduce the use of the USD. Former IMF economist Eswar Prasad called the CIPS a “potential game changer.” “China is setting up an infrastructure for payments and payment messaging that could one day provide an alternative to the western-dominated international financial system and in particular Swift,” he told the FT.

But how close are we really to a displacement of the USD? China still faces challenges. Chinese policymakers remain reluctant to fully liberalize the currency and allow it to be fully-convertible. Having countries store reserves in RMB would be a hard sell if they cannot freely convert it into any other currency. And the fact remains that the RMB is still not used that often in international trade. “We have very accommodative monetary policy, we are very open with our markets, things are easily convertible and we are safe as an economy. Until those things change, the rest of it ain’t changing,” Brian O’Toole, a sanctions expert at the Atlantic Council and former US treasury official told the FT. “Where else are you going to go? There’s no place else that has anything approaching the level of liquidity and access that the US market has. It doesn’t exist anywhere.”