Dollar Beware

No one can accuse Xi Jinping of lacking ambition. Under his leadership, China is determinedly pushing for regional dominance and global influence while trying to make autocracy the wave of the future by marrying advanced technology to political repression. The two projects have merged in China’s bid to create a widely used digital currency, an initiative that, if successful, will further entrench the Chinese Communist Party (CCP) in power while undercutting the advantages America has enjoyed from the long-term dominance of the U.S. dollar.

For all the talk of a “return of great-power competition,” this rivalry is different from anything the United States has confronted before. America will need a sophisticated, innovative response.

Of all the geopolitical advantages Washington possesses, the dollar’s dominance of the world financial system is perhaps America’s most quietly consequential. The centrality of the dollar gives the United States a financial flexibility other great powers lack, allowing it to borrow at low cost and thereby finance its global military presence alongside its other domestic and international programs. The same feature creates relationships of financial influence that reinforce U.S. alliances and other strategic partnerships. Not least, dollar centrality provides an enviable capacity to punish: American financial sanctions are feared by non-state and rogue actors around the globe.

Now, however, China is challenging America’s financial edge, by creating a digital currency/electronic payment (DCEP) system. Beijing has been exploring this move for several years, but the rollout has accelerated dramatically during the covid pandemic. As with many of Xi’s initiatives, DCEP reflects the Chinese regime’s grandest dreams and deepest insecurities.

At home, DCEP is an effort to fortify the regime’s surveillance and control of its own people. The creation of a digital currency backed by China’s central bank would rein in financial technology firms such as Ant and Tencent while blocking the emergence of cryptocurrencies or other alternative payment methods that might allow Chinese citizens to circumvent a CCP-controlled financial system. Indeed, DCEP is a digital currency but not a cryptocurrency. Because it is centrally issued, its establishment would help the CCP directly monitor its citizens’ transactions.

Abroad, DCEP is meant to increase Beijing’s global influence at Washington’s expense. Today, there is increasing global demand for digital currency, as not just a store of value but as a method of frictionless, 24/7 exchange in an increasingly digital world. Yet the appeal of cryptocurrencies is limited by their speculative nature. In 2019 Facebook, understanding this gap, introduced its own digital coin, called Libra, backed by a basket of currencies and an impressive list of corporate partners.

Regulators around the globe resisted, citing concerns about financial instability and money laundering. But the attempt showed that digital currencies could gain traction and likely encouraged Beijing to accelerate its rollout of DCEP, which aims to harness the appeal of digital currency while providing the security and relative stability of central bank backing.

If the yuan is the only digital game in town, or has a sizable head-start on other digital currencies, Beijing calculates, it can ride the wave of technological adoption to significantly increased global standing. Being an early mover in digitization may create greater leverage and freedom of action for the CCP.

For instance, if DCEP succeeds, Beijing can insist that foreign companies doing business in China maintain digital wallets subject to CCP surveillance. Xi’s government also hopes that DCEP can lay the groundwork for a China-centric digital currency bloc that would weaken the global stature of the dollar and provide protection against the financial sanctions Washington may employ in a sharpening competition. As Zhou Li, former deputy minister of the International Liaison Department, put it in June of 2020, “We must make preparations to break free from dollar hegemony.”

The stakes of Beijing’s gambit are even higher because it unfolds during an unprecedented global printing of money and accumulation of debt by central banks, a trend that predates covid but has accelerated because of it. At the moment, the value of dollar supremacy is attenuated by historically low global interest rates. But if the increase in money supply continues during economic recovery, resulting in global inflation and higher interest rates, different regimes’ competitive positions could once again matter greatly.

The United States is better suited than most countries to weather this scenario. Nonetheless, any sizable future shift in the demand for dollars—toward DCEP, for example—could decrease America’s ability to finance deficit spending without risking increased instability.

To be clear, there is little likelihood of DCEP’s displacing the dollar on a global scale. So far, covid and its associated risks have in some ways made dollar-denominated assets relatively more attractive. Moreover, the future of the yuan as a global reserve currency, digitized or not, is clouded by not just the incomplete internationalization of the yuan but by the high levels of mistrust that many advanced democracies feel toward Beijing.

Still, the potential strategic implications of DCEP are real. If its widespread adoption allows Beijing to reduce its reliance on the SWIFT payments system, the CCP would become less vulnerable to U.S. financial sanctions. In addition, China could more readily use its expertise and technology to help other actors, like North Korea, reduce their own exposure to such sanctions. Further, DCEP might prove attractive to third-world countries enmeshed in China’s Belt and Road Initiative, especially if China uses its broader economic leverage to encourage adoption. And, if use of DCEP becomes more prevalent, Beijing will have greater insight into these countries’ financial transactions, with all the accompanying intelligence dividends.

In sum, China cannot become a true superpower so long as it relies on a financial system dominated by another reigning superpower; DCEP is Beijing’s effort to meet that challenge.

So far, America’s response has been lethargic. Apart from the Federal Reserve, the U.S. government has lagged in seriously considering dollar digitization or in shaping efforts to set global standards for digital currencies. Indeed, in recent years the United States has used financial sanctions so promiscuously that it has led even friendly nations to skirt their use of the dollar. The European Union’s INSTEX platform, created to evade sanctions threatened against European firms when Washington pulled out of the Iran nuclear deal, may portend things to come.

A better U.S. response would be based on five key principles.

First, Washington and its private-sector partners should accelerate the exploration of a digital dollar or Central Bank Digital Currency, while recognizing that significant uncertainties remain. It may be that only a digital dollar can forestall a shift to a digital yuan. Or perhaps America and other countries can reduce the appeal of digital currencies altogether through reforms that would reduce the costs of non-digital currencies. True, the antiquated U.S. financial infrastructure would make such reforms more difficult, but, given the strategic ramifications, America urgently needs to address these issues.

Second, America and its allies, especially those in Europe and East Asia, should develop a common approach to global standards for digital currencies. The focus here, as with other emerging technologies, should be on enshrining standards that support democratic norms rather than autocratic predation.

Third, Washington must show greater restraint in its use of financial sanctions, especially where key allies and other major economies oppose such sanctions. Otherwise, as former Treasury Secretary Jack Lew has put it, we risk undermining the attractiveness of the dollar and, thus, “the source of power behind economic statecraft.”

Fourth, the United States should reinforce the broader global architecture of American power. U.S. alliances and military deployments reinforce dollar centrality and vice versa. Studies show that U.S. allies are more likely to hold dollar reserves when they are more committed to the overall system that American leadership sustains. Thus, combating the perception that Washington is veering into large-scale geopolitical retrenchment or aggressive nationalism is important in preserving American financial influence.

These issues relate to a final principle: the need to systematically integrate diverse types of knowledge and power. The U.S.-China competition has been called a “new cold war,” and studying the U.S.-Soviet rivalry can yield powerful insights about protracted competition against an authoritarian power. But the Soviet Union never wielded China’s economic muscle or had the ability to push the frontiers of technological innovation in the way China does.

The new cold war will be more complex than the old one. Addressing the implications of digital currencies will require bringing together expertise within a variety of government institutions, as well as the tech and financial sectors. It will also call for a deeper understanding of the relationship between familiar tools of military and diplomatic influence and new issues produced by technological change and the shifting global economy.

The idea that great-power competition has returned was the animating theme of the Trump years, and, indeed, the basic rhythms of rivalry don’t change much from era to era. Yet the tools of rivalry do evolve, as does the universe of expertise required to wield them effectively. The United States will only succeed in this new competition if it recognizes that this contest will be, in important ways, distinct from what it has experienced in the past.

Hal Brands, a contributing editor of American Purpose, is the Henry Kissinger Distinguished Professor of Global Affairs at the Johns Hopkins School of Advanced International Studies, a senior fellow at the American Enterprise Institute, and a columnist for Bloomberg Opinion.

Douglas Silverman is the managing partner of Senator Investment Group, a New York-based investment management firm he co-founded in 2008.