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China and the Limits of U.S. Sanctions

Sanctions should be used sparingly, or they won’t be a tool at all.

Many in the international business community assumed the Biden administration would go easier on China than the Trump administration, leading to a quick trade war détente. Yet President Biden’s U.S. trade representative, Katherine Tai, says U.S. tariffs on $370 billion of Chinese imports are here for the foreseeable future. On top of the Trump administration’s tariffs, Biden recently placed human rights sanctions on China, and is looking to craft closer military cooperation with countries surrounding China.

China is responding. Saber-rattling over Taiwan is increasing. China also just crafted a $400 billion agreement with Iran to trade oil for Chinese investment. The deal includes the creation of a joint Iran-China bank, which will help circumvent U.S. sanctions.

But China could be laying the groundwork for an even larger shift in the balance of power, especially when it comes to sanctions. China just announced the creation of a “digital yuan” which could replace cash domestically and, some say, eventually rival the U.S. dollar. The U.S. should take note.

The primary motivation for a digital yuan (or “eCNY”) lies in domestic control. In a cashless society, China’s government can track who spends money on what, and monitor and regulate overall flows of money in and out of China. China’s central planners will potentially be able to see broad dips in spending in real-time and respond with stimulus to offset any large demand-reductions. But there’s a longer-term prospect that the eCNY could allow China to bypass the global banking system, because countries could make direct eCNY payments to China.

Right now, the global banking system flows through Washington because of the world’s reliance on the U.S. dollar. Everyone needs a unit of account they agree on when trading internationally, and the unit of account must be widely available, easily transactable, and instill confidence. When people use dollars to settle international transactions, the U.S. Federal Reserve and banking system act as the central point in this system. Everything dollar-based flowing through the U.S. system gives America immense sanctions and financial power. Yet America’s intensive and frequent use of sanctions has countries like China, Russia, Iran, and even allies in Europe, looking to create a system to evade Washington’s control.

Many fret that—due to Washington’s overspending and overuse of sanctions power—we’ll wake up one day and the dollar will plummet in value and no longer be the world’s reserve currency. In the near-term, that’s unlikely. For global commerce, the dollar is the cleanest dirty shirt out there. The euro is limited by Europe’s fractured political and fiscal system. The Chinese yuan is limited by rule of law issues in China, capital controls, and a history of government interventions. A very small percent of international transactions are denominated in yuan. Even looking at trade between China and the rest of the world, only 10 to 15 percent of transactions are denominated in yuan.

Rather, it is far more likely that the dollar slowly loses preeminence and trade and currency regionalization takes hold. While this won’t be a “crash” in the dollar, the dollar would lose its singular reserve status, and Washington would lose its power—it would have to tighten its belt and would find that its sanctions power was diminished. The digital yuan is a step in this direction, because it would improve cross border payment efficiency which would potentially mean other countries are willing to transact in eCNY without ever touching dollars.

The solution for Washington isn’t panic, or to create a digital currency of our own in order to give the government more control. The solution is to begin to find ways to tighten our belt now, and reduce our multi-trillion dollar deficits, before we are forced to by the market.

The immediate incentive for countries trying to work around the dollar-system is America’s overuse of sanctions. That’s a real shame, because broad sanctions rarely accomplish their desired outcome. A shotgun approach to sanctions both ensures immediate term goals won’t be accomplished, and America’s ability to deploy targeted sanctions in the future, where they would be effective, will be diminished. Having sanctions power is important but abusing it risks undermining U.S. power. Stated differently, there’s no reason for countries outside of China to adopt the eCNY if Washington abandons excessive and broad sanction-use.

President Biden should launch a commission to examine existing sanctions and reevaluate whether they are achieving their desired outcome. The review should also publicly state what America seeks as a condition for lifting sanctions. Permanent penalization and enmity are not proper uses of sanctions. Instead, they should be used to compel specific behavior, and removed once that behavior changes.

Willis L. Krumholz is a fellow at Defense Priorities. He holds a J.D. and MBA degree from the University of St. Thomas, and works in the financial services industry.

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