Donbass Crisis Will Test The Dollar

Date: 4/6/2021
Author: Mr. X

I hate to say I told you so.

Back in October, which seems like a million years ago, I warned that China was going to roll out a digital version of the yuan. “This is part of a larger play by China to challenge the dollar’s supremacy as the world’s reserve currency,” I said. “In this, it is joined by Russia. Both nations now use the dollar less than 50 percent of the time in bilateral trade, in what some call a ‘financial alliance.’” I also said that in the end, it may come down to a military conflict.

Well, as we speak, American and Chinese naval forces are posturing in the Pacific. A complicated game is playing out in the Middle East, as Russia stands by Syria and Iran while the Biden Administration tries to tempt the Islamic Republic back into the treaty the Trump Administration unceremoniously destroyed. And perhaps more important than all that, the digital yuan has arrived.

The Wall Street Journal breathlessly reported: “China Creates its Own Digital Currency, a First for Major Economy.” It emphasizes what many people still don’t understand – a central bank is now turning “legal tender itself into computer code.” It retraces territory our readers should be familiar with – the relative ease of use, the way digital currency can empower the state to document transactions, and the potential for the digital yuan to “gain traction on the margins of the international financial system.”

While it doesn’t mean an instant overthrow of the dollar, it does mean that China will now be chipping away at the basis of America power. The dollar also has its own challenges to overcome domestically.

Despite (briefly) enjoying united Republican government, the Trump Administration massively accelerated spending and deepened the debt crisis. “Fiscal conservatism” was nowhere to be seen.

Now, after the pandemic, the united Democratic government is in no mood for austerity. Officially, inflation hasn’t hit yet, but rising prices for fuel, lumber, and consumer goods like diapers and toilet paper suggest that it may be on the way… even without a deliberate effort to undermine American currency.

And that effort may be about to happen. Political power is often downhill from economic power. This applies in geopolitics as well as in business. And America’s adversaries are poised to attack the dollar like never before.

The Russian-Chinese alliance is now a simple fact of global politics. It is arguably the product of American hubris after the end of the Cold War. Despite assurances that NATO would not extend to Russia’s borders, the United States has aggressively moved into what Moscow considers its traditional sphere of influence.

Of course, we could argue that we are simply defending the interests of small nations that until very recently felt the heel of the Soviet jackboot. However, for Russia, and especially for the ex-intelligence agent Vladimir Putin, everything is a potential threat. Let’s not forget that Vladimir Putin called the breakup of the Soviet Union the “greatest geopolitical catastrophe of the century.”

Main Cathedral of the Russian Armed Forces Patriot.jpg
The newly constructed “Main Cathedral of the Russian Armed Forces” Image Credit – “Velbes,” Used Under C.C. BY-S.A. 4.0

The 2016 and 2020 elections hardly improved Russian-American relations. While the degree of Russian interference in President Trump’s election may have been exaggerated by some (no, the Russians didn’t literally change votes in the machines), Russia unquestionably interfered in Donald Trump’s favor. The result was an investigation that stretched for years and has made any kind of Russian-American rapprochement unthinkable.

Any Republicans who suggest breaking Russia away from the Chinese orbit by extending a hand of friendship (in an ironic reversal of Richard Nixon’s diplomatic coup) would be called traitors. #MoscowMitch, in reference to GOP Senate Leader Mitch McConnell, is literally trending on Twitter as I write this.

President Joe Biden would have more credibility for such an approach (just like “only Nixon could go to China”), but he’s already called Vladimir Putin a “killer” and refused to apologize. For all intents and purposes, Russia and America are adversaries. We’re one step away from being enemies.

This works to China’s advantage. Long-term, migration patterns and China’s economic growth mean that it can start making claims on Russia’s thinly populated eastern regions. Putin unquestionably knows this, but given American hostility, he must align with China now if he doesn’t want Russia to be crushed in the short-term.

While Putin has the reputation of a geostrategic genius, he’s actually playing with a very weak hand. Russian influence over many former Soviet states has collapsed, direct Russian military aid is needed to prop up Syria, and Russia had to stand by and watch as Turkey helped Azerbaijan win a military victory over Armenia.

Military parades, new cathedrals, and lightning annexations don’t conceal the fact that Russia is being squeezed geopolitically and economically. Living standards are falling. A younger generation that doesn’t remember the collapse of the 1990s are impatient with Vladimir Putin’s autocratic rule and tolerance of corruption. Vladimir Putin already had to deal with the return of political dissident Alexei Navalny by crudely throwing him in prison before the entire world, sparking large protests. Something has to give.

And that something is in Donbass.

One of the West’s great foreign policy triumphs of the last few years was breaking Russian influence over Ukraine with the Euromaidan movement in 2013-2014. That expelled a generally pro-Russian government. While it allowed Russia to annex Crimea, one suspects Putin would have probably preferred to keep influence over all Ukraine. The pro-Russian separatist movements that have established proto-states in the Donbass region of eastern Ukraine are a financial drain on Moscow’s already limited resources.

Flag of the Federal State of Novorossiya#Donetsk People's Republic
Flag of the “Donetsk People’s Republic,” one of the two breakaway states

Now, the Ukrainian army, which is far better armed and trained than it was in 2014, is in a better position to take on the separatists. Russia can’t afford the diplomatic humiliation of “Novorossiya” being crushed. Russia is moving troops to the border.

I think Putin wishes he could just be rid of the problem. However, if Ukraine moves decisively to retake what still is (to most of the world) its territory, Russia will strike back to protect its prestige and its ownership of Crimea. Vladimir Putin himself must strike back to protect his regime.

At that point, the true war on Russia’s economy will begin. The first target – the Nord Stream 2 pipeline to Germany. If canceled, it would be a crippling blow to Russian financial prospects. It might also lead to whispers among Russia’s oligarchs about whether keeping Putin is worth all this trouble. Perhaps, some businessmen may muse, it might be better to make a deal with the West.

However, with China’s new digital yuan, the Russian government has its own way of fighting back. Until recently, Russia was stocking up on gold and likely has formidable reserves. It can join China in the economic war to eliminate the dollar as the world’s reserve currency.

By itself, it can’t undertake such an effort. With China and other powers who might be interested in seeing America weakened (including Turkey, Iran, and Pakistan), Russia could inflict serious costs on the American economy.

The Chinese are unlikely to simply invade Taiwan even if a shooting war breaks out in Donbass. However, it will certainly increase its already provocative moves. It’s already claiming island territories that Japan and the Philippines insist belong to them.

The Chinese have also been stoking nationalism skillfully over the last few years. Despite some noise from the USA, the Chinese Communist Party easily crushed a rebellion in Hong Kong. Corporate America may have had no problem going after Donald Trump, but CEOs (and “woke” celebrities) are mostly silent when it comes to China’s human rights abuses. China’s leaders may feel untouchable – which makes them dangerous.

Chinese leaders might well decide that if America is distracted in Europe, it’s time to move on Taiwan. I think such a decision would be irrational. However, the greatest disasters in history have come when people assumed national leaders would put “rational” economic interests above factors like patriotism, honor, and pride. After all, Chinese leaders might think, what better time to strike than when America is trying to dragoon a reluctant Europe into confronting Russia? Why not hit now when the USA appears internally divided?

America also showed a bit of weakness when Treasury Secretary Janet Yellen called for a global minimum tax rate on corporations. This would presumably prevent corporations from fleeing the tax hikes that will pay for President Biden’s spending programs. Yet why would other countries go along with this? America would need to call on its already diminishing diplomatic, military, and financial resources to get other nations to agree to this plan.

America is not without powerful allies. Japan, Australia, Vietnam (ironically), and especially India would be part of the American bloc in any economic and political conflict. Yet would Europe automatically back the United States? Germany has already defied America on Nord Stream 2. American and European interests are simply not the same. I expect the Russians would be able to create some cracks in the Atlantic alliance rather easily.

I’ll put myself on the line. I fully expect a shooting war to break out in Ukraine very soon. Indeed, some would say it’s already begun, as four Ukrainian soldiers were recently killed by rebel artillery bombardment. Another Ukrainian soldier was killed a few days ago by a mine, and Russia’s media is circulating stories that a Ukrainian drone attack killed a child. It’s getting harder every day for either side to pull back.

I expect Russia will be forced to intervene, though Vladimir Putin will be trying to contain the situation as much as possible. I don’t think he has some master plan to conquer Ukraine. I think he wants out of this quickly. Yet events are conspiring against him.

Flag of Novorossiya#Luhansk People's Republic
Flag of the “Luhansk People’s Republic”

If I had to make a specific prediction, I think Putin will make a token show of force and then quietly agree to some concessions because Russia simply can’t afford a full-scale war in Ukraine. Putin will accept a tactical defeat if America gives him a way out. What I don’t know is if America will give him that dignified exit.

Russian president Vladimir Putin simply does not have the financial and military resources to hold on to eastern Ukraine if Kiev (backed by the West) seriously attempts to reclaim these territories. Politically, he’d be in serious trouble if Russia lost the Nord Stream 2 pipeline and was hit with more sanctions. America does have the power to push Russia hard, and arguably take Putin’s government to the brink of collapse. Yet that would be a mistake on Washington’s part.

In such a situation, Putin’s best move would be to appeal to nationalism and anti-American sentiment. If his regime and personal security is on the line, there’s no reason not to appeal to the memory of the Great Patriotic War once again. He’d also push China to take even more forceful action. If the Chinese follow his lead, the impact on the global economy would be catastrophic. The military situation would be extremely dangerous.

The most rational move for all concerned would be for the admittedly hypocritical situation in eastern Ukraine to simply go on. At some point, Russia could hopefully rid itself of the problem without losing face. Unfortunately, that probably won’t happen for years.

Ukraine won’t concede Crimea anymore than China will concede Taiwan. Vladimir Putin can’t possibly give back Crimea, even if it meant a restoration of normal economic ties. Unless Ukraine is willing to forgo Crimea, the only way this ends is with a post-Putin Russian leader returning Crimea in exchange for normal economic relations with the West. And even Alexei Navalny has said he wouldn’t give Crimea back if he somehow took power.

The real importance of the situation is that it will accelerate a deliberate effort by Russia, China, and other nations to weaken the dollar’s status as the world’s reserve currency. The Wall Street Journal quoted a staffer at the Atlantic Council who said the digital yuan threatens the dollar over the long-term and “anything that threatens the dollar is a national security issue.” Russia and China know that too.

Something close to an economic war between America and Russia/China appears to be inexorable. A shooting war in Donbass seems likely between Ukrainian and Russian-backed forces. Though it will be contained, it could prove to be more intense than what we saw in 2014. I’d be looking to increase my holdings in cryptocurrency and trying to limit my positions in companies that depend on Sino-American trade.

Perhaps I’m being too paranoid or pessimistic. But when soldiers have already been killed and atrocity tales are already circulating, it’s hard not to believe the war has already begun. Maybe I’m not being paranoid enough.

One thing I know for sure is that the real battlefield in this war will be in the currency markets… and the Chinese have just developed a powerful new weapon. The diplomatic crisis in Donbass could prove to be its first test. This is America’s economic “Sputnik moment.” If the USA can’t reply with a digital currency of its own, our long-term decline is virtually assured.


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