"Geopolitical Risks Deepen 'Financial Weaponization'... Dollar Hegemony May Weaken"

Acceleration of Movement to Escape US-Centered Financial System
Increased Potential of Virtual Assets as Alternative Payment Methods
Need for Response Including System Improvement Related to State-Issued Virtual Assets

[Image source=Yonhap News]

[Asia Economy Reporter Minwoo Lee] As geopolitical risks increase globally, "economic security" has emerged as a key issue, and finance is naturally operating as a weapon. An analysis suggests that the more severe this phenomenon of "financial weaponization" becomes, the weaker the power of the weapon is likely to be. This is based on the judgment that demand for new financial instruments, such as alternative settlement assets, may grow further to break away from hegemonic powers.

On the 28th, the Korea Institute of Finance published a report titled "The Impact of Increasing Geopolitical Risks on the Financial Sector," which contains these findings. The report diagnosed that as geopolitical risks rise?from supply chain issues triggered by COVID-19 to the Russia-Ukraine war and conflicts between the U.S. and China?the phenomenon of financial weaponization will intensify. Similar to increasing access for one’s own country or allies and reducing access for hostile countries to key resources such as raw materials and semiconductors, financial services are also expected to face increasing regulations. For example, immediately after Russia invaded Ukraine, Visa and Mastercard restricted card usage for Russian citizens, which aligns with this context.

Financial weaponization is not a new phenomenon in the U.S. dollar-centered international financial system. However, recent increases in geopolitical risks have heightened the possibility of such financial weaponization. More importantly, paradoxically, the more severe the financial weaponization becomes, the weaker the weapon’s effectiveness may be.

Yoon Seok Lee, Senior Research Fellow at the Korea Institute of Finance, emphasized, "If relations with the country leading the international financial system are poor, there is a higher likelihood of choosing exit strategies in preparation for usage restrictions." He added, "As geopolitical risks increase and financial weaponization intensifies, 'localization of payment methods' will progress, potentially weakening the power of the hegemonic currency."

In fact, Russia is trying to reduce its dependence on the U.S. dollar by disposing of U.S. Treasury bonds. Russia’s holdings of U.S. Treasury bonds were over $100 billion (approximately 133.72 trillion KRW) in January 2018 but have now dropped to about $2 billion. Additionally, countries hostile to the U.S., such as China, Russia, and Iran, are actively exploring ways to use their own payment systems?such as the China International Payment System (CIPS) and the Russian Financial Messaging System (SPFS)?for regional trade or financial transactions without relying on the dollar.

The spread of non-face-to-face digital financial services, accelerated by COVID-19, also fuels this possibility. Digital financial services are likely to be actively utilized and developed to promote localization of payment methods, with particular attention on the growth of virtual asset-related services. The research fellow explained, "Although virtual assets are currently stagnant due to incidents like Terra and Luna and minimal related regulations, Ukrainian citizens, immediately after the outbreak of war, exchanged their financial assets into Bitcoin out of concern that their dollar assets might be frozen during evacuation." He added, "This is an example showing that virtual assets can serve as a temporary substitute for existing fiat currencies during crises."

The report advises that the domestic financial sector should also prepare for such changes. Since geopolitical risks are expected to remain high for the time being and have medium- to long-term impacts, the possibility that the U.S.-centered world order and the status of the dollar could be shaken cannot be ruled out. The research fellow analyzed, "In preparation for the realization of significant changes, the Bank of Korea’s foreign exchange reserves and the currency composition of overseas investment assets of pension funds should be considered from a medium- to long-term perspective." He added, "If new digital payment methods such as virtual assets emerge, it is necessary to thoroughly discuss and consider regulatory measures regarding the coexistence possibilities and role-sharing with central bank digital currencies (CBDCs), which are likely to replace existing fiat currencies."