The Challenges of Fragmentation of the International Financial System – Towards a Brave New World Order?
1. Introduction
The emerging new world order will be subject to a number of strong and unexpected effects, transforming and fragmenting the international monetary system. The multilateral world economy has come under the influence of a multipolar power structure, triggering geopolitical tensions, which has led to the creation of economic and financial blocs, and the struggle to strengthen power positions. Financial fragmentation poses risks to international financial and monetary stability.
The development of the world and of humanity has reached a stage when the old order is coming to an end or being substantially transformed. This historic change has implications for the global financial system and financial relations.
Fragmentation of the international financial system has several dimensions depending on the financial market, e.g., in securities markets, banking markets, or payment and credit services. It can arise for a number of reasons other than financial regulation, including natural barriers, market forces, and differences in the institutional environment. Its analysis should include its impact on the efficiency of financial services, including market liquidity, its impact on transparency, consumer and investor protection; and finally, its relationship with overall (global) financial stability. From a substantive point of view, fragmentation can be seen and understood both in the global space and within the framework of national and local jurisdictions.
One of the key reasons behind the emergence of the elements in the international monetary system is that the process of deglobalization has caught up to the process of operational globalization, which had been steadily gaining ground in recent times.
It should suffice to just list recent developments that have triggered deglobalization. In the era of the Fourth Industrial Revolution, the new digital world came into being as an integral part of it, with the rise of artificial intelligence and robotics, the outbreak of the coronavirus pandemic, geopolitical tensions intensified, the energy crisis, global inflationary pressures, trade wars emerged, supply chains were disrupted, and the Russian-Ukrainian war broke out. These processes in themselves brought changes in international economic and political relations, but several effects were interlinked and mutually reinforcing, fundamentally altering the relatively calm post-Cold War environment free of geopolitical tensions.
The fragmentation of the existing world order has three mutually reinforcing and, in specific cases, weakening factors: (i) global political and geopolitical power relations; (ii) changes in economic and trade relations; and (iii) changes in the operating conditions of the international monetary system, and restrictions on the free flow of capital.
2. The historical roots of the changing global order
World War II totally changed the international power structure.
In 1944, the Bretton Woods Agreement was concluded in the USA, which made it possible to lay the foundations for a new world economic system. The International Bank for Reconstruction and Development (1944), the World Bank (1945) and the International Monetary Fund (1944) were created. This meant the establishment of a regulated framework for the international monetary system, and at the same time the United States became the dominant, hegemonic power in the international economic system. The US dollar became the dominant currency of international trade, with the exchange rate of all currencies fixed in dollars and the value of the dollar pegged to gold at a fixed rate.
Subsequently, the North Atlantic Treaty Organization (NATO), a military alliance led by the US, was founded in Washington in 1949, with twelve countries at the time of its signing, now thirty-one. As a result of this process, the United States has become a hegemonic world power. The other pole of world power was the Soviet Union and the Soviet bloc with the Eastern European countries it occupied. The confrontation between these two blocs became more and more acute in all areas, as the creation of the Iron Curtain illustrates. The Cold War era began, and the bipolar world power system was established.
The Helsinki Final Act, adopted by the Conference on Security and Cooperation in Europe (CSCE) and signed by thirty-five countries in 1975, paved the way for the close of the Cold War. However, it finally came about in 1990–1991, when the two Germanys were united and Soviet troops withdrew from the Warsaw Pact countries.
The period following the end of the Cold War created favorable geopolitical conditions for the emergence of global economic and trade relations and value chains. The international monetary system was stable, supported by a system of rules and regulations of international financial institutions, and backed by the monetary policies of independent central banks. At the same time, this bipolar system of world power, marked by the USA and the Soviet Union, was determined primarily by the military balance of power, and directly by their economic and financial systems, and there were several developments and efforts to change it.
In the background of this process, three factors became dominant over time, revealing the fault lines of the bipolar world order. This led to the emergence of a multilayered international monetary system, the foundations of which are changing and being transformed in the new tripartite world order. For a long time, the global hegemonic power of the US was backed by the Bretton Woods system, [1] the International Monetary Fund (IMF), and the dollar-based SDR system. There is strong economic and financial competition between the three dominant players in the world order, the US, China, and the European Union, with the growing trend toward a reduction in the dollar's hegemonic role
The second and most significant event is the creation and development of the European Union. Over the past two decades, the EU has become an economic powerhouse; the development of the Economic and Monetary Union was successful, the creation of the eurozone made it possible to establish the Banking Union, and the Capital Markets Union has developed substantially. From an economic and financial point of view, the European Union became a global geopolitical player, the second pole of the world order.
The next element of this process was that China became a global political and economic player alongside the US and the EU. A tripolar world order was established, which led to a new type of bloc formation backed by major financial and trade agreements. A new force in the future will be the competition between central bank digital currencies (digital dollar, yuan, and euro), which will be crucial for international monetary policy and financial cooperation.
The impact of Brexit has not weakened the international position of the EU, and the euro area in particular, but has strengthened it. In response to the post-Brexit situation, EU authorities but also the EU’s financial centers represented in the EU Roundtable of Financial Centers (a regional chapter of the World Alliance of International Financial Centers), have focused on increasing the EU financial markets’ competitiveness.
In 2022, this tripolar order was hit by an unexpected new impact of the Russian-Ukrainian war. In terms of international financial cooperation and the expected development of fragmentation, this military conflict will have a longer-term negative impact – which cannot be assessed today. Traditional trade flows in a number of products have disappeared or fallen sharply over the period (energy, agricultural, and high-tech products), particularly within Europe, with a knock-on effect on financial relations. Some of the severe sanctions imposed due to the war, including on the financial sector, are effective, but others also affect those who have imposed them.
3. Fragmentation in the New World Order
In the post-Cold War period, in the emerging tripartite world order, China became a global power with the second-largest GDP in the world. The central objective of Chinese economic policy was to ensure sustainable economic growth. One important element of the strategy developed was that the considerable industrial surplus capacity and capital reserves accumulated over several decades as a result of intensive capital inflows should be used abroad. In the post-Cold War period, in the emerging tripartite world order, China became a global power with the second-largest GDP in the world. The central objective of Chinese economic policy was to ensure sustainable economic growth. One important element of the strategy developed was that the considerable industrial surplus capacity and capital reserves accumulated over several decades as a result of intensive capital inflows should be used abroad.
The basis of the "relationship" between the actors in the new power structure is competition, to ensure the financial autonomy and stability of their own bloc. A complete separation of international financial relations between the actors in the new tripartite power structure is not possible. The competition between the blocs they have created is intensifying, and the drive for independence is growing, while the US wants to maintain the leading role of the dollar. All of this leads to the so-called financial strategic divergence between competing blocs and the fragmentation of financial relationships.
The Regional Comprehensive Economic Partnership (RCEP), a free trade agreement signed in 2020, is an example of this strategy, the drive for independence from the dollar and a new element of fragmentation, with fifteen countries, including China, Australia, Japan, Indonesia, and South Korea.
A long list of bilateral or multilateral economic, trade and financial agreements could be enumerated, which have been concluded in the last decade and in some way, individually and together, reinforce the process of the emergence of the new world order. These agreements are having a major impact on global financial markets, increasing the risk of volatility and signaling that member countries that have signed up to these agreements want to reduce their dependence on the existing global financial system, especially the dollar.
In addition to political and military arrangements, the development of financial dependency has become a major factor in influencing the balance of power over the past decade. Its primary instrument is (long-term) lending to partner countries' economies and infrastructure investments, while also determining the currency of such financing and loan contracts.
These regional and bilateral agreements have not strengthened the previous multilateral system. By the end of the last decade, the world had split into a tripolar bloc, known as the "strategic divide". On one side is the USA, on the other the European Union, and on the third side, China and the South-East Asian region. The direct consequence of this divide is the transformation, the "disintegration" of the former financial system. The aim of the competing blocs is to maintain and strengthen their positions of power and influence using a variety of means. Strategies to support this include both attack and defense.
Geopolitical tensions trigger the fragmentation of the international monetary system directly and indirectly through multiple channels, which in turn amplifies the risks to the system. Geopolitical tensions may lead to the introduction of measures restricting the flow of capital and cash, creating unpredictability and uncertainty for investors in international financial relations. Such effects include recent financial sanctions, regulations restricting capital investment and international asset freezes. This increases financial fragmentation, which negatively affects the profitability, liquidity and lending capacity of banks. The vulnerability of negatively affected countries to financial shocks increases.
4. The dangers and risks of global economic and financial fragmentation
The negative effects of the increasing geopolitical tensions of recent years have triggered a process of economic and financial fragmentation and an unwelcome fragmentation of global financial markets to an extent that could threaten international financial stability. Uncertainty caused by geopolitical tensions hampers the conditions for the cross-border flow of capital. The negative impact on capital flows adversely affects foreign investment, creating tensions between investors and host countries. International payment systems may be hampered. As stability is shaken, banks' funding costs rise, their profitability falls, and they reduce their lending. Fragmentation risks can lead to significant economic costs and price increases due to disrupted supply chains, import restrictions, or sanctions.
The historical experience of different economic cycles is that, following a crisis or a tension, a double effect prevails. On the one hand, monetary and fiscal policy is gradually loosening, and the flow of capital movements and leverage is expanding. On the other hand, the lessons of the crisis will be used as a basis for more stringent financial regulation that will trigger international cooperation. Fragmentation can have a negative impact on the stability of the international monetary system, which is important for global economic stability and sustainable growth.
In addition to de-dollarization, the emergence of central banks digital currencies (CBDCs) poses a particular challenge for the transformation of the international monetary system.
Within a short time, it became clear that the applicability of CBDCs beyond national borders could become a tool for increasing international trade and financial influence, and thus global power struggles. All three major geopolitical players in the global economy are now actively preparing to launch their own digital currencies: the digital dollar, the digital euro, and the digital yuan. China is a pioneer in this field, with the digital yuan already being tested in practice and rules for its domestic use being developed. In order to reduce exposure to geopolitical tensions and the negative effects of financial fragmentation, the EU considers it necessary to strengthen European financial integration in addition to preparing for the introduction of the digital euro.
Fragmentation can undermine broader common economic policy objectives, and supervisors, regulators, and financial institutions need to be aware of the risks to financial stability arising from the rise in geopolitical tensions and commit to identifying, quantifying, managing, and mitigating these risks. Several international financial institutions have argued that in the emerging multipolar world order, power players are seeking to give priority to their national and regional interests, while global cooperation would be needed more than ever. Due to increasing geopolitical tensions, the adequacy of the global financial safety net needs to be ensured, which requires high levels of international reserves for countries, the development of bilateral and regional financial agreements, and the provision of precautionary credit lines by international financial institutions.
5. Fragmentation and Central Bank digital currency
In a multipolar world order, the functioning of the international monetary system, which can also be used as a tool for competition between power blocs, is significantly affected by central bank digital currency.
China has been at the forefront of the early implementation and piloting of central bank digital currency. As it has become a dominant player in the world economy and world trade in recent decades, it has sought to use its currency, the renminbi, to gain influence in the international financial market and in the financing of international trade. It is now clear that the introduction and the preparation for the use of the digital dollar is inevitable and that its implementation will have a significant impact not only on the US financial system and monetary policy but also on global financial processes.
Preparations are also underway for the introduction of the digital euro.
The emergence and preparation for the introduction of central banks' digital currencies are not a consequence of fragmentation but can significantly impact its strengthening or mitigating risks. Soon after CBDCs were introduced, groups of central banks agreeing to use CBDCs across borders appeared as the first signs of financial blocs.
These developments confirm that the fragmented international financial environment, the digital era, and the emergence of competing blocks are challenging central banks, requiring them to review their monetary stability, reform their payment systems, and issue their digital currencies. They also confirm that risk mitigation requires stronger international regulatory cohesion.
The cross-border, international emergence of CBDCs will certainly have an impact on the global financial system and power relations.
The first version is that the dollar could retain its dominance, as it will be cheaper and more accessible than its competitors. Alternatively, the United States may lose its global financial dominance as its competitors use their central bank digital currency in blocs organized around themselves, fragmenting the international monetary system. Many countries are under pressure to join the US or China-led bloc, which threatens security, economic growth, and financial stability. With geopolitical tensions already present, the possibility of this happening is minimal.
6. Summary
One of the major questions of our day and age is how the new world order in transition will affect the international monetary system, and how it will reinforce its fragmentation. This is primarily driven by efforts to change the global balance of power, creating strong geopolitical tensions.
In order to achieve power goals, economic and trade relations that previously operated at a global level are changing, and fragmentation is occurring, not triggered by, but as an inevitable consequence of the fragmentation of the international monetary system. Among the means of changing the geopolitical situation and the balance of power, there are military-political, local armed conflicts, which are not the subject of our analysis, but we must be aware that they are important factors in international financial fragmentation.
The three main players in the new multipolar order are the US, China with the South-East Asian region, and the European Union. The first two want not only to defend their positions of power but also to strengthen their economic, financial, and military influence. The primary objective of the European Union is to safeguard the economic and monetary stability of the Union and, within it, the euro area, and to strengthen its geopolitical role.
The rapidly changing and unpredictable international situation has a negative impact on cross-border flows of capital, capital allocation and foreign investment. All of this will undermine the profitability and liquidity of banks, increase financial market volatility, accelerate the contagion of negative effects and threaten monetary stability.
The outcome of the changing world order, and the fragmentation it entails, is unpredictable. Competing blocs would have an interest in preserving the stability of the international monetary system and reducing the expected risks to the international payment system, but this is hampered by geopolitical tensions and the power ambitions of the competing blocs.
This article was written in collaboration with Ádám Kerényi.
The full text of the essay is available in the periodical of the Hungarian Central Bank, Finance and Economic Review:
https://en-hitelintezetiszemle.mnb.hu/letoltes/fer-23-2-e1-muller-kerenyi.pdf
https://en-hitelintezetiszemle.mnb.hu/letoltes/fer-23-2.pdf
[1] The 80th anniversary of its creation will be in July 2024.