2022.04 The Taiwan Banker NO.148 / By David Stinson
China Would be Harder to Sanction than Russia, But Still VulnerableBanker's Digest
By all accounts, Russia’s domestic economy was completely unprepared for the unprecedented wave of sanctions that Western countries imposed on it following the invasion of Ukraine. The decision was made within a very tight circle of advisors, and absolute secrecy was preserved until the last minute, aiming for an element of surprise. As a result, the country is now switching to Chinese systems, under duress and at great cost – all of which could have been substantially avoided. China has long watched Russian politics with great interest, and if one day it considers making a similar move on Taiwan, it will approach the situation differently. It is already preparing its financial system to operate outside the reach of US regulators. Meanwhile, in contrast to Russia, which was highly dependent on imported machinery and other productive equipment, China has been working hard to increase its technological self-sufficiency. Nevertheless, it has not achieved economic self-sufficiency, and is unlikely to in any reasonable time frame. China is the world’s largest food importer. A 2020 report by the Chinese Academy of Social Sciences found that China could face a “food shortfall” by 2025. It has stockpiled large amounts of grain, but this is only useful on an assumption of short-term disruption. There is almost no aspect of security more fundamental than food security. Recognizing this situation, Chairman Xi Jinping said in a CCTV address on March 6, “On the issue of food security, we should not be careless at all. We should not think that after becoming industrialized, the problem of food will become optional, and we should not expect to rely on the international market.” The potential for supply interruptions in the wake of the present crisis was probably at the top of his mind, but China is also thinking about other contingencies as well. Food security is financial security Food may seem like a non-financial type of vulnerability, but in fact import dependence is closely related to key financial metrics. The entire reason China has built up approximately US$ 3 trillion in reserves is its use in crisis situations. Its deficit counterparts (such as the US) receive more than they produce for export, while China earns something that it considers to be worth the foregone potential imports. The surplus and deficit countries do have some degree of symmetrical dependence, but it is precisely in a crisis where the surplus side is more vulnerable. This symmetry is however the most difficult aspect of sanctions to plan. In a situation approaching total war, all sanctions are economic, rather than financial in nature. In many previous cases of sanctions, a significant size difference existed between the US and the target country. Russia is already important enough on global markets that Europe’s gas dependence limits the strength of the sanctions; with China, the questions would be economic ability and political will, rather than the much-discussed international status of the RMB. One could imagine a situation where payments were completely disassociated with other economic activity. Digital currencies create the possibility for individuals or firms to deal directly with the central bank, eliminating all intermediaries. This is however not how China’s CBDC, or that of any other country for that matter, is set up. Eliminating banks from the payment flow would constitute a radical restructuring of any economy. Banks are necessary not only for compliance monitoring, but for the more fundamental function of lending. In theory, there may be some ways around central banks’ well-founded reluctance to engage in direct lending. Lower interest rates could make up the difference. Nevertheless, this implementation method can be considered science fiction at the moment. When banks are involved, the balance of power simply reflects the attractiveness of respective regulatory jurisdictions. This is more of a political question than a financial one. Much has been written about the future dominance of the dollar and US use of sanctions, or alternatively, the effect of sanctions use on the dominance of the dollar. This commentary typically highlighted trans-Atlantic disagreements in the use of SWIFT sanctions against Iran or other smaller states. In a real crisis, however, it turned out that no significant gap existed in perception between the US, EU, and even Japan, issuers of the world’s top three currencies respectively. It is inconceivable that an international bank would have no regulatory exposure in one or more of these places. Overseas assets Besides digital currency, as part of its long-stalled push for RMB “internationalization,” China has also created the CIPS messaging system as a local equivalent to SWIFT. This is clearly an inter-bank solution, but the plan is for RMB trading to become significant enough that international banks must pay attention to Chinese regulation. Its 2021 annual transaction volume was US$ 12.68 trillion, worth only a few days’ worth of SWIFT’s transaction volume. The reason why this vision has been unsuccessful so far is that a country must run substantial deficits, as the US has done, in order to become a force on international capital markets. China has thus far been unwilling to open up its capital account, hoping to avoid a run on its currency such as those other countries experienced during the Asian financial crisis. Opening up so would also require internationally-oriented and independent legal institutions. Moreover, the longer it delays its opening, as it becomes increasingly clear that the growth drivers during the opening-up period have become outdated, foreign investors will suspect information asymmetry, i.e. the country is only marketing its second-rate securities overseas. Having delayed this long, it will become increasingly difficult for China to recover its momentum. Capital accounts are also important for another aspect of sanctions: mutual expropriation. Russia recently found that a large portion of its liquid forex reserves were in fact under overseas control. As a result, the central bank to be unable to intervene to stop its currency from crashing. Russia responded by preventing foreign shareholders from withdrawing their funds overseas, although Russia, like China, is also a net creditor, and thus lacked foreign investments on that scale. China’s massive forex reserves are potentially vulnerable to similar action. Statistics published by the US show that China holds about US$ 1 trillion in US securities. This figure represents treasuries held in US custody, which could thus be vulnerable to sanctions. Observers have long suspected that China also has additional holdings through offshore locations like Luxembourg and Belgium. As mentioned above, these jurisdictions are likely to comply with US requirements in a real emergency. It remains unclear to what extent China may be able to sanction-proof its reserves. The flip side of the US’s capital account deficit, meanwhile, is a trade deficit. China provides value to the US through its exports, otherwise the transactions wouldn’t take place, but the question is what kind of value. Are these products easily substitutable? If so, a sudden stop in trade would go towards inflation in China’s export markets, which has the potential to be painful but manageable. The US has paid more attention to supply chain diversification since the COVID outbreak, so this issue is well known. The much-discussed scenario of China dumping US debt, on the other hand, is quite unrealistic. That market is extremely deep, and any temporary disruptions could be relieved by the Fed. Complex consequences It is difficult to predict exactly how the course of events would go in this scenario, considering how unprecedented such an action by China would be. Nevertheless, it is clear that when sufficient motivation exists, political motivation to implement sanctions is linked closely with economic power. This equation worked well in the case of Russia, which had the approximate GDP of Florida. China, an order of magnitude larger, is clearly a more difficult question, yet it still lacks the strength to take on the entire world at the same time. Some smaller countries (particularly in the Middle East) resent the power of the Western world to impose sanctions, and are also not predisposed against China. They however are not prepared to re-orient their trade to China in a way that would take them out of the entire dollar/euro ecosystem. Only Russia itself is considering re-orienting its entire economy towards China. That pairing makes some sense in theory, considering that Russia exports energy, as well as food, while China imports both. At the same time, in its full extent, that transition will be generational task. Russia’s entire history, geography, and economy looks east, rather than south. Ultimately, China’s size also works against it. Its needs are enormous, and any rash actions could affect a billion people. It would need to carefully consider its confidence in being able to access its reserves during a crisis, as well as the consequences of being wrong. Food insecurity is a terrible threat for the US to wield, but this reflects the importance of the norm, forged through two world wars, that territory is not to be acquired by force.