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Ukraine war: 1 year on
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China’s currency has benefited considerably from Russia’s de-dollarisation efforts, with a significant increase in the yuan’s use in trade. Illustration: Lau Ka-kuen

Ukraine war, 1 year on: conflict presents China, US with financial-decoupling woes that weigh on both

  • The impact on Russia from its aggression in Ukraine serves as a reminder that Beijing must prepare for the worst as it manages bilateral ties
  • Further straining of relations between the United States and China threatens far-reaching implications for global trade that leaders on both sides are trying to guard against
Russia’s invasion of Ukraine in February 2022 has led to tens of thousands of deaths on both sides and created Europe’s largest refugee wave since World War II. In this multimedia series marking the one-year anniversary of the conflict, we look at China’s response to what Russian President Vladimir Putin called a “special military operation” and its diplomatic, military and economic impact.

China has been taking steps toward boosting its own currency overseas and empowering its contingency-payment and settlement systems in the past year, as the Ukraine war significantly altered the geopolitical landscape and also China’s strategic thinking in regard to international financial regimes.

US dollar hegemony has been a frequent target of criticism by the Chinese government in recent years, with the US-China trade war plunging bilateral relations to a decades-low point, and the ongoing tech-decoupling endeavours of the Biden administration have raised concerns of an all-out clash.

The impact on Russia from its aggression in Ukraine has included a measurable cost of financial decoupling, and for China it serves as a reminder that Beijing must manage bilateral ties and prepare for the worst, according to analysts.

Sweeping Western sanctions against Russia – including the freezing of central bank reserves, kicking major banks off of the Swift financial messaging service, and imposing a price cap on crude-oil exports – have dealt heavy economic blows.

What does the Russia-Ukraine war mean for China’s energy security?

It also sent shock waves through Beijing’s policy circles, as fears grew that China could also find itself in the cross hairs for being diplomatically close to Russia, or that escalated bilateral conflicts could follow.

“Weaponisation of the US dollar has damaged its credibility the most, making it an increasingly high-risk asset,” said Zhang Monan, deputy head of the US and Europe research division at the Beijing-based China Centre for International Economic Exchanges (CCIEE).

“Also, the uncertainty of secondary financial sanctions generated a chilling effect. It will force many countries to think about how to evade such risks.”

Many policy advisers, including Yu Yongding of the Chinese Academy of Social Sciences, have openly expressed worries over the safety of China’s massive overseas assets.

Ding Yifan, a senior fellow with the State Council’s Development Research Centre said the dollar’s weaponisation also violates international rules.

“What if we are targeted as a rival?” he asked.

15:17

Russia invaded Ukraine 1 year ago. What has happened so far?

Russia invaded Ukraine 1 year ago. What has happened so far?

The authorities need to strengthen their capability to strike back, such as by considering options like dumping US debt holdings under extreme conditions, Ding suggested.

In a quantitative research report published in the Economics Letters peer-reviewed journal in November, Du Xiayi and Wang Zi, two researchers with the Shanghai University of Finance and Economics, said that the West’s economic sanctions could plunge real income in Russia by 11.98 per cent, “mainly by restricting Russia’s access to foreign intermediates”, and that there could be a “permanent decline” in real gross domestic product (GDP).

Russia’s GDP, with an equivalent size to China’s Guangdong province, has contracted by 22.3 per cent since Western sanctions on Russia’s economy after its annexation of Crimea in 2014.

It fell by 2.1 per cent last year, compared with a pre-war International Monetary Fund (IMF) forecast for a 2.7 per cent rise.

“I don’t think it’s been as directly consequential as many people thought, but there are very big costs,” said Randall Germain, a professor of international political economics at Carleton University in Ottawa, Canada. “The coalition in support of sanctions on Russia was very large, broad and strong.”

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However, Germain does not foresee similar intentions against China, noting that the two sides would face heavy losses given how deeply entwined the Chinese and American economies are.

“China is totally different. A totally different situation,” Germain added.

The world’s second-largest economy did face the threat of being kicked out of the US dollar-denominated financial system in the summer of 2020, when Washington sanctioned 14 high-ranking Chinese officials, as well as then-Hong Kong chief executive Carrie Lam Cheng Yuet-ngor, in response to the national security law in the former British colony.
To counter such long-arm jurisdiction, China released rules for an unreliable entity list in September 2020, barring the access of American firms to the Chinese market, and enacted an anti-sanctions law in June 2021.

Although no secondary sanctions on China have been disclosed so far, US officials have repeatedly warned of significant costs if Beijing was found to have helped Moscow avoid the sanctions.

Beijing heavily relies on Russian energy, some of which has already fallen to Western sanctions. It bought 86.2 million metric tonnes of crude oil last year, or 17 per cent of its total crude imports, helping lift bilateral trade value to a record high of US$190.2 billion in 2022.

The yuan has benefited considerably from Russia’s de-dollarisation efforts, with a significant increase in its use in global trade finance and foreign exchange trading.

The Russian finance ministry announced last year that it was doubling the cap of yuan-denominated assets in its US$148 billion National Wealth Fund, to 60 per cent. And in September, energy giants of both countries agreed to settle half of their transactions in yuan and the rest in rouble.

The yuan’s share in the global trade finance market jumped to 3.91 per cent in December from 2.05 per cent two years earlier, according to Swift.

Its weight in the IMF’s special drawing rights currency basket was also raised by 1.36 percentage points to 12.28 per cent, while the yuan reserves held by central banks worldwide rose to 2.76 per cent by the end of September 2022, up from 2.66 per cent a year earlier, according to data from the international financial institution.

To convince the rest of the world to use the [yuan], basically, China has to pay them to do it
Randall Germain, Carleton University

Special drawing rights are an international reserve asset, and the yuan’s weight represents the recognition of its status in the international finance system.

However, the US dollar continues to dominate international financial transactions – it accounts for 41.89 per cent of global payments, 88 per cent of global foreign exchange transactions, 41.73 per cent of the IMF special drawing rights basket, and 59.79 per cent of global foreign exchange reserves.

Meanwhile, around 35 of 49 major export merchandises were denominated by the US dollar, followed by 12 for the euro, highlighting how most trade is settled in US dollars or euros, and not the yuan.

“There’s a little bit of room to grow for the [yuan] as an international currency, but it’s really a kind of regional currency, mostly in Asia,” Germain said.

The slowed liberalisation of capital accounts and the yuan’s convertibility, which is expected to continue under China’s new leadership line-up, has also limited the currency’s growth prospects, according to Germain.

“To convince the rest of the world to use the [yuan], basically, China has to pay them to do it. That’s a bit costly,” Germain added.

What does the yuan’s intensifying internationalisation mean for China’s economy?

Beijing has set no specific timetable nor road map for the yuan’s internationalisation, but it is aiming for an “orderly expansion”, according to government documents.

In a joint circular released in early January, authorities encouraged qualified firms to apply for yuan loans for their overseas projects, while state-owned enterprises were told to use the Chinese currency in their business dealings with overseas subsidiaries, and to extend yuan use in their supply chains.

The CCIEE’s Zhang said the yuan’s overseas use is to primarily serve the needs of domestic development, while also noting that China is under-represented in the international financial system.

The yuan’s shares in global payments, settlements, reserves and foreign-exchange transactions are all lower than its GDP share of around 18 per cent.

“It’s not a matter of whether the yuan can challenge the US dollar, but how long the US dollar hegemony can last,” she said.

What China does is to evade the risks of the US dollar, and to increase its safeguard capabilities
Zhang Monan, CCIEE

Zhang said that the US dollar’s credibility has been deteriorating since 2008, attributing this to Washington’s excessive money printing, ballooning debt, volatility and misuse of the US dollar’s dominance.

Also, the US’ endeavours to revive manufacturing – in line with its goal of reducing bilateral trade deficits – could reverse the flows of US dollars and commodities traded in the dollar, she argued.

“What China does is to evade the risks of the US dollar, and to increase its safeguard capabilities,” she added.

Meanwhile, Beijing’s fears of being financially strangled – by being denied access to the US dollar or having its overseas assets frozen – have accelerated its pace of diversifying its forex assets now dominated in the US dollar, and equipped itself with independent options such as the Cross-border Interbank Payment System (CIPS) and a joint venture with Swift.

How much more is China’s yuan being used in global trade settlements?

Chinese authorities reduced their holdings of US treasury bills to US$867.1 billion by the end of last year – a fall of US$173.2 billion from the previous year, and a 12-year low.

Instead, they increased China’s gold reserves for three straight months from November, taking its total to 65.12 million ounces. China increased its gold reserves for the first time since September 2019 in November by 1.03 million ounces to lift its holdings to 63.67 million ounces.

Cross-border yuan payments through the home-grown CIPS system, an equivalent to the US’ Clearing House Interbank Payments System, increased by around 20 per cent, year on year, to 25 trillion yuan (US$3.62 trillion) in the first three quarters of last year, according to the latest figures, and it has hundreds of global participants through client banks and clearing centres.

The People’s Bank of China also fast-tracked its digital yuan programme, expanding a pilot scheme to 5.6 million merchants in 26 large cities, while international collaboration projects – including the multi-country mBridge central bank digital currency project – have been launched to promote potential cross-border yuan use.

Why should we turn hostile against the US? What would China get from that?
Chinese economist

The latest endeavour was seen in President Xi Jinping’s lobbying of Arabian countries to use the yuan, rather than the US dollar, in bilateral energy deals, during his visit to Saudi Arabia in December.

Some researchers say that domestic de-dollarisation discussions are too emotional, advising Beijing not to make any hasty decisions without first weighing the costs and benefits.

“Russia was forced to quit the US dollar system … It’s a reality that we are somehow living in the US dollar system, and it won’t change in the short term,” said a prominent economist who declined to be named due to the sensitivity of the issue. “Overall, China benefits more from the US dollar system than loses.”

The economist said China needs to consider what might happen in extreme circumstances, but added that a full-scale financial decoupling scenario like has been seen between Russia and the West is very unlikely for China in the short term.

“Why should we turn hostile against the US? What would China get from that? Many things like financial sanctions won’t happen once the two countries reconcile,” the economist added.

Morgan Stanley has already observed China’s pivot to pragmatism in dealing with external relations.

“At the current juncture, China also has little incentive to pursue a hard decoupling,” the investment bank said earlier this month.

China is opening its stock and bond markets wider, while it has pledged to keep foreign investors onshore and lure more with promises of easier access.

China’s merchandise trade with the US also reached a new high of US$690 billion in 2022, according to the US Department of Commerce.

[The US and China] are bound together, economically and financially. Decoupling is not realistic.
Qu Qiang, Renmin University

Qu Qiang, a researcher with Renmin University’s International Monetary Institute, which closely tracks the yuan’s internationalisation progress, said the US consolidated its role when forming a united front with allies against Russia. But he also struck a cautious, rather than pessimistic, tone over the China-US relations.

Financial sanctions are unlikely because its relations with the US are distinct from US-Russia ties, he said.

Instead, the world’s two largest economies should join hands in preventing a global economic recession, instead of confrontations.

“We are bound together, economically and financially,” he said. “Decoupling is not realistic.”

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