The Russian invasion of Ukraine and the sanctions imposed by the U.S. and its allies have raised questions about the ways China could be impacted.

• That’s what we’ll cover in this issue of the CHINAMacroReporter – and there’s a lot to cover.

Looking at China’s economy, Columbia’s Shang-Jin Wei notes:

• ‘In early March, Premier Li Keqiang announced that China is targeting GDP growth of “about 5.5%” this year.’
• ‘That would be ambitious even without Russia’s war against Ukraine and the attendant increases in global energy and food prices.’
• Add to that ‘the economic costs would be substantially higher for China if comprehensive sanctions, including on energy, are imposed .’

That’s not all. ‘While the crippling economic blows against Russia are applauded in the West, Chinese leaders watch them with great alarm,’ writes Claremont’s Minxin Pei.

• With good reason.

Beijing knows if it is a little too supportive of Russia, China could face sanctions itself.

• And, its leaders, with a ringside seat to the effect of the Russian sanctions, especially the SWIFT ouster, know China could be in for worse if it invades Taiwan.

Minxin Pei again: ‘Although the same type of economic sanctions leveled at Russia would unavoidably hurt Western economies, they could be catastrophic for China in the event of a war across the Taiwan Strait.’ – or not.

• These last points are questioned by Harvard’s Ken Rogoff, who writes:

‘Many academic studies of globalization’s net benefits suggest that sanctions on China or a break in Sino-American economic ties probably would have a smaller quantitative impact than one might think, at least over the medium to long term.’

• But the studies Dr. Rogoff cites don’t include China’s being kicked out of SWIFT and other financial sanctions, so the impact could be massively greater on China and the rest of the world.

In any case, China’s leaders would no doubt agree with him when he writes:

• ‘That is the theory, at least. It would be much better not to test it.’

China’s leaders would also no doubt agree with Dr. Pei:

• ‘The only insurance China has to protect itself against such perils is to sanction-proof its economy.'

That said, China had already begun on the path to ‘self-sufficiency’ years before the Russian invasion.

• And it is making progress toward that end in areas like technology.

But the really tough challenge is becoming independent of the dollar-dominated international payment system and SWIFT.

• The key to that is the internationalization of the RMB.
• And, as Dinny McMahon says, that could be 10-15 years away, if ever.

In the meantime, some contend, China has a payment system, the Cross-Border Interbank Payment System or CIPS, that could make it independent of SWIFT.

• Not so, says Bloomberg,

It’s answer to the question, ‘Is there an alternative to SWIFT?’:

• ‘Not really, or at least not yet.’

‘China has CIPS.’ but it’s mainly a settlement system for renminbi transactions that also offers some communication functions.’

• ‘Most banks that use CIPS still communicate via SWIFT.’
• ‘And CIPS is minuscule compared to SWIFT’

Who would have thought that SWIFT could be so interesting?

part one | China. Consider yourself warned.

The U.S. has repeatedly warned China against aiding Russia. For example, National Security Adviser, Jack Sullivan, told a press briefing:

• “We are communicating directly, privately to Beijing, that there will absolutely be consequences for large-scale sanctions, evasion efforts, or support to Russia to backfill them.”
• “We will not allow that to go forward and allow there to be a lifeline to Russia from these economic sanctions from any country, anywhere in the world.”

Just in case China didn’t get the message, Politico EU reports that Ursula von der Leyen, president of the European Commission told Xi Jinping at last week’s EU-China Leaders Summit :

• "We expect China, if not supporting the sanctions, at least to do everything not to interfere in any kind. No European citizen would understand any support to Russia's ability to wage war.”
• “Moreover, it would lead to a major reputational damage for China here in Europe — the reputational risks are also the driving forces in the exodus of international companies from Russia."

So far, to avoid the possibility of secondary sanctions and other punishments, as well as the hit to its reputation, China, although not imposing sanctions, appears to be abiding by the sanction regime imposed on Russia.

• As Bloomberg notes:

‘China hasn’t joined western countries in sanctioning Russia and has vowed to continue normal trade relations with Russia, which is seen as a strategic partner.’

• ‘But U.S. Treasury Secretary Janet Yellen said in a March 10 CNBC interview that she hadn’t seen “evidence that China is providing Russia with any significant workaround for our sanctions.” ’

‘It’s unlikely that China’s largest state-owned banks would seek to bypass Western sanctions, considering that their international operations require access to dollar transactions, which could be cut off if they were caught via so-called secondary sanctions.’

• ‘Two of the biggest, Industrial & Commercial Bank of China Ltd. and Bank of China Ltd., have already restricted financing for purchases of Russian commodities, especially in dollars.’

This, even though, as China’s Foreign Ministry spokesperson Zhao Lijian said at a daily briefing that his country:

• “Disapproves of solving problems through sanctions, and we are even more opposed to unilateral sanctions and long-arm jurisdiction that have no basis in international law.”

But China’s abiding by the sanction regime doesn’t mean that China’s economy is not feeling the impact.

part two | Russian sanctions impact on China's economy

Even without direct sanctions, China is feeling the effect of the Russian sanctions on its economy.

• And knows the risks that more sanctions would bring.

In ‘Will China Hit Its Growth Target?,’ Columbia’s Shang-Jin Wei notes:

• ‘In early March, Premier Li Keqiang announced that China is targeting GDP growth of “about 5.5%” this year.’
• ‘That would be ambitious even without Russia’s war against Ukraine and the attendant increases in global energy and food prices.’

‘Today, both the Ukraine war and an expected series of interest-rate increases by the US Federal Reserve this year have made the external environment much less favorable to growth.’

• ‘The OECD estimates that the recent spike in energy and food prices triggered by the conflict will reduce global GDP growth by more than one percentage point.
• ‘Given that China is a big importer of oil, gas, wheat, and other commodities, its growth could slow by a similar amount.’

‘Rate hikes by the Fed – the first of which came on March 16 – will likely further depress emerging-market growth.’

• ‘This will occur through a combination of reduced export demand in high-income countries, capital-flow reversals away from developing countries, and possible foreign-currency debt crises.’

‘China can mitigate these risks to some extent.’

• ‘For example, by not participating in the Western-led sanctions against Russia, China may be able to purchase gas, petroleum, and other products from Russia at pre-war prices.’
• ‘China may also be able to withstand higher US interest rates better than many other developing countries.’

‘But it will be difficult for China to offset these two negative external factors completely.’

• ‘After all, lower growth and higher uncertainty in other parts of the world will translate into reduced demand for Chinese exports, implying a net negative impact on growth.’

The biggest risk to China’s economy would be sanctions on Russian energy.

• In ‘Can Sanctions on Russia Work Without China?,’ Dr. Wei notes:

‘Based on data from 2019 (the last full year before the pandemic), China is Russia’s largest trading partner, accounting for about 14% of Russia’s exports and 19% of its imports.’

• ‘More than 60% of Russian exports to China are crude oil and refined petroleum, which – at least for now – are exempt from the European Union’s sanctions.’

‘If the West decided to target Russia’s energy sector, and China replaced its energy imports from Russia with imports from the Middle East or other regions, gas and electricity prices in the United States, Europe, and elsewhere would likely spike further.'

• ‘But, ‘the economic costs of comprehensive sanctions, including on energy, would be substantially higher for China.’
• ‘These additional costs could jeopardize the Chinese government’s GDP growth target (about 5.5% in 2022) at a time when domestic demographic forces, tighter regulations, and geopolitical tensions with the West are already putting tremendous downward pressure on growth.’

part three | SWIFT risk

1 | Sanction Proofing

Beijing wants to avoid Russia's outcome if China ends up on the receiving end of sanctions some day. As Minxin Pei writes in ‘China's long game has just gotten a lot harder’:

• ‘While the crippling economic blows against Russia are applauded in the West, Chinese leaders watch them with great alarm.’

‘Their country is far more economically tied to the West than Russia is.’

• ‘Although the same type of economic sanctions leveled at Russia would unavoidably hurt Western economies, they could be catastrophic for China in the event of a war across the Taiwan Strait.’

‘The only insurance China has to protect itself against such perils is to sanction-proof its economy.’

• ‘This may sound appealing in theory, but in reality, the costs would be astronomical.’
• Besides completely reversing China's opening to the West that began in 1979, such a fateful pivot would mean transforming a globally integrated economy that recorded $6.05 trillion in total foreign merchandise trade in 2021 into a closed war economy.’

That said, China had already begun on the path to ‘self-sufficiency’ years before the Russian invasion.

• And it is making progress toward that end in areas like technology.

But the really tough challenge is becoming independent of the dollar-dominated international payment system and SWIFT.

• That financial sanction proofing is a challenge.

2 | ‘The race is not to the swift.’ Really?

During the U.S.-China trade war, Trump hardliners contemplated excluding China from SWIFT, the main messaging network through which international payments are initiated – and the main currency is the U.S. dollar.

• No SWIFT, no dollar transactions.

But China didn’t get kicked out. And that’s a good thing.

• As Kurt Tong notes in ‘Hong Kong and the Limits of Decoupling: Why America Struggles to Punish China for Its Repression’:

‘Such an attack would lead to global financial instability, lost national savings for the United States, and redoubled Chinese efforts to create an alternative to the dollar-dominated SWIFT payments system.’

• ‘All of those developments would significantly damage the U.S. economy.’

SWIFT is such a strong sanction that it took longer than the initial sanctions to persuade some U.S. allies to act.

• And when they did, the ban wasn’t comprehensive.
• But now China has a front-row seat to what happens to the Russian economy without SWIFT.

As the Chinese government-backed news platform, Global Times, notes:

• ‘Since late February when the Ukraine situation [never “war”] aggravated, non-Western countries and their leaders, the wealthy industrialists and individuals, and national security scholars and strategists there, were astounded to find out that the US government, together with its allies, threw Russia out of the SWIFT international financial messaging regime.’
• ‘And, the West went to the extreme to freeze all of Russia's overseas assets denominated in US dollar, euro and Japanese yen.’
• ‘Even Switzerland, a well-known neutral nation for a long time, followed suit by freezing Swiss bank accounts of Russia and its nationals.’

To be sure readers get the message:

• ‘As a colossal economy of more than $18 trillion, China should be on high alert and phase in a set of contingency plans in case the US and its allies decide to take on China.’

3 | Wait. Doesn’t China already have its own version of SWIFT?

In Bloomberg’s excellent Quick Take, ‘Why SWIFT Ban Is Such a Potent Sanction on Russia’ (and I’ll add on China), the question ‘7. Is there an alternative to SWIFT?’ is answered:

• ‘Not really, or at least not yet.’

And another Bloomberg Quick Take, ‘Why China’s Payment System Can’t Easily Save Russian Banks Cut Off From Swift,’ explains more:

‘2. Is CIPS a rival to SWIFT?’

‘They’re not direct competitors.’

• ‘China has a payment system known as the Cross-Border Interbank Payment System, or CIPS.’
• ‘Whereas SWIFT is a messaging system for global banks to communicate, CIPS is mainly a settlement system for renminbi transactions that also offers some communication functions.’
• ‘Most banks that use CIPS still communicate via SWIFT, either out of habit or because they don’t have the CIPS-specific messaging tool installed, or both.’

‘By size, CIPS is miniscule compared to SWIFT, which has more than 11,000 members and handles more than 42 million transactions a day.’

• ‘As of February CIPS had about 1,300 participants, primarily in China, and processed about 13,000 transactions a day.’

‘4. Why was CIPS created?’

‘It’s part of China’s strategy to encourage global usage of the renminbi, which remains small compared to the size of China’s economy.’

• ‘(The yuan was only about 3.2% of global transactions in January, according to SWIFT).’

‘It’s also seen as a way China is seeking to decrease its dependence on the Western financial system and use of the dollar, especially after the U.S. extended economic sanctions on Iran in 2010 and then sanctioned Russia for its invasion of Crimea in 2014.’

‘5. Could CIPS be used to bypass western sanctions?’

‘It would only work if the transactions are in renminbi .’

• And the great majority aren’t, so China’s financial sanction proofing has a long way to go.

part four | Financial sanction proofing

The problem remains for China that sanction-proofing from being thrown out of SWIFT and having its foreign reserves frozen requires the internationalization of the RMB.

• But this may be the toughest of all to sanction proof.

As Dinny McMahon said at one of our recent CHINARoundtables:

• ‘There has been an awareness in China for quite some time that it is genuinely exposed to the sorts of measures that are being imposed on Russia.’
• ‘And that its exposure to the dollar is a strategic vulnerability.’
• ‘The West's response to Russia's invasion of the Ukraine will increase the urgency and accelerate Beijing's timeline for achieving some sort of decoupling.’

‘Since about 2018, China’s developed a strategy that can be probably best considered RMB internationalization 2.0.'

• ‘We're at the very early stages of it being implemented.’
• ‘And it's difficult to say which parts, if any, will be successful.’

‘But these are the three moving pieces to watch for.’

• ‘The first is about making the renminbi at least as easy and cost-effective to use as the dollar.’
• ‘The second is to promote the use of the renminbi for cross-border trade, invoicing, and settlement.’'
• ‘The third is to develop China's domestic and offshore capital markets such that foreigners are both willing and able to invest in renminbi-denominated assets.’

‘Reducing that vulnerability is very much dependent on how the rest of the world responds to China's domestic changes.’

• ‘And how the rest of the world continues to feel about the dollar in the future.’
• ‘It also depends on China's willingness to pursue the domestic reform, particularly with regard to capital account liberalization.’
• ‘So there's a whole lot of things that kind of need to come together all at once for this to work, for China to genuinely become independent of the dollar.’

‘China realizes that its ability to make itself less exposed to that is going to take a lot of time:’

• ‘I've been working on a project on China's efforts to decouple from the dollar. (And needless to say, that's taken on a degree of relevance over the last few weeks that I hadn't quite anticipated.)’  
• ‘My research partner thinks it will take about 10 years for China to reach a point where it can comfortably function with a minimal use of the dollar.’
• ‘I am inclined to think that this was a generational project - maybe we're talking about at least 15 years.’

‘That’s largely because so much of what needs to occur isn't in China's hands.’

• ‘It will be the result of decisions made by foreign firms and governments, and this really comes down to is the rest of the world's willingness to use the renminbi.’
• And there are few compelling reasons to use the RMB instead of the U.S. dollar.

But as China can see with the Russian sanctions, SWIFT is on the table.

• And for what the U.S. and its allies consider an egregious breach – say, China’s invasion of Taiwan – China knows it could face the ultimate decoupling from the international financial system, despite the damage it could do to those imposing the sanction.

part five | Weathering sanctions

The flip side of sanction proofing is the ability to weather the impact of sanctions – and here, because of China’s position in trade and finance, that means the impact on the world as well as China.

• For China, this could be the limited impact of secondary sanctions brought on by assisting Russia a little too much, or Russia-style sanctions brought on by something huge, again like the invasion of Taiwan.

As noted above, Minxin Pei writes in ‘China's long game has just gotten a lot harder’:

• ‘Although the same type of economic sanctions leveled at Russia would unavoidably hurt Western economies, they could be catastrophic for China in the event of a war across the Taiwan Strait’ – or not.

These last points are questioned by Harvard’s Ken Rogoff in ‘Can the World Afford Russia-Style Sanctions on China?’. You might recall that Dr. Rogoff and a colleague caused a stir among those who analyze China’s economy when their research concluded:

• ‘The outsize impact of real estate and related services on Chinese GDP – a staggering 25%.’

From his research on the ‘what if’ China incurred Russia-style sanctions, he reports:

• ‘Many academic studies of globalization’s net benefits suggest that sanctions on China or a break in Sino-American economic ties probably would have a smaller quantitative impact than one might think, at least over the medium to long term.’

‘One recent study found that decoupling global value chains, which would be hugely affected by a reduction in trade with China, would cost the US only 2% of GDP.’

• For China, the cost might be higher, but still only a few percentage points of GDP.’

‘Many academic studies estimate a smaller-than-expected quantitative impact from a US-China economic rupture.’

• ‘That is the theory, at least. It would be much better not to test it.’

Note: The studies that Dr. Rogoff cites don’t, as far as I can see,  include the impact of financial sanctions like cutting China out of SWIFT.

• My guess is that these would generate tremendous contraction of China’s economy as well as those of the sanctioning countries – so it really is better not to test it.