The geopolitical risks to the international financial system have increased significantly with the outbreak of the Russia-Ukraine conflict. Such risks include the financial sanctions imposed on Russia by the Western countries, mainly the United States and Europe. Nearly USD 300 billion in foreign exchange reserves have been frozen, and most of Russia's financial institutions have been withdrawn from the SWIFT system. Russia’s “denationization” from the international financial system has dealt a deep blow to its economy and financial system.
Will China be subjected to the consequences of Western sanctions against Russia? Will it face similar direct pressure in the future as the Taiwan situation evolves? At both strategic and tactical levels, China must examine and respond to all of these factors.
The U.S. President Joe Biden and the U.S. State Department and Treasury have repeatedly threatened that China would face serious consequences if it helped Russia evade the sanctions. The move to "weaponize" the international financial system effectively signifies one major repercussion. It will be in the form of the growing influence of geopolitical risks in the international financial system and will further drive the trend toward geo-politicization of foreign exchange.
In a recent speech at the Atlantic Council, Secretary of the Treasury Janet Yellen said that the people had witnessed three major events. The first two events are the current situation facing Russia and the strength of the U.S. with its allies and partnerships. The third event is the importance of the dollar and the euro as a tool for trading and imposing costly sanctions on Russia. At the same time, she believes that replacing the dollar as the global economy’s main reserve currency will take a long time.
Yellen made it clear that the war in Ukraine and the sanctions imposed on Russia had emphasized China's critical role. “Going forward, it will be increasingly difficult to separate economic issues from broader considerations of national interest, including national security”, she said. “The world’s attitude towards China and its willingness to embrace further economic integration may well be affected by China’s reaction to our call for resolute action on Russia”.
Among China’s external financial assets, there are USD 258.19 billion of direct investment assets, USD979.7 billion of portfolio investment assets, US$15.4 billion of derivative assets, US$2,320.5 billion of other investment assets, and USD 3,426.9 billion of reserve assets which accounted for 28%, 11%, 0.2%, 25%, and 37% of the assets respectively.
Meanwhile, among the external liabilities: are USD 3,623.8 billion of direct investment liabilities, USD 2155.4 billion of portfolio investment liabilities, USD 10.3 billion of financial derivative liabilities, and UD $155.16 billion of other investment liabilities, which accounted for 49%, 29%, 0.1% and 21% of the external liabilities respectively.
A huge quantity of hard-to-realize-immediately direct investment assets is invested in underdeveloped nations, primarily in the "Belt and Road" initiative. The direct book losses may not be significant in the context of sanctions. However, the actual losses may be much more.
To explain this, the Chinese Ministry of Commerce once published the "wealth accumulated" from China's overseas direct investment. The data reported that by the end of 2020, China's 28,000 domestic investors had set up a total of 45,000 outward foreign direct investment companies in 189 countries and regions around the world. These companies recorded total assets of USD 7.9 trillion and a cumulative net of USD 258.06 billion in outward foreign direct investment at the end of that year.
By the end of 2020, the total number of employees employed by Chinese-invested overseas companies reached 3.613 million. This figure included 218.8 million foreign employees, accounting for 60.6%. In 2020, these overseas companies paid a total amount of USD 44.5 billion in taxes to the countries and regions where they invested.
Researchers at ANBOUND estimate that (if actual losses are taken into account), the loss of assets from China's outbound direct investment is almost USD 3 trillion. This figure represents the second largest after the loss of reserve assets. Sanctions would put China's almost one trillion-dollar outward assets portfolio in danger once more. China of course, could chose to reciprocate by restricting and freezing the physical and foreign investors’ assets portfolio in the country. However, that would mean China could be entirely "decoupled" from the West.
The United States and Europe have imposed sanctions on China, putting its vast official reserve assets at the highest risk. In the event of financial sanctions, the following assets could be directly frozen. These include USD 3.4 trillion in reserve assets, excluding gold reserves, IMF reserves, and SDR reserves, and almost USD 3.2 trillion in foreign exchange reserves, including USD 1.1 trillion in U.S. Treasuries. As a result, China's ability to protect its foreign exchange reserves will be put severely to the test.
According to Reuters, the financial regulatory authorities, including China's central bank, recently convened an internal meeting of senior members of the domestic and foreign financial industry. The purpose of the meeting was to discuss China's handling of financial sanctions imposed by the United States and other Western countries. China’s regulatory authorities were concerned that the U.S. may impose the same sanctions on China. This concern makes sense should there be a regional military conflict or other crisis.
At the central bank meeting, nobody could resolve how to protect China’s overseas assets, especially the USD 3.2 trillion foreign exchange reserves, the report said. Some opined that China’s banking system was not prepared for the assets to be frozen or excluded from the Society for Worldwide Interbank Financial Telecommunications (SWIFT). To increase onshore holdings in USD, some bank representatives suggested that China’s central bank could require exporters to convert all foreign exchange earnings into Chinese yuan. Exporters are currently allowed to keep a portion of their foreign exchange earnings for their future use.
The USD 50,000 yearly exchange quota; allocated to Chinese residents for international travel, education, and other offshore purchases could also be significantly reduced. Whether the possibility of diversifying into more Japanese yen or euro assets or otherwise, some bank representatives at the meeting said that it was not practical.
Although the Chinese economy has a greater global and profound influence than in the past, financial sanctions on China would definitely affect the West. However, with the United States and Europe dominating the geopolitical, international monetary, and financial system, it is almost certain that the Chinese government and individuals will suffer massive losses. This situation could come to reality if countries such as the United States and Europe are willing to bear those losses in extreme circumstances.
How should China cope with the possible threat of a similar situation? It is complex and requires extensive research and decision-making involving everything from strategy to tactics and policy. In short, the ideal option is to avoid getting into such a passive scenario. Besides that, it is crucial to avoid the extremes of being sanctioned, antagonistic, or even going to war.
If changing the confrontational-environment is impossible, China will need to respond in a variety of ways. It needs to improve its economic, military, and political hard power. Meanwhile, China also needs to remain open globally and expand its geopolitical influence.
On the other hand, it needs to be proactive to promote the internationalization of the Chinese yuan. Additionally, China has to expand its supply of offshore yuan to ease potential future pressures. Simultaneously from the short to medium term, the government, businesses, and citizens must assess the external dangers they face and take steps to decrease their exposure to minimize potential direct harm.
Final analysis conclusion:
The conflict between Russia and Ukraine, and the Western financial sanctions on Russia, have further worsened the geopolitical threats to the world financial system. This system's "weaponization" poses a real and long-term threat to China. As a result, China's long-accumulated abroad assets are now vulnerable to severe geopolitical risks. Therefore, China needs to conduct a systematic strategic study to identify an effective answer to the long-term negative geopolitical situation.
