How China can defend itself against US financial war
Part II of whether the US is preparing for a dollar blockade against its main rival
Dear all
I hope you had a good Christmas (or at least some relaxing time off).
As many of you would have seen I published an article on 22 December called “To lead, China must learn how to win friends and stop coming across as a bully”, based on an earlier post I made revealing how China had fooled Sweden into opening a dual-purpose military-civilian space facility on its territory.
Today I’m following on from last week’s post, asking if the US is getting ready to ramp up the current trade war into a full-on financial assault on China. There are certainly those who believe it possible.
The question is, what could China do about it?
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One critical element of any financial war against China would be the establishment of a dollar blockade, i.e. a total ban on all financial dealings with Chinese companies. China may have some $3 trillion in foreign reserves, but its currency holdings wouldn’t last forever given its food and fuel importing requirements, both of which have at present to be mainly paid for in dollars, and its $2 trillion of foreign debt. If a dollar blockade came to pass then China would have to take quick, drastic action.
An RMB Bloc
One way out of it would be for China to persuade countries in its sphere of influence to accept the RMB as payment. In other words, to internationalise the RMB for a select number of Chinese allies.
This would not be from a standing start. For some years now China has been pushing the RMB as a unit of international payment with some success, partly in fear of its vulnerability to American clout. China-Russia trade for example is now conducted in RMB-Roubles rather than US dollars.
This particular bilateral switch was initially driven by a Moscow determined to decrease Washington’s leverage against it. According to the IMF, Western sanctions against Russia, imposed following its annexation of Crimea in 2015, reduced Russia’s growth rate by 0.2 percentage points every year between 2014-2018. It is a lesson not lost on China.
Covid has increased the use of the RMB in international trade. "The use of yuan in cross-border transactions has been increasing during the pandemic, up 40% in the first three quarters from a year ago”, said a People's Bank of China representative last month.
Whilst the RMB still only accounts for around 2% of global payments, what is important is that in recent years what the IMF describes as a nascent RMB bloc has emerged. These are countries whose currencies the RMB had a dominant influence on, mainly Asian and BRICS nations, together which contribute approximately 31.6% of global GDP.
The question is, is such a bloc useful for China in the event of financial war against America? The answer is, probably not yet.
Although China has made itself the dominant force in global trade, being the leading trade partner with almost 70% of the countries in the world, while the dollar remains the most popular reserve currency these countries would find it very hard to ditch the greenback.
Most countries, if forced to choose between staying part of the dollar-based international system, or throwing their sovereignty in with Beijing, would most likely choose the status quo. After all, the D10 – the US, UK, and their main democratic allies – together with the EU account for more than 60% of the world’s GDP.
A Digital Payments Option
A second option would be for China to bypass the dollar with a digital yuan. China has begun rolling out an ambitious test of a digital version of the RMB; pilots exist now in four Chinese cities, where transactions totalling more than 2 billion yuan ($300 million) have already taken place. The pilot, and any subsequent roll-out, is made easier by the fact that 83% of payments made in China in 2018 were made through mobile devices, with just 17% in cash or cards.
The internal benefit to making a digital currency mainstream would be to give Beijing an unprecedented view of what everyone was spending their money on (including anything the Communist Party didn’t approve of).
Internationally, a digital yuan – or Digital Currency Electronic Payment (DCEP) as it is properly known - would boost Chinese influence if it was mass-adopted. It would also serve as a defence against any US-backed global digital currency, like Facebook’s on-off Libra project.
The use of DCEP for cross-border transactions would, however, probably face the same barriers to adoption as the physical yuan. Countries may ban its use in fear of US reprisals, China’s capital account is not fully open, and the RMB is not freely convertible even in digital form.
It is therefore unlikely that DCEP could meaningfully rescue China in the short term from any type of dollar blockade.
Call in the Wall Street Cavalry
The third action Beijing might take in the event of a financial war would be to sequester American assets in China. It is probably with this partly in mind that we have seen a revolutionary change in the Chinese attitude to outside money in the last few years.
For decades China has in effect been cut off from outside finance. Whilst corporate investments have been possible for a long time – Volkswagen set up their China subsidiary in October 1984 – it is only recently that asset managers and financiers have been given access to the massive domestic Chinese market, allowing significant sums of dollars to flow into the country.
In 2017 Bond Connect was launched, which allows foreigners to invest in onshore bonds through Hong Kong. It was a move that was instantly successful. China’s bond market is the world’s second largest, and it attracted $60 billion of foreign money in just 2019. Some 1900 overseas investors are now registered with Bond Connect, up from 700 a year ago; 3% of the Chinese bond market, and 8.8% of its government bonds, are now in foreign hands.
Chinese regulators have also been accelerating moves to open wealth and asset managers into the country. New rules published in July 2019 saw a wholesale relaxion in rules, for example allowing foreign firms to set up or take stakes in bank wealth management subsidiaries, and to set up and take stakes in pension management companies.
Major American asset managers are taking advantage of these regulatory changes, including BlackRock, the world’s biggest with $7 trillion under management. In August this year China allowed the American leviathan to create the first wholly overseas-owned mutual fund entity in China.
The advantages of attracting US institutional money into China are twofold.
First, dollars are injected into the system: $432 billion was invested through portfolio flows into China in the three years to 2019, according to data from Capital Dialectics, an economic research firm.
Second, Beijing turns Wall Street into its proxy protectors.
The more skin in the Chinese game Wall Street has, the more it will complain about any moves Washington makes to wage financial war on Beijing. They may be onto something, as BlackRock emerges as a powerful entity under the new Presidential Administration. The firm's global head of sustainable investing, Brian Deese, is set to head Biden's National Economic Council, and Adewale “Wally” Adeyemo, a former chief of staff to BlackRock’s chief executive, has been named as the number two at the Treasury Department.
It is also expected that BlackRock’s CEO Larry Fink will serve as a top official at the Treasury.
Fink is a well-known advocate of the economic possibilities of doing business in the Middle Kingdom. “We are here to work with China,” he said to a forum via videolink in June this year. The feeling is mutual: in 2015 Fink was brought in by Beijing to advise on how to handle market volatility.
Conclusion: Wall Street Can’t Buy Everything
Wall Street may not, however, get its way with China. There is a growing feeling in Washington that China needs to be confronted and its efforts to challenge US hegemony thwarted, and so the arguments of wealthy financiers may not cut much ice.
If a financial war does occur then it is not just China that will suffer. US investors will no doubt see their China holdings either shrink or disappear. Western financial institutions with a foot in the door of both America and China will either have to choose one side or the other, or split their entities in two. Likewise with the many Chinese companies who do strong business in the West.
A financial war would unleash economic armageddon for much of the globe. But if America is intent on defending its hegemonic position, it may be the only option. It is certainly leaving the door open to do so.
The one bit of good news is that unleashing such a conflict is something that would have come from the playbook of the outgoing President Trump – but it didn’t happen. This does not, however, mean that it won’t.
With so much at stake, no wonder China is busy courting the kings of Wall Street.
They might want to hurry up on their other defences, too, just in case.