17 February 2023

What China Has Learned From the Ukraine War

Evan A. Feigenbaum and Adam Szubin

When Russia invaded Ukraine in February 2022, China’s leaders attempted to balance two fundamentally irreconcilable interests. First, they aimed to bolster China’s entente with Russia to counterbalance American power and alleviate growing strategic pressure from the West. Second, although they backed Moscow, they sought to avoid unilateral and coordinated sanctions aimed at China’s government, companies, and financial institutions.

For a year, China has been performing the “Beijing straddle,” tacking uncomfortably between these competing objectives under the white-hot light of international scrutiny. China has generally refused to sell arms to Russia and to circumvent sanctions on Moscow’s behalf because preserving global market access is more important to Beijing than any economic link to Russia. Simply put, China has no interest in being Russia’s proxy. But Beijing has also tried to have its cake and eat it, too, by endorsing Russia’s rationales for the conflict, coordinating with Moscow diplomatically while it cautiously abstains in United Nations votes, taking full advantage of discounted Russian oil, and enhancing economic linkages to Russia that do not violate Western sanctions. Indeed, China-Russia trade rose by a staggering 34.3 percent in 2022 to a record $190 billion.

Beijing has also learned important lessons even as it struggles to maintain this balance. Specifically, it has closely studied the Western-led sanctions campaign. And it knows that, if tensions with the West continue to intensify, these same economic weapons may well be turned against China. Over the last 20 years, China’s leaders have watched as Washington honed and more frequently deployed economic weaponry, including sanctions, export controls, investment restrictions, and tariffs. But the major Western sanctions campaigns have generally not applied to China because they targeted second-tier economies, such as Iran and Iraq, or more often, marginal economies such as Cuba, North Korea, and Sudan. The current Ukraine conflict has, at long last, given Beijing an opportunity to study the strategy, tactics, and capabilities of a Western sanctions coalition as it works to cripple one of the world’s largest economies.

Of course, in some ways, it is too soon for Beijing to draw the full range of lessons from the Western sanctions effort against Russia. The sanctions include both measures that have instant effect, such as asset freezes, and those that are designed to bite ever more deeply in the years to come. Among the latter are export controls on computer chips and advanced technologies and restrictions on helping Russia develop the deep-water, Arctic, and shale resources on which its future energy revenues depend. But China has already absorbed certain key lessons, some of which are sobering. Perhaps the most important has nothing to do with payment systems or oil tankers but is rather about the power of international partnerships.

DO AS I SAY, NOT AS I DO

The lessons China is drawing from the current conflict reflect, in part, the profound shift that has occurred in its own approach to economic warfare in recent years. Historically, China has criticized sanctions launched unilaterally by countries—most notably, the United States—as an illegitimate incursion on the targeted country’s sovereignty. In Beijing’s view, only the UN Security Council, where China can and has wielded its veto, sometimes in coordination with Russia, has the legitimacy to impose sanctions on a fellow UN member state. In the last two decades, China condemned U.S. sanctions on Cuba, Iran, Myanmar, and other countries that exceeded the prohibitions of the council, arguing that they “gravely undermined the sovereignty and security of other countries . . . and constitute a gross violation of international law and basic norms of international relations.”

But China wielded its economic might unilaterally against its own adversaries throughout this period. It just did so quietly, or often by justifying action on “public health” or environmental grounds, to punish a company from a country with which Beijing was locked in a diplomatic dispute. China would not generally acknowledge its punitive measures to be “sanctions” and publicly denied that these steps had anything to do with geopolitics. For example, when Chinese dissident Liu Xiaobo was awarded the Nobel Peace Prize in 2010, Norway’s salmon exports to China not-so-mysteriously collapsed. In 2016, when the Dalai Lama visited Mongolia, hundreds of truck drivers for the mining conglomerate Rio Tinto, which owns 66 percent of the country’s leading copper and gold deposits, found themselves stuck in a massive traffic jam caused by a “temporary” Chinese border closure. The Philippines’ assertion of maritime claims in the South China Sea in 2014 led to a sudden Chinese declaration that tons of Philippine bananas were contaminated with pesticides; the Philippines temporarily lost the most important market for one of its largest exports. Similarly, South Korea’s deployment of a U.S. missile defense system provided by the South Korean conglomerate Lotte led China to shutter 90 Lotte supermarkets in China in 2017 for “fire safety.” China also quietly instructed its tourism sector to cut the number of Chinese group tours to South Korea. It is estimated that South Korea lost $5.1 billion in revenues as a result.

In these cases, Beijing clearly wanted the targeted countries—and the world—to understand that these were geopolitically motivated measures; it aimed to punish certain policies by these countries and discourage future choices and behaviors that would disadvantage China. But the informal nature of these actions allowed China to dial them up or down without any explanation and permitted Beijing to cling to its public claim that unilateral coercive economic measures have no place in the international system.

Beijing’s economic arsenal is now complete.

In the last three years, however, China has shifted course. It has embraced unilateral economic measures with vigor, establishing its own copies of all the main weapons in the U.S. economic and financial arsenal. In 2020, China’s Ministry of Foreign Affairs began to levy targeted asset freezes and visa bans against officials from Canada, the United Kingdom, the United States, and the European Union who criticized Beijing’s actions in Xinjiang and Hong Kong—a page taken from the U.S. Treasury and State Department sanctions on Chinese officials and groups. That same year, China’s Ministry of Commerce established the Unreliable Entities List to restrict designated companies from accessing Chinese goods and investment, mirroring the U.S. Department of Commerce’s own longstanding Entity List. In its 2020 Hong Kong national security law, Beijing also added sanctions for those interfering with China’s sovereignty over Hong Kong, even asserting extraterritorial reach—something Chinese officials have criticized especially harshly in the past—threatening sanctions against individuals and companies for activities conducted outside China.

Perhaps Beijing’s most sweeping response came in its anti–foreign sanctions law, passed in June 2021. This law allows the Chinese government to apply countermeasures to companies and individuals for a broad range of vaguely defined actions. Article 15 empowers Chinese officials to impose sanctions on any foreign individuals or companies that “implement, assist, or support actions” that “may be deemed to endanger China’s sovereignty, security or development interests.” The law also borrows from Canadian and EU blocking laws, making it a crime to implement foreign (typically, Western) sanctions on Chinese soil.

This Chinese legal architecture is still fairly new, and Beijing has moved cautiously in implementing it, lest aggressive enforcement scare away Western businesses and capital flows into China. But Beijing’s economic arsenal is now complete and boasts a full complement of the unilateral sanctions and controls it still claims are unlawful.
TOO BIG TO SANCTION?

That is the context for the fresh lessons Beijing has learned since February 2022. When Moscow’s tanks raced into Ukraine, the United Kingdom, the United States, and the EU scrambled to come up with a punitive response. In the 2014–15 Ukraine crisis, the West crafted careful sanctions over many months to impose costs on Russia, alter Moscow’s behavior, and obtain leverage for negotiations. In 2022, when it became clear that Russian President Vladimir Putin sought not merely more territory in Ukraine but a full takeover of the country, the scope of the sanctions response shifted to an immediate all-out economic war. Within days of the invasion, allied governments announced asset freezes on all of Russia’s foreign reserves across Australia, Canada, Japan, the United Kingdom, the United States, and the EU; sanctioned Russia’s biggest financial institutions; and severed their access to SWIFT, the secure messaging platform connecting banks worldwide.

No economy close to Russia’s size had been subjected to measures like these since World War II. At the start of the 2022 invasion, Russia had the world’s tenth largest economy by GDP. Its daily oil production was near 11 million barrels per day, almost three times larger than the Islamic Republic of Iran’s oil production at its peak in 2005. Russia was the largest natural gas exporter in the world and the leading supplier of key global goods and inputs, from fertilizer and grain to titanium.

From a geopolitical perspective, Russia, like China, is a nuclear weapons state and a permanent member of the UN Security Council. Also like China, Russia has been a member of a wide variety of global institutions. It is true that China’s economy is still ten times larger than Russia’s, and China’s footprint in the global economy—in terms of trade, investment, and capital flows—dwarfs Russia’s, particularly in its ties with the United States. But if Chinese decision-makers once believed that a first-tier economy was too big to sanction, this past year has been disconcerting.

Beijing has been surprised by the ferocity of the Western response to Russia’s aggression.

No longer can Beijing simply assume that the West will never risk economic shocks over, say, a Chinese invasion of Taiwan. Beijing has just witnessed the United States and its European allies take on considerable national and global risks for Ukraine, an exponentially smaller and less global economy than Taiwan’s, which has the seventh largest economy in industrial Asia and provides a pivotal link in global supply chains. And Washington has greater historical, legal, and emotional ties with Taiwan than it does with Ukraine. China can no longer presume that the West will impose major sanctions only on marginal countries and marginal sanctions only on major countries.

Beijing has been surprised, too, by the ferocity of the Western response to Russia’s aggression. In the wake of the 2014 Donbas invasion, Putin and Chinese President Xi Jinping walked away with the lesson that the West—and especially risk-averse U.S. allies, of which there are many in both Asia and Europe—would not support costly sanctions on behalf of a third party. This time, that lesson does not apply. When Moscow’s tanks charged toward Kyiv, the gloves came off. An escalation ladder that had taken 18 months in the sanctions campaign against Iran was collapsed into a weekend. Even Russia’s oil and gas exports, which had been seen as too important to touch in 2014, were sanctioned. The West has moved more quickly than many thought possible to wean itself off Russian oil, and the G-7 recently rolled out a price cap system aimed at depressing the price Russia receives for its crude oil and petroleum products elsewhere in the world, at the same time ensuring that energy markets are still well supplied.

These steps required sacrifices. And the West has borne real costs in the form of inflation, higher energy bills, and gas shortages. But so far, with help from a mild winter, the coalition has held. The lesson for policymakers in Beijing is unmistakable: a major threat to international order can incur a very painful economic response indeed, even if it comes with costs for the countries imposing the sanctions.

FORTRESS CHINA

Countries make strategic decisions, including for war, because leaders weigh costs and benefits and then judge that aggression is worth the risk. China will not, therefore, eschew the use of force against Taiwan merely because it fears sanctions. China will, however, try to absorb lessons from Russia’s Ukraine experience about how to plug vulnerabilities, assure resilience, and create more options.

Since Putin’s difficult experience with sanctions in 2014–15, Moscow has boasted of a series of maneuvers to “sanctions proof” its economy; it proudly nicknamed itself “Fortress Russia.” Moscow built up its foreign currency reserves to $631 billion and largely shifted its reserves out of the U.S. dollar. By 2021, Russia had reduced its dollar holdings to 16 percent of total currency holdings, with Russia’s central bank purchasing $90 billion in gold and expanding its renminbi and other nondollar holdings. Russia introduced its own Mir national credit card system and an alternative to the Belgium-based SWIFT interbank messaging system.

If Russia had become “sanctions resistant,” however, it was not at all “sanctions proof.” As a matter of necessity, many of Russia’s repositioned dollar reserves had been moved to the highly liquid currencies of Canada, Japan, the United Kingdom, and Europe. When those jurisdictions moved in lockstep with the United States to freeze Russia’s reserves, nearly half of Russia’s foreign holdings—some $300 billion—were no longer accessible. Russia even saw a portion of its gold holdings immobilized because it had been storing them in jurisdictions that joined the sanctions effort.

Russia’s other defensive measures proved even less successful. After seven years of work, the Mir credit card network had secured a few medium-sized bank partners in Asia. But when the U.S. Treasury announced in September 2022 that banks working with Mir would be viewed as circumventing Western sanctions, those banks in Kazakhstan, Tajikistan, Turkey, Uzbekistan, and Vietnam severed ties with Russia’s card system. Russia fared even worse with its System for Transfer of Financial Messages, its purported alternative to SWIFT. Unsurprisingly, there was not widespread demand for a Russia-based financial messaging system that had limited reach and was more cumbersome and less secure than SWIFT.

Beijing is bumping up against economic and geopolitical realities that will not allow it to subvert the global financial system.

In today’s interconnected world, true sanctions-proofing is impossible. China has had more success than Russia in this respect, but it has also encountered some cold realities. For one, China’s State Administration of Foreign Exchange claims that China has reduced the portion of its foreign reserves held in U.S. dollars from 79 percent in 1995 to 59 percent in 2016. (China stopped providing a breakdown that year.) But the increasing role of China’s state-owned banks in foreign exchange purchases—purchases that are not reported—means that China’s true U.S. dollar holdings are unknown and may not have decreased by the reported amount. And China’s alternatives are limited. Unlike Russia, it cannot move any of its foreign reserves into renminbi—to protect against risk and manage monetary policy, reserves must be held in a different currency than one’s own. And the economies that have the depth to absorb a meaningful part of China’s foreign reserves are all part of the coalition that has stood up against Russia’s violation of international law. It is not clear where China can go.

China has also rolled out its own renminbi payment system, the Cross-Border Interbank Payment System and has set up mechanisms in its central bank to clear bilateral trade with countries such as Russia, skirting the use of the dollar and the euro. At the end of March 2022, CIPS had 1,304 participating institutions, a significant number, but about one-tenth of SWIFT’s participating institutions. China’s defensive steps have made more headway than Russia’s—China’s weight as the largest trading partner for the majority of the world gives it substantial clout in bilateral negotiations. But it will be difficult, perhaps even impossible, for China to convince the world’s advanced economies to entrust global financial flows to a Chinese-run platform.

So China has more leverage than any other nation to develop workarounds and alternatives to Western platforms, protocols, and institutions, and it is working overtime to do so after 2022. But Beijing is bumping up against economic and geopolitical realities that will not allow it to subvert the global financial system or to arrange for the renminbi to supplant the dollar and the euro as the dominant international currency.

BEIJING’S MISSING COALITION

Probably the most important sanctions lesson from the current conflict is the vital importance of coalitions. Washington has tremendous clout when it takes advantage of U.S. technology, financial markets, and the dollar. The sanctions on Russia, however, would have had a fraction of the bite (and Russia would have had numerous workarounds) had this not been a joint effort with Australia, Canada, Japan, South Korea, Taiwan, the United Kingdom, and the EU.

China can wield frightening influence over its individual trading partners, but it does not have a corresponding coalition to muster. This is a liability on offense and defense. The limitations of China’s offensive economic weapons have already been seen in recent years. When Beijing targeted Australia and Lithuania with harsh measures, both countries withstood them thanks to economic and political support from a number of friends and partners. And China remains vulnerable to broad, concerted sanctions from the advanced economies of the world. The threshold for such an economic attack would undoubtedly be quite high, but another kind of deterrence is the fact that Beijing cannot know exactly how high.

For Beijing, the lesson is less about economics and more about diplomacy and relationships. As it reopens its economy after three years of lockdowns, China is working to rebuild relationships, host foreign leaders from Asia and Europe, make business deals, and complicate any putative American effort to forge a counter-China coalition. For Washington, the takeaway is the same—in any potential confrontation with China, the most valuable weapon in America’s economic arsenal will be the strength of its international partnerships.

No comments: