The battle that will not decide the outcome of the currency war – Why did China’s banks comply with the sanctions? With the threat of secondary sanctions keenly felt by Chinese banks, Washington appears to be temporarily winning a battle – but in an economic war it is decisively losing. The resilience of the Russian economy in the face of harsh and unprecedented Western sanctions has inspired feelings of excitement among those cheering the rise of multipolarity. And this caused a huge embarrassment for the West. But Russia’s growing trouble settling payments in bilateral trade with China shows that this resilience cannot be taken for granted as a currency war rages on. Last June, the US Treasury Department targeted local banks in countries that trade with Russia for secondary sanctions. Regulations for sanctions against companies or individuals found to be doing business with sanctioned entities were initially implemented in December, but in June Washington expanded the measure and sent strong signals that this time things were serious! These threats were particularly felt in China, Russia’s largest trading partner. Top trading partners 
What happened and when?
It started with the big state-owned Chinese banks, which began to avoid doing business with Russia earlier this year.
But there were always smaller, regional banks, seen as less exposed to the Western financial system, that would take their place. For a while, it looked like these banks would hold out. But now even these institutions have followed suit.
By the summer, Chinese banks were rejecting and returning about 80% of Russian payments made in Chinese yuan.
According to an article in Izvestia from mid-August things were even worse: 98% of Chinese banks refused to receive direct payments in yuan from Russia. The result of the above has disrupted payments for many Russian importers.
Trade with Russia is being “massively” closed and payments worth trillions of yuan are being suspended, according to a government source.
Many Russian businesses have had to use various chains of intermediaries in third countries to process their transactions, which has led to an increase in both costs and processing times. The problems have mainly affected smaller companies active in the consumer goods sector. Bilateral deals for large companies – such as Russian commodity exporters – appear to still be working for the most part, although there have been some problems there as well.
Liquidity in yuan
Meanwhile, tighter restrictions have drained yuan liquidity in the Russian market. In other words, it has become more difficult and more expensive for Russian companies that need yuan to acquire the currency.
Given how much of Russia’s trade is now done in Chinese currency, this is certainly an issue. The cost of pumping yuan for one day (overnight rate ) on the Moscow Stock Exchange has soared. The situation had indeed started to deteriorate by the end of August.
On August 30, the last business day of the month, the overnight rate rose from 8.5% per annum to 42.2%. Bankers explained the fact because of the increased demand at the end of the month. But this week – well into the new month – the rate continued to rise, reaching an unprecedented 212% on Wednesday (4/9), before falling somewhat.
This market behavior highlights the acute yuan liquidity deficit. It has also pushed the ruble to its lowest level against the Chinese currency since April.
As a result of the pressure, more and more companies must regularly turn to a channel previously used as a last resort – expensive currency swaps with the Russian central bank (where entities deposit rubles as collateral in exchange for yuan).
In early September, Russian banks drew a record 35 billion yuan through this credit line, well above the daily average of 20 billion in August and the 10 billion average in June.
Essentially, the Bank of Russia is forced to fill the gap left by Chinese private banks operating in Russia. Banks are now calling on the Russian central bank to increase the supply of the yuan through swaps.
Decrease in exports
Payment problems this year have already affected imports, although current figures are lagging and do not reflect the most recent rise in yuan costs.
Russian imports from China fell more than 1 percent to $62 billion in the first seven months of this year, according to official Chinese data. Russia’s central bank has forecast that the country’s total imports of goods and services will fall by up to 3% this year.
But it will be important to watch how China’s export figures to Russia – whether directly or through other countries – shape up for the rest of the year in light of rising trade costs. In the short term, of course, there will continue to be losses.
Reliable solutions
The Russian yuan money market has not recovered, suggesting that Russian banks are struggling to find reliable solutions.
The Russian central bank will almost certainly have to play a bigger role, and exporters will likely also step in to provide liquidity. But there is no quick and easy solution.
To understand these issues, first of all, it is important to note that this problem is well understood in Russia and is being discussed freely, including at the highest levels of government and in the media. There is no attempt to silence this story.
It is in the headlines of the Russian financial press. Also note that Russia-China trade isn’t exactly collapsing. In fact, despite the problems, turnover actually increased by 1.6% in the first half of this year.
More importantly, the experience of recent years has shown that any headwinds that arise end up being powerful drivers of change.
Tougher Western sanctions are weighing on Russia, but Moscow continues to find ways to keep the country’s economy afloat.
What solutions can arise?
In July, China’s ambassador to Russia, Zhang Hanhui, presented the possibility of cooperation through the Russian Mir payment system, stating that Russian and Chinese institutions are studying the possibility.
While China would likely not consider the Mir system as a long-term solution, it could be a stopgap measure. Such rhetoric also demonstrates the seriousness the Chinese side is showing in the task of finding a solution to the roadblocks put up by Washington.
Meanwhile, in a major policy shift, Russia earlier this summer embraced the use of cryptocurrencies for international settlements. Commenting on the regulator’s soft stance towards digital assets, Bank of Russia governor Elvira Nabiullina stressed the need to adopt new financial technologies to address current challenges.
Central bank digital currencies (CBDC) – which are like cryptocurrencies but backed by central banks. Both Russia and China have been at the forefront of pioneering such infrastructure.
Basically, there are few countries that have made serious progress in using national digital currencies. This is why technologically, the Russians are simply not ready to launch a digital currency in mutual settlements with other countries.
CBDC settlements will likely be common practice within five years. More than half of the world’s central banks are either considering or already developing CBDCs, according to the IMF.
As these CBDCs become increasingly interconnected, it would essentially recreate the network of correspondent banks that underpins the current system. Such a CBDC-based network, covered by bilateral currency exchange lines, would allow central banks to act as intermediaries for currency flow between local banking systems.
This is important precisely because commercial banks are at the forefront of sanctions enforcement. They have both the responsibility and the authority to block transactions involving restricted entities. But what if these banks are completely excluded from cross-border trade?
Will the US resort to sanctions on the central banks of countries that do business with Russia?
Such an infrastructure will require strong cooperation between central banks and the use of a single technical platform or some kind of unified clearing system. None of these are currently operational but they are not impossible to create either.
The Bank for International Settlements, an international organization owned by member central banks, is already overseeing a pilot CBDC platform for cross-border wholesale payments.
Pyrrhic victory of Washington
Let’s get back on topic and try to understand what this all means.
The West has been deeply frustrated by its inability to deal a significant blow to the Russian economy. Having doubled and tripled the strength of financial sanctions, he now sees Russia’s payment problems as confirmation that sanctions, if applied strictly enough, can have the intended effect.
Washington apparently feels that infringing on the sovereignty of other nations is a reasonable trade-off in favor of raising transaction costs for Russian businesses and proving that the yuan still lacks the power of the dollar.
For all the rhetoric of “friendship without borders” between Moscow and Beijing, when forced to choose between doing business with Russia and maintaining access to the Western financial system, China chooses the latter.
But those celebrating China seemingly backing down on sanctions don’t want to admit it’s a choice made under duress. China would prefer to trade freely with both the West and Russia and deeply resents being prevented from doing so. Chinese officials have stated this on several occasions.
China is a sovereign state that naturally looks out for its own interests, and Russia expects nothing less from it. There are no feelings, after all.
As cliche as it sounds, it really is a relationship defined by mutual respect for dominance. In the current situation, Beijing must act realistically, but the erosion of goodwill towards the US caused by this episode in Beijing will manifest itself.
It is also argued that the huge difference in interest rates between Russia and China points to the fact that the economies of the two countries are fundamentally misaligned.
This is an exaggeration, but to the extent that it contains a kernel of truth, it is largely an artificially imposed distraction and should prove temporary, especially when Russian interest rates eventually fall.
The Russian and Chinese economies are actually quite complementary. So is the difficulty in payments a victory for US sanctions? Yes, undoubtedly. But it is a rather short-sighted and ephemeral victory. It is a battle being won in an economic war that is being decisively lost. Far from being a show of force, Washington’s blatant meddling in the trade relations of sovereign states around the world is more akin to someone burning furniture to keep warm.
