How China is fortifying its economy for war with the West

President Xi Jinping has been quietly preparing for years for confrontation, write Ben Marlow and Melissa Lawford

In the frantic weeks that followed Russia’s invasion of Ukraine, China’s most senior officials scrambled to understand the implications that the conflict posed for the Chinese economy.

With tensions between Washington and Beijing intensifying over trade as well as Taiwan, the Chinese regime feared that it could soon be facing the same harsh sanctions that the West had been quick to impose on Moscow.

Representatives from every major domestic and foreign bank, including HSBC, were reportedly summoned to an emergency summit where worried officials from the central bank and finance ministry demanded to know what steps could be taken to protect the country’s economy in the event of Western economic action.

President Xi Jinping’s administration was particularly alarmed by the ability of the US and its allies to freeze the Russian central bank’s dollar assets. They wanted to know how China’s $3.2trillion (£2.5trillion) in foreign reserves could be protected.

On the one hand, the regime was right to be concerned. Last year, a report by the Atlantic Council, a Washington think tank, and a New York-based research company, Rhodium Group, analysed various sanctions scenarios in the event of a major escalation over Taiwan.

It found that in the most extreme sanctions scenario on China’s major financial institutions, “at least” $3trillion in trade and financial flows “would be put at immediate risk of disruption”.

The risks for both sides are massive. A close examination of Xi’s economic manoeuvres suggests he has been quietly preparing for years for such a confrontation.

New world order

In fairness, the West has not been entirely passive as the threat of war rises. Donald Trump’s calls for a “decoupling” from China during the pandemic prompted a rapid revaluation of ties.

Although the G7 has gone to great lengths to dismiss the prospect of such a fracture, it has acknowledged a need to reduce dependence on the world’s second largest economy under a policy of “de-risking”. Diane Choyleva, chief economist at Enodo Economics, says it all amounts to “a fundamental rewiring of how the world works”. Agathe Demarais, a senior policy fellow at the European Council on Foreign Relations, points out that countries at odds with the West have long been pursuing policies designed to shield themselves from any confrontation – chief among them the People’s Republic. “Western countries did not invent these policies. If there is an inventor and world leader of decoupling and de-risking, it is by all accounts Beijing,” Demarais said in a recent article for Foreign Policy magazine.

In China, a quest to develop its own food industry and microchip plants has played out in plain sight. But buried in the financial markets and hidden from view, another scramble has been taking place to limit its reliance on the Western financial system.

Indeed, Demarais believes that China’s attempts at reconfiguring the global financial order are so extensive that it is effectively “laying the groundwork to not have to use Western financial channels”. She says: “China is building an entire edifice of Western-proof financial mechanisms.”

With China building up its military on a “scale not seen since the Second World War”, according to US Navy Admiral John Aquilino, Beijing is also fortifying its economy for war.

Gold Rush

Days after US secretary of state Antony Blinken visited Saudi Arabia last June, the Gulf Kingdom hosted the 10th Arab-China Business Conference. More than 3,000 officials and business leaders gathered and posed for selfies under lurid green chandeliers at the King Abdul Aziz Conference Centre in Riyadh. Billions of dollars in deals between China and the Middle East immediately followed, including a $5.6bn agreement between Chinese electric car maker Human Horizons and Saudi Arabia’s ministry of investment.

China is ploughing cash into the Gulf on a dramatic scale. Between January and September last year, Chinese businesses announced investments in Saudi Arabia worth $16.2bn, according to fDi Markets – a record high. In 2022, the figure was just $1.3bn.

This wave of investment is helping China to build its financial resilience, says Alicia García-Herrero, chief economist for Asia Pacific at French investment bank Natixis.

The Saudi riyal, like other Gulf state currencies, is pegged to the dollar. “They are buying assets that are dollar denominated but they are not dollar assets – they have no risk of

‘It’s all about selfreliance non-stop. That is how Xi views the world’

being seized,” says García-Herrero. On one key measure, China is much more vulnerable to this type of financial sanction than Russia, says Ken Rogoff, Harvard professor and former IMF chief economist. “Russia’s reserves were a few hundred billion dollars. China’s dollar reserves are probably at least a couple of trillion.”

Investment in Saudi Arabia is just a tiny part of China’s race to build assets that will be immune to Western sanctions.

The central bank is taking steps on an even larger scale. The People’s Bank of China (PBOC) began a record gold-buying spree in October 2022, building up a stockpile worth $170bn.

It bought 27 tonnes of gold in the first three months of this year, taking its total reserves to 2,262 tonnes, its largest ever. It has now been buying gold for 17 months in a row, its longest streak since at least 2000, bolstering its reserves by 16pc. That this spree has taken place at a time when prices have been at a record high shows a degree of urgency, says Jonathan Eyal, associate director at the Royal United Services Institute (Rusi).

At the same time, PBOC has been shedding US Treasuries. This was already happening before Russia’s full-scale invasion of Ukraine, but since then it has become much more rapid.

From November 2013 to February 2022, PBOC shrank its Treasury holdings from $1.31 trillion to $1.02 trillion, a drop of 22pc, according to Pantheon Macroeconomics data. In the two years since, it has reduced its holdings by a further 37pc, to just $760bn.

“There’s no doubt in my mind that the objective is to create a depository of value that is outside the hands of dollar or euro denominated transactions and therefore cannot be frozen at a moment’s notice,” says Eyal. But hoarding gold won’t be enough. China has had to come up with other ways to ensure it can continue to do business.

Digital defences

Government employees in Changshu, a city of 1.5m people in the eastern province of Jiangsu, have become unwitting guinea pigs in a state-sponsored experiment that could one day have huge significance for global finance. From May last year, the city began paying all public sector workers solely in digital yuan, according to the state-sponsored financial newspaper The

Securities Times. It was the first example of widespread adoption of the digital yuan, or digi-yuan, in China since the central bank began developing a digital currency in 2014. The regime insists the goal of the virtual currency is not to compete with other international currencies.

“The motivation, for now at least, is focusing primarily on domestic use,” PBOC deputy governor Li Bo told attendees at the Boao Forum, Asia’s answer to Davos, in 2022.

Yet some analysts see the move as a critical part of Beijing’s master plan to chip away at the longstanding supremacy of the greenback, amid growing concerns about its weaponisation by Washington.

“It is another means for China to avoid dependence on the dollar. Digital currencies are transacted directly with the central bank and therefore bypass the banking system altogether,” Andrew Collier, founder of Orient Capital Research, says.

But for the digi-yuan to stand a chance of being adopted overseas, it first needs to be a success on the domestic front. There have been multiple state-driven promotional initiatives designed to encourage take-up.

Chinese cities, including Beijing, Shanghai, and Shenzhen, have given away millions of dollars of the digi-yuan to residents as part of a series of citizens’ lotteries. Winners can spend their windfall at designated outlets.

The central bank has also released a wallet app on both China’s Android and Apple app stores that can be used in more than a dozen cities and regions, and big Western multinationals such as McDonald’s, Visa and Nike were pressed to accept the digital yuan during the Beijing Winter Olympics in 2022 amid an influx of foreign tourists.

Yet take-up has been slow. At the end of August 2022, transactions totalled just 100bn yuan ($14.5bn) – equivalent to an average of 3.6bn yuan per month since the trial started, according to PBOC data. By June 2023 that figure had jumped to 1.8trillion yuan, now former central bank governor Yi Gang announced at a lecture in Singapore. However, the value of digi-yuan in circulation accounted for just 0.16pc of China’s money supply, or cash in the economy, Yi conceded.

The launch of a virtual currency was partly borne out of a desire to check the growing power that tech giants Ant Group and Tencent were able to wield over China’s financial system through their respective payment apps Alipay and WeChat. Having forced Ant Group to pull a planned $34bn stock market float in Shanghai and Hong Kong in 2020, the digi-yuan was seen as a broader attempt to rein companies like this in. “These guys became too big for their boots – they weren’t sharing the data that the party wanted to have from them. So Xi kicked them in the shins,” Choyleva says.

Yet, there are doubts about whether the digi-yuan will be able to mount a meaningful challenge. “Consumers seem reluctant about changing their payment habits and switching transactions are still dwarfed by the volume of mobile payments,” the Bank of Finland Institute for Emerging Economies said in a recent study.

Hopes are high for a digital currency cross-border payment project that China’s central bank has launched with counterparts from Thailand, United Arab Emirates and Hong Kong. Though in its infancy, it hints at a longer-term strategic goal of encouraging worldwide use of the yuan.

Demarais argues that critics have misunderstood what Beijing is trying to achieve. “The road will be long for a Chinese digital currency to become global. But dominance may not be the point: China’s goal is to have alternative financial channels as a means of protection, which only requires them to be operational.”

Swift action

China’s faith in a global financial system long dominated by America began to wane following the financial crisis as the aftershocks quickly swept through the country. Western demand for China’s manufactured goods cratered, millions of people found themselves on the jobs scrapheap and the regime was forced to unveil a record 4trillion yuan fiscal package to save its economy.

The real turning point was the War on Terror, launched in the wake of the September 11 terrorist attacks. It demonstrated the extent to which Washington was both able, and willing, to deny foreign individuals and institutions access to a US-led global financial system, Choyleva says.

This was usually achieved by shutting them out of the combined Swift and Chips global banking system through which an estimated 90pc of the world’s money is moved across borders. Chinese officials were particularly alarmed by the West’s decision to cut off Iran’s access in 2012 as part of international efforts to deprive Tehran of the funds needed to develop nuclear weapons.

China’s answer to this glaring vulnerability was to bypass the existing framework and create its own version: the Cross-Border Interbank Payment System (Cips) in 2015.

Again, there are widespread doubts about how effective it will be. In testimony to the powerful House Financial Services Subcommittee on National Security in 2022, the Washington-based think tank the Centre for a New American Security dismissed both CIPS and the digi-yuan as immediate threats to “mainstream financial plumbing”.

However, it had this warning: “These alternative payment systems are growing in technical sophistication and domestic adoption these systems could gain traction internationally and scale up accordingly.”

It went on: “Chinese alternative payment systems could eventually erode the effectiveness of US and allied sanctions and challenge the institutions under the current financial order over the long run.”

According to the Cips website, Cips currently has 139 direct participants, 100 of which are in Asia, and 23 in Europe. In 2023, the volume of CIPS’s annual business was 123 trillion yuan ($17trillion). By the beginning of this year, average daily transactions had reached 666.8bn yuan.

Collier cautions that Cips “is minuscule in processing total currency transactions” whereas “Chips has at least 10 times as many participants and processes 40 times more transactions than Cips.”

Again, Demarais warns against misinterpreting China’s aims. Its payments network may be much smaller than Swift but “it connects most banks across the world and would provide a backup if Swift were to disconnect Chinese banks,” she says.

De-dollarisation

Self-sufficiency is at the heart of Xi’s ideology, says Charles Parton, a former diplomat and former special adviser on China to the foreign affairs committee. “This idea of self-reliance is central to everything that he thinks or says.”

This goes hand in hand with an anti-Western approach. “Anti-Americanism is … the foundation stone of Chinese foreign policy,” says Parton.

And the touchstone of America’s economic and geopolitical power is the hegemony of the US dollar. Its position as the world’s reserve currency means countries are intertwined with the US economy. “In China they believe that the Western financial system has always been stacked against them,” says Parton.

As well as trying to move to assets outside of the dollar system, China is trying to de-dollarise its international transactions.

Xi has a long-term goal for the yuan to challenge the dominance of the dollar, an aspiration widely dismissed by economists. The dollar makes up 58pc of the world’s foreign currency reserves while the yuan accounts for little more than 2pc, according to the International Monetary Fund (IMF).

This is unlikely to change significantly while China maintains strict capital controls. The dollar is also easily convertible whereas the yuan is not, and is far more widely used in global payments.

But use of yuan is becoming rapidly more widespread outside the West – even if China can’t de-dollarise the world, it is building a degree of financial self-sufficiency by de-dollarising a part of it.

“Where they have been really successful in pushing for internationalisation of the yuan has been with specific trading partners,” says William Hurst, Chong Hua professor of chinese development at the University of Cambridge.

In the past three years, use of the yuan in global trade has tripled and it has recently overtaken the euro as the second most used currency in trade finance.

Last year, Argentina used yuan to settle a $2.7bn payment to the IMF, because its dollar reserves were in the red. Bangladesh used yuan to make payments to Russia for a nuclear power plant. The yuan has replaced the dollar as the Russian central bank’s primary holding for international reserves, and Russia is also selling oil to China in yuan. Crucially, China has been laying down the infrastructure to further scale up use of the yuan through swap lines – agreements which give countries free access to each other’s currencies at a preagreed exchange rate.

“That is quite important because you’re encouraging central banks which are themselves controlling each country’s system, to feel more relaxed about allowing the yuan to blossom,” says Rogoff.

“It’s all about self-reliance. It is non-stop. That is how he [Xi] views the world: we are decoupling from the West, we are getting independence from it and we will cosy up to the rest of the world because we have to for our own security,” says Parton.

Uninvestable

China’s post-pandemic property crash is so vast that the scars are not difficult to find, even in a country of 3.7m square miles.

Investment bank Nomura has estimated that there are about 20m abandoned or unfinished homes scattered across China – each one a painful reminder of Beijing’s failed debt-fuelled property boom. Some have been left behind by the country’s largest property developer Evergrande, which imploded in January owing $300bn to an army of creditors, including overseas banks, insurers, and bond investors.

In January, a court in Hong Kong ruled that Evergande must be liquidated. But the expectation is that if anything can be recovered, the Chinese government will ensure domestic creditors are prioritised over their foreign counterparts.

It is a reminder of a glaring inconsistency at the heart of the Chinese economy. “The [Communist] Party is willing to tolerate free markets up to the point where it’s happy with the outcome. At that point it intervenes, often in ways that ignore the interests of foreigners and investors. Over the past couple of years, China has been labelled “uninvestable” by some, specifically for this reason,” a report by Enodo Economics said.

Its failed property experiment was an attempt to generate wealth domestically for the country’s middle classes, often with backing from foreign investors who chucked money at the big developers.

With the property boom well and truly over, China is now dumping excess manufactured goods such as electric cars on to Western markets and it remains heavily-reliant on the West for consumption.

Yet, in the context of its vast markets, foreign ownership of financial assets remains low relative to Western countries. The reason for this is that although China’s financial markets have become more internationalised in recent years, the government has always prevented significant foreign involvement in domestic finance from occurring.

Demarais points out that overseas ownership of Chinese stocks and government debt – at 5pc and 7.5pc respectively – is extremely low compared with other developed countries. Its banks remain almost entirely Chinese-owned – non-Chinese investors controlled less than 2pc of Chinese bank assets and 6pc of the insurance market as of 2019; and strict capital controls implemented during the Asian financial crisis of 1997 remain in place.

Critical judgment

But what has the West done to make itself less reliant on China? In September, foreign direct investment in China was negative for the first time since records began in 1998.

Meanwhile, many multi-nationals are rethinking their choice of China as a major manufacturing base. To what extent though? Despite plans to diversify and build factories in India, Vietnam and Brazil, 95pc of the goods Apple sells are still made in China.

Have Western attempts at decoupling come too late? Chinese exports to the G7 totalled nearly $1trillion last year, according to the United Nations Comtrade database on international trade.

Rishi Sunak’s welcomed decision to up UK defence spending to 2.5pc of GDP is a reminder that some G7 nations are only just beginning to re-arm despite Russia’s bombardment of Ukraine being well into its third year.

As Beijing steps up war drills on the islands and waters around Taiwan, and Washington warns that Xi’s nuclear arsenal has expanded sharply, the critical judgement will be whether the West has more to fear from sanctions than China.