Facing U.S. Sanctions, China Mulls De-Dollarizing Its Finances

China's tentative steps to respond to potential U.S. sanctions over Hong Kong will be limited by a largely dollarized system for global payments and clearing settlements. Beijing could, however, adopt disruptive "blocking actions" that force companies to choose between Chinese and U.S. systems.

What Happened

On July 28, the state-owned Bank of China released a report arguing that the threat of sanctions from the U.S. Hong Kong Autonomy Act should prompt China to make more international payments through its own financial infrastructure. The report also recommended that China make it illegal for companies doing business with China to comply with U.S. sanctions via a blocking statue, in addition to its main advice of moving away from largely U.S. dollar-based clearing and payments settlement in order to shield China's finances from potential U.S. intrusion via secondary sanctions enforcement.

It's not clear whether the bank's report was directed at senior Chinese leadership, but it was released shortly before a Politburo meeting to review China's economy and likely Beijing's eroding U.S. relations. Following the meeting, the Politburo endorsed a somewhat vague idea from President Xi Jinping that China should reorient its economy toward self-reliance and replace its current export-led growth model.

Why It Matters

To reduce its exposure to Washington's financial wrath, China could direct more of its own trade and finance into yuan-denominated channels through its Cross-Border Interbank Payment System (CIPS). But the system remains in its infancy, and the yuan is still a relative financial weakling as well. CIPS provides settlement and clearing services of yuan-denominated cross-border and offshore transactions. When the system was first established in 2015, China was pressing for the greater international use of its national currency. Those efforts, however, have since flat-lined, with the yuan's share of global foreign currency reserves stuck at less than 2 percent over the past year. CIPS was also a response to China's strategic rivalry with the United States, and was partially intended to advance the de-dollarization of global foreign currency reserves and international exchange.

Currently, unsettled international payments that aren't cleared bilaterally depend largely on the 30 million daily payment orders sent through the Brussels-based Society for Worldwide International Telecommunications (SWIFT), a private company that messages correspondent banking instructions.
CIPS's average daily transactions in totaled just $19.4 billion in 2019, compared with SWIFT's $5-6 trillion average daily transactions.
The yuan also accounted for only 1.14 percent of international currency payments in June (excluding payments within the euro area). Moreover, the yuan's average daily "turnover," which indicates its daily use as a transactional currency in global foreign exchange markets, was only $280 billion per day in mid-2019 (which is latest data available from the Bank for International Settlements) — making up only 4.4 percent of a $6.6 trillion net market. Turnover for the U.S. dollar, by contrast, was 88.4 percent of the net market.

Further progress in the yuan's global use is inhibited by a closed financial account in the balance of payments with capital controls and a managed exchange rate, as well as a lack of outside access to a wide, liquid range of domestic financial assets. For now, the expansion of CIPS and routing transactions away from SWIFT remains a limited enterprise. Since signing an operational memorandum of understanding with SWIFT in 2016, CIPS has relied on the Brussels-based payment system and now lacks the ability to operate independently. So, the notion that anything other than yuan-based transactions can be cleared and settled through CIPS remains far-fetched because it would take years, if not at least a decade, for CIPS to develop relations with correspondent banking systems. Until that happens, the Bank of China's recommendations will thus remain largely aspirational. Bilateral trade settlement is the easiest part of such an effort, but only to the extent that trade partners want to accept and hold the yuan to help bolster the internationalization of China's national currency.

Aside from forcing companies to choose between Chinese and U.S. payment systems, Beijing's ability to reduce its sanctions exposure will be limited by the yuan's meager use in global markets.

There's a chance, however, that China could follow through on the Bank of China's recommendation to adopt legislation akin to the European Union's blocking statute, which makes it illegal for European companies to implement U.S. sanctions on Iran. In practice, the EU blocking statute has been ineffective, as when multinational corporations are forced to chose between either working with either the United States or Iran, the answer for most is clearly the former. The choice between the United States and China, however, would not be as clear cut for multinational firms, adding another layer of risk for companies with both U.S. and Chinese exposure.

China's implementation of such a blocking statute in a significant way is unlikely, as this would ultimately be self-defeating by making the country a less attractive investment destination. But having the law on the books would still give China the legal ammunition to use it selectively in high-profile cases, should Beijing ever want to make a statement or even deter either mainland Chinese or Hong Kong companies from complying with U.S. sanctions.