War in Ukraine and Its Impact on the Chinese Economy

By Alicia García Herrero, Emerging Markets Institute Academic Advisory Board

The war in Ukraine and the unprecedented sanctions imposed on Russia by Western allies as a response to Russia’s invasion are surely going to have a negative impact on the global economy well beyond Russia and Ukraine. The European economy will be hit hard not only due to its dependence on Russian energy, but also because of the huge flow of refugees the continent is absorbing.

The direct impact on the Chinese economy is bound to be much more muted, at least in the short run, though still negative. The huge jump in energy prices is bad news for China, given its dependence on energy imports, and because China’s carbon reduction goals (as outlined in its Five-Year Plan) require additional imports of gas to transition away from coal. In fact, one key outcome of the China Two Sessions (meetings of the National People’s Congress and the Chinese People’s Political Consultative Conference in early March 2022) was a temporary hold on annual carbon emission targets as a means of dealing with the war-fueled increase in energy prices.

The other immediate downward pressure on the Chinese economy is the slew of Western sanctions imposed on Russia. Chinese corporations and financial institutions will need to tread carefully when trading with or investing in Russia and this seems to be happening already: Chinese banks are no longer offering letters of credit for trade with Russia, and Chinese energy companies—including Sinopec—are putting aside their projects with Russian counterparts.

Still, the impact of such retrenchment from Russia should be quite moderate for China, since Russia is ten times smaller. In addition, China does not even need to fully cut its ties with Russia, but just avoid hard currency payments and some targeted entities such as the Russian central bank and the ministry of finance. As for commercial payments, the fact that several large banks are still allowed to use SWIFT makes it clear that the sanctions will not preclude China from all economic relations with Russia.

China’s rhetoric vs. its actions

China’s rhetoric has been anti-US and anti-NATO, while being quite accommodating with Russia and opposing Western sanctions against the nation. However, this runs counter to the actual decisions made by Chinese financial institutions and companies, which suggest an adherence to Western sanctions. This means that China will abide by the letter of the law, even if reluctantly,  but not necessarily the spirit of the law: China will use any space available to support the Russian economy for the simple reason that this is in China’s interest. Energy security, military cooperation, and playing a role in the Artic are among the many reasons China has a vested interest.

So how will China attempt to support Russia economically and financially? Stronger trade ties with China, along with Western sanctions, will likely push Russia to accept, reluctantly, the renminbi as a means of payments. According to SWIFT data, Russia’s use of the renminbi has increased rapidly in the last few months and renminbi deposits in Hong Kong have spiked in the last couple of months. Russia can count on increasing trade with China to mitigate the impact of Western sanctions on its economy, but only if it is ready to accept an increasing relevance of the renminbi in the Russia economy.

Beyond the immediate future, there is no doubt that China can leverage its economic size to foster the use of its international payments system (CIPS) and its currency—but there is a limit to how much it can do. Russia will likely not be happy to become a part of a renminbi-centric world, since it remains non-convertible and it cuts Russia further from the rest of the world.

All in all, the war in Ukraine constitutes a negative shock to the Chinese economy but the direct impact remains limited except for that of high commodity prices. The problem is that it is happening at a time when China is beset by a severe Omicron COVID-19 wave on top of a cyclical deceleration and negative market sentiment stemming from a regulatory crackdown. Though China seems keen to abide by the letter of the law and comply with sanctions, the country also seems willing to take risks to maintain its strategic relationship with Russia. This is clearly a razor edge for China, as it could be caught in the fire not only of Western sanctions, but also of potentially negative decisions by Western companies operating in China.

About Alicia García Herrero

Alicia García Herrero, chief economist for Asia Pacific at Natixis, is a member of the Emerging Markets Institute Academic Advisory Board at the Cornell SC Johnson College of Business as well as a collaborator on the Emerging Market Multinationals Report. She also serves as a senior fellow at the Brussels-based European think-tank BRUEGEL, as a nonresident senior fellow at the East Asian Institute of the National University Singapore, and as an adjunct professor at the Hong Kong University of Science and Technology.