Below, Atlantic Council experts answer four pressing questions about what just happened and what to expect next.

1. Why did Russia pull out of the deal?

Moscow’s notification to the UN, Kyiv, and Ankara that it was suspending participation in the grain deal and would not renew the deal further is part of a negotiating strategy to loosen sanctions and gain more freedom of maneuver. Russian standard practice is to make humanitarian measures conditional upon concessions that serve its military, economic, and political interests—as it has with earlier negotiations on the grain deal and numerous times over relief and aid deliveries in Syria. 

Specific demands in this case include readmitting the Russian agricultural lender Rosselkhozbank back into the Society for Worldwide Interbank Financial Telecommunication (SWIFT) mechanism, allowing Russia to import repair parts for agricultural machinery, and unfreezing other assets. Moscow claims that the deal, known as the Black Sea Grain Initiative, has not delivered on points that were to benefit Russia, but this round of pressure is certainly about more than the letter of the deal; it is about easing sanctions pressure.

—Rich Outzen is a nonresident senior fellow at the Atlantic Council IN TURKEY and a geopolitical analyst and consultant currently serving private sector clients as Dragoman LLC.

2. What’s the next move for Ukraine and its Western partners?

In October 2022, Russia left the grain deal, actually suspended its participation, and there were only three parties left: the UN, Turkey, and Ukraine. The grain corridors at that time functioned well, in part because the Russian inspectors had been disrupting the grain deals from inside. The most rational way to react to this withdrawal is to proceed in the trilateral format with the UN, Ukraine, and Turkey. I don’t think Russia has a lot of options now. In the northwestern part of the Black Sea, Russia lacks capacity to inflict any major damage. Since Ukrainian armed forces retook Snake Island last year, the maritime area has been largely controlled by the Ukrainian side. So there is little possibility for a major disruption by Russian vessels in this part of the Black Sea.

Russia could say that continuing the deal in a trilateral format crosses a “red line.” But if Russian forces attack a vessel transporting grain, it could trigger a major reaction that Moscow would not want to face, depending on which country the vessel belongs to, who is the owner, and who the sailors are. I would not be surprised if after a meeting or phone conversation with Turkish President Recep Tayyip Erdoğan in the next few weeks, Russia rejoins the grain deal.

Meanwhile, messages from Ukrainian President Volodymyr Zelenskyy have been very clear that there has been no deal between Ukraine and Russia. The deal is among Ukraine, Turkey, and the UN. What Putin undermines now is his agreement with the UN and Turkey, not with Ukraine. Russia’s halt of its participation in the deal will likely further increase insurance costs, but in June the Ukrainian government approved a maritime compensation scheme so that vessels calling at Ukrainian ports will be compensated if they are damaged due to Russian military activity. So, from the Ukrainian side, there is readiness to proceed with the deal.

While trying to keep the grain corridors functioning, it’s also important to step up efforts to restore freedom of navigation in the Black Sea, a basic principle of international law. Crimea must be de-occupied and should not become a bargaining chip in negotiations with Moscow, because Russia will continue to use Crimea to threaten security in the Black Sea and global food markets for as long as it is allowed to do so.

—Yevgeniya Gaber is a nonresident senior fellow at the Atlantic Council IN TURKEY and a former foreign-policy adviser to the Ukrainian prime minister. 

In practice, the deal had pretty much collapsed some time ago when ships started to disappear from the horizon off of Odesa’s Black Sea coast. Normally, up to a dozen bulk carriers are waiting to be loaded; in the past couple weeks, one or two at best—indicating things weren’t working well at the joint clearance center in Istanbul. (Ukrainians have blamed Russian inspectors for deliberately slowing down clearance procedures.) 

So what happens next? The UN and Western nations should not succumb to the Kremlin’s blackmailing tactics. Russia should not be given another chance to weaponize food—nor be given sanctions relief in exchange for allowing ships carrying food to sail through international waters.

A global food emergency should be declared and, as I told BBC World News this morning, arrangements made for ships to sail under armed escort through the Black Sea. Of course, such a measure would never get past Russia’s veto in the UN Security Council. So creative diplomacy is required, perhaps with the European Union taking the lead.

In the near term, Ukraine should also be assisted with moving grain transport onto alternative arteries such as the Danube River and onto trains and trucks. Poland can play a key role by alleviating the days-long waits truck drivers currently face entering Poland from Ukraine. 

—Michael Bociurkiw is a nonresident senior fellow at the Atlantic Council’s Eurasia Center based in Odesa, Ukraine.

3. What are the prospects for getting the deal back, and what could the UN and Turkey do right now?

The deal will likely survive because Ukraine, Turkey, and Europe more broadly, as well as a number of developing nations, benefit from it, which likely makes modest concessions to the Russian position acceptable to the leaders of those countries. Given the disinclination of either the Turks or NATO to directly intervene in the conflict, it is unlikely that there will be direct military escorts for grain ships rather than a negotiated deal. Nor do the Russian forces appear ready for a major naval escalation in the Black Sea, so there is a fair chance they will settle in the end. The reputational and economic costs of a prolonged end to grain shipments will hurt Russia, too, so I do not expect a prolonged or permanent cancellation of the deal.

—Rich Outzen

4. What impact does this have on the developing world?

The threat to global economic landscape and food security—especially in Africa and other developing regions—is hard to overstate. While once soaring food prices amid pandemic supply chain disruptions and Russia’s war had begun to stabilize, thanks in large part to the more than thirty million tons of wheat exported from Ukraine under this deal, the situation remains volatile. Down from its peak of 160 in March of 2022, the Food and Agriculture Organization’s Food Price Index was at 122 in June, still a third higher than June 2020, when it was 93. Globally, food price inflation remains higher than 5 percent per year in more than 60 percent of low-income countries and nearly 80 percent of lower-middle-income and high-income countries. Real food inflation is as high as 80 percent in Zimbabwe, 30 percent in Egypt, and 14 percent in Laos. And within countries, women and already vulnerable communities tend to be hardest hit. In just the last two weeks, the World Bank reported that wheat prices had decreased by 3 percent globally—gains Monday’s announcement are all but certain to reverse.

—Nicole Goldin is a nonresident senior fellow with the Atlantic Council’s GeoEconomics Center and global head, inclusive economic growth at Abt Associates.

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The USMCA has certainly been successful in increasing the volume of Mexico’s trade with the United States and Canada. According to the US Census Bureau, in April 2023, the United States imported more goods from Mexico than from any other country; in 2022, Mexico-US trade was almost 27 percent higher than in 2019, and Mexico-Canada trade grew 21.8 percent in these same years. Between 2020 and 2023, Mexico received fifty billion dollars in US and ten billion dollars in Canadian investments.

This increase in trade and investment flows is explained not only by the USMCA’s implementation, but also by the Biden administration’s decision to diversify supply chains, relocate production to North America, and “de-risk” from China. By seeking to reduce the vulnerability of supply chains in North America, the integration facilitated by the USMCA acquired greater relevance for companies, workers, governments, and societies.

Even though the agreement has spurred dynamism in trade and investment, its implementation has not gone without serious challenges and confrontations, which Mexico will need to address before the 2026 joint review. These include differences in the way the three countries have chosen to comply with the USMCA, heightened scrutiny on labor and environmental issues, and incomplete implementation of the agreement’s provisions.

Unsettled disputes

First, Mexico has faced difficulties on both sides of the USMCA’s dispute settlement mechanism, established in Chapter 31. Mexico’s use of this mechanism signals that it considers the agreement an effective instrument to defend its commercial and investment interests. Together with Canada, Mexico requested the establishment of a panel to settle its differences with the United States regarding the interpretation of the methodology to determine the regional value content of essential auto parts in cars manufactured in North America. The panel ruled in favor of Mexico, but there seems to be no interest in enforcing the ruling.

Mexico has also been the target of Chapter 31. Both the United States and Canada requested consultations regarding Mexico’s energy policy in July 2022 and restrictions on trade in genetically modified corn in June 2023. While both consultation processes could still lead to requests for the establishment of panels, the parties have been in conversation regarding the substance of their concerns.

Chapter 31 is of great value to the private sector in North America because it offers a legal tool to solve differences. The USMCA offers a dispute settlement mechanism that works, unlike the World Trade Organization Dispute Settlement Body, which is paralyzed. The USMCA’s panel reports are binding, and panel decisions are not affected by domestic political pressures.

However, it is the three governments’ responsibility to comply with the panels’ decisions, even if they are unfavorable, and to make sure that rulings are fully enforced. Not doing so undermines the value of the USMCA dispute settlement mechanism and the agreement itself.

High standards, heightened scrutiny

Second, Mexico has been subject to scrutiny on labor and environmental matters, reflecting US and Canadian national priorities and their need to respond to political pressure from their own domestic constituencies. Regarding labor, under the Rapid Response Labor Mechanism, the United States has initiated eleven cases against Mexico, and Canada has initiated one. Mexico’s labor authority has sought to address the concerns raised in each case, avoiding sanctions and prohibitions on exports.

On environmental matters, Mexico has faced questioning from its partners regarding compliance with its environmental legislation and its USMCA obligations. For example, in February 2022, the United States requested consultations with Mexico on the protection of the vaquita porpoise, which is associated with totoaba illegal fishing. In May 2023, the US Fish and Wildlife Service determined that Mexico has not done enough to prevent the illegal trafficking of totoaba, so later this month, US President Joe Biden could decide to impose an embargo on the trade of wildlife products from Mexico, in line with Mexico’s Convention on International Trade in Endangered Species of Wild Fauna and Flora obligations, which are also recognized in the USMCA. In labor and environmental affairs, the United States and Canada have used and may continue to use the USMCA mechanisms to pressure Mexico to comply with its obligations, since these issues are key to their own domestic political agendas.

Unfinished business

Third, Mexico has yet to fully implement several USMCA provisions. These include the Asia-Pacific Economic Cooperation Cross-Border Privacy Rules Framework, established in Chapter 19, which is already overdue. In addition, Mexico will have to become a signatory to the 1991 agreement of the International Union for the Protection of New Varieties of Plants as provided in Chapter 20. Likewise, the USMCA has a built-in agenda of future negotiations, such as the inclusion at the sub-federal level of provisions on state-owned companies and designated monopolies (Chapter 22), which should have been concluded in June 2023. Mexico needs to make sure that these provisions are enforced according to its USMCA commitments, since this will align its regulations and policies with those of its North American partners.

At the halfway point between USMCA’s entry into force and its first joint review, Mexico has seen a substantial increase in its trade and investment flows, which are key engines for its economic growth. However, Mexico still faces serious challenges in the full implementation of its commitments and in making sure that the United States also complies with a panel report favorable to Mexico. It is in Mexico’s interest to fully comply with the agreement while also requesting compliance from the United States, since that will provide certainty and predictability to investors in the region. This will facilitate the agreement’s extension at the six-year review in 2026 and will allow Mexico to promote opportunities for North American productive integration and the relocation of supply chains.

Luz María de la Mora is a nonresident senior fellow with the Atlantic Council’s Adrienne Arsht Latin America Center, where she supports the Center’s Mexico work. From December 2018 to October 2022, she served as undersecretary of foreign trade in the Mexican Secretariat of Economy, during which she helped implement the USMCA.

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Read insights below from Atlantic Council experts on what’s in the strategy and what it reveals about Europe’s economic and geopolitical future.

Click to jump to an expert analysis:

Jörn Fleck and James Batchik: Europe is taking a hard look at itself

Barbara C. Matthews: The EU is acting to decrease points of vulnerability for renewable energy

Charles Lichfield: While not mentioned, China is the central focus of the strategy

Sarah Bauerle Danzman: The road to an EU outbound investment mechanism will be rocky

Elmar Hellendoorn: The strategy seeks to be adaptable but also comprehensive

Europe is taking a hard look at itself

The European economic security strategy represents a welcome development not just for its contents but in how the European Commission is thinking about economic security—and itself.

Under a framework of “promote, protect, and partner,” the strategy sheds light on the commission’s approach to de-risking, the phrase du jour of today’s geopolitics. It proposes new assessments of vulnerabilities, strengthened rules on key areas like foreign direct investment and export controls, and new rules on outbound investment. It also recycles existing proposals—the Critical Raw Materials Act, Net-Zero Industry Act, and Cyber Resilience Act, for example. By themselves, these are not groundbreaking. But it would be a mistake to stop there. Taken together, the strategy is a welcome document that outlines how the commission sees its policies become larger than the sum of their parts. 

The contents of the strategy notwithstanding, there are three takeaways about how Europe sees its economic future. First, it starts with knowing oneself. The strategy opens with a frank acknowledgement that Europe was “insufficiently prepared” for many of the challenges that the COVID-19 pandemic, Russia’s war in Ukraine, and challenges from unnamed—read: China—players posed to Europe. Second, the strategy acknowledges that the European market, its regulations, and cohesion is by itself a European strength that can “keep global supply chains open and shape standards.” Third, that there is a direct reference that the economic risks identified could threaten Europe’s national security is a small but notable addition. It shows a recognition of the convergence of the geopolitical and the economic. 

However, the strategy also shows both the potential and the limitations of the commission. First, as much as the Berlaymont may be thinking geopolitically, the commission still relies on capitals across the continent to approve and implement new rules. Throughout the strategy, there are polite reminders for member states to implement or enforce existing or future rules. Second, and perhaps more crucially, it’s clear that the commission is increasingly out ahead of member states on issues of security, defense, and now economics. Many member states will have reservations, if not objections to some of the conclusions and proposals in the strategy. There is no shared consensus among member states about how to adequately defend themselves against China.

It’s important to remember that, as the strategy’s sentences, conjunctions, and punctuation will now be parsed and debated across the continent and the European Parliament, the strategy is not a roadmap that will solve all of Europe’s woes but an opening salvo.

—Jörn Fleck is the senior director of the Europe Center at the Atlantic Council.

—James Batchik is an assistant director at the Atlantic Council’s Europe Center. 

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The EU is acting to decrease points of vulnerability for renewable energy

The newly announced European economic security strategy constitutes a shift beyond the EU’s previous “strategic autonomy” security priorities. It will likely generate friction with both China and the United States in the near term regarding key renewable energy resources.

Until this year, the EU’s main focus was to ensure that its capacity to pursue its strategic interests remain unconstrained. It sought to ensure that policy conflicts and tensions between the United States and other countries (such as China and Russia) did not adversely impact its own interests.  

Now, the EU seeks actively to minimize “the risks arising from economic linkages that in past decades we viewed as benign.” Those past linkages include Russia (natural gas), China (automobile component and other industrial manufactured exports) and the United States (a deeply integrated, multidimensional trade relationship that includes a deep reliance on retail technology giants that dominate the twenty-first century). Following Russia’s illegal invasion of Ukraine in 2022, the EU effectively replaced Russia with the United States as the key external supplier of energy resources, even as it made great strides toward delivering an energy mix that, for the first time, is generated more from renewable sources (specifically, wind and solar) than from gas. 

The new EU “de-risking” strategy now views none of these economic linkages as benign. It views concentrated economic relationships as a source of risk that must be managed through a diversification strategy that places alignment on key norms (such as democracy, decarbonization, and commitment to open economies) as the foundation for future engagement.

Europe’s successful shift in the last year toward renewable energy implies a sharp increase in demand by Europe for a range of energy inputs that are, at present, predominantly controlled by China. Not only does China “dominate all steps of solar panel production,” it also has long served as the “dominant or near-monopoly producer” of most critical minerals needed to produce modern technology and renewable energy components such as wind turbine parts. Europe’s demand for hydrogen and lithium are set to skyrocket in the next decade, increasing the importance of the forthcoming Critical Minerals Agreement negotiations with the United States. The EU is acting now to decrease these points of vulnerability by mobilizing significant financial resources to promote renewables developments across Africa, the Middle East, and Latin America, even as it prepares to implement its carbon tax later this year.

The European policy shift to “de-risking” holds the promise of aligned transatlantic policy priorities in which EU and US initiatives complement each other to provide an effective counterbalance to Chinese economic pressure globally across the resource-rich Global South. It also holds the risk that misalignment with the United States regarding resource access and digital policy will generate frictions that can be exploited by other countries. Successful execution of this policy will require more than checkbook diplomacy. It will require Washington and Brussels to focus on the larger strategic picture to avoid individual technical issues from derailing their strategic relationship.   

—Barbara C. Matthews is a nonresident senior fellow at the Atlantic Council. She was the first US Treasury attaché to the EU with the Senate-confirmed diplomatic rank of minister-counselor.

While not mentioned, China is the central focus of the strategy

The seventeen-page long “communication” on a European economic security strategy does not mention China once. It does refer to Russia, but only in its scene-setting introduction. For the rest of the paper, economic risks stem only from phenomena, not countries. Third countries are the focus of the section following these risks, but this puts them in an exclusively positive light: to confront challenges to its economic security, Europe needs the broadest possible partnerships. 

Can there be any purpose to a strategy that dares not mention which countries are causing the risks it is supposed to tackle? The answer is still yes. 

The robust discussions that took place between European Commission President Ursula von der Leyen’s team and the European Council—representing the views of all twenty-seven member states—are well publicized. A critical mass of national capitals, though concerned about the consequences of Chinese economic practices, are keen to avoid falling into a ratchet of policies and partnerships leading to an anti-China coalition. This includes members who have long been calling for the EU to take a more hands-on approach on economic statecraft, such as France.

And yet, even under such constraints, the strategy gets many things right. Alongside the traditional calls for cooperation, it pushes for more structured dialogue with the private sector—something that has been lacking on economic security strategy so far. We should also remember that von der Leyen did get to set out her views on EU-China relations not too long ago. So even if China isn’t mentioned, we can be pretty sure it remains the central focus of the EU’s fledgling strategy.

—Charles Lichfield is the deputy director and C. Boyden Gray senior fellow, of the Atlantic Council’s GeoEconomics Center.

The road to an EU outbound investment mechanism will be rocky

This strategy makes clear that the commission is going to bat for outbound investment controls, likely tightly connected to the three emerging technologies most poised to transform war making capabilities—advanced semiconductors, quantum computing, and artificial intelligence. This position reflects a rapid evolution in the commission’s thinking; just last year it was less enthusiastic toward outbound controls when the United States first announced its intention to develop a tool to regulate such investments. Then it only agreed to “study the issue.” Despite the commission’s commitment to propose an outbound initiative by the end of 2023, the debate between the EU, member states, and the business community is likely to be fierce.

In the near term, the inclusion of outbound investment in the strategy has two important implications. First, it substantially increases the likelihood that the United States will move forward with its own mechanism—through an executive order—in the next couple of months. The Biden administration can now point to the document as evidence of a growing consensus among partners and allies to place narrow restrictions on outbound investments into key strategic technologies. Second, and in line with the recent Group of Seven (G7) communiqué on economic resiliency, it frames the issue of outbound regulation squarely around technology security and technology leakage rather than around broader policy objectives such as supply-chain diversification.

The road to an EU outbound investment mechanism will be rocky. The economic security strategy identifies technology security as an element of “economic security,” but the proliferation of dual-use technology has traditionally been viewed as a matter of national security—an area over which member states, rather than the commission, have competence. Moreover, the EU has traditionally—through both export control and inward screening policies—sought to develop tools that do not discriminate between foreign countries. If the EU maintains this policy principle, its outbound mechanism will likely look quite different from the United States’ plan to only focus on investments into entities operating in or owned by “countries of concern” such as China.

—Sarah Bauerle Danzman is a nonresident senior fellow with the GeoEconomics Center’s Economic Statecraft Initiative and associate professor of international studies at the Hamilton Lugar School for Global and International Studies, Indiana University Bloomington.

The strategy seeks to be adaptable but also comprehensive

The most important element of the document can be read between the lines: it is not so much about what the commission is going to do about economic security but how. Three key principles seem to be guiding the commission’s economic security strategy.

The first principle is strategic adaptability. The commission announces that it will constantly work toward a vision on economic security that will help to tie the different policy instruments together. As geopolitical circumstances are changing in unforeseeable and complex ways, the commission has wisely refrained from setting its economic security policy approach in stone. Adaptability and flexibility appear to be baked into the commission’s thinking on this issue. 

The second principle is comprehensiveness. In the strategy, the commission clearly expresses the ambition to break through different policy silos. While it does sum up the different policy instruments the EU has to strengthen its economic security—ranging from foreign direct investment screening to cybersecurity—the underlying question is how it is going to coordinate the use of its economic statecraft toolkit to achieve a maximum result. 

The third principle is cooperation. The commission also shows a certain humility in pointing out all the work ahead on economic security. Clearly, it needs the support of its member states, not only in terms of policy execution, but also in helping to fully understand the challenge. Also, the EU is going to align its diplomacy and economic security policy more, thus targeting countries that the EU can work with to achieve greater economic security. Lastly, in terms of further conceptualization of its strategic approach to economic security, the commission also seems to be reaching out to the wider private sector.

—Elmar Hellendoorn is a nonresident senior fellow with the Atlantic Council’s GeoEconomics Center.

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Table of contents

Executive summary

I. Introduction

II. The role of economic statecraft in a Taiwan crisis

Goals of economic countermeasures

Current economic statecraft tools

Tools in a future crisis

III. Sanctions scenarios and their costs

Economic countermeasures aimed at China’s financial system

Economic countermeasures aimed at individuals and entities associated with CCP and PLA leadership

Economic countermeasures aimed at China’s industrial sectors

IV. Practical challenges in sanctions development

Conclusions and recommendations

Executive summary

In recent months, growing tensions in the Taiwan Strait as well as the rapid and coordinated Group of Seven (G7) economic response to Russia’s invasion of Ukraine have raised questions—in G7 capitals and in Beijing alike—over whether similar measures could be imposed on China in a Taiwan crisis. This report examines the range of plausible economic countermeasures on the table for G7 leaders in the event of a major escalation in the Taiwan Strait short of war. The study explores potential economic impacts of such measures on China, the G7, and other countries around the world, as well as coordination challenges in a crisis.

The key findings of this paper:

1. In the case of a major crisis, the G7 would likely implement sanctions and other economic countermeasures targeting China across at least three main channels: China’s financial sector; individuals and entities associated with China’s political and military leadership; and Chinese industrial sectors linked to the military. Past sanctions programs aimed at Russia and other economies revealed a broad toolkit that G7 countries could bring to bear on China in the event of a Taiwan crisis. Some of these tools are already being used to target Chinese officials and industries, though at a very limited scale.
2. Large-scale sanctions on China would entail massive global costs. As the world’s second-biggest economy—ten times the size of Russia—and the world’s largest trader, China has deep global economic ties that make full-scale sanctions highly costly for all parties. In a maximalist scenario involving sanctions on the largest institutions in China’s banking system, we estimate that at least $3 trillion in trade and financial flows, not including foreign reserve assets, would be put at immediate risk of disruption. This is nearly equivalent to the gross domestic product of the United Kingdom in 2022. Impacts of this scale make them politically difficult outside of an invasion of Taiwan or wartime scenario.
3. G7 responses would likely seek to reduce the collateral damage of a sanctions package by targeting Chinese industries and entities that rely heavily and asymmetrically on G7 inputs, markets, or technologies. Targeted sanctions would still have substantial impacts on China as well as sanctioning countries, their partners, and financial markets. Our study shows economic countermeasures aimed at China’s aerospace industry, for example, could directly affect at least $2.2 billion in G7 exports to China, and disrupt the supply of inputs to the G7’s own aerospace industries. Should China impose retaliatory measures, another $33 billion in G7 exports of aircrafts and parts could be impacted.
4. Achieving coordination among sanctioning countries in a Taiwan crisis presents a unique challenge. While policymakers have begun discussing the potential for economic countermeasures in a Taiwan crisis, consultations are still in the early stages. Coordination is key to successful sanctions programs, but high costs and uncertainty about Beijing’s ultimate intentions will make stakeholder alignment a challenge. Finding alignment with Taiwan in particular on the use of economic countermeasures will be central to any successful effort. G7 differences on Taiwan’s legal status may also prove a hurdle when seeking rapid alignment on sanctions.
5. Deterrence through economic statecraft cannot do the job alone. Economic countermeasures are complementary to, rather than a replacement for, military and diplomatic tools to maintain peace and stability in the Taiwan Strait. Overreliance on economic countermeasures or overconfidence in their short-term impact could lead to policy missteps. Such tools also run the risk of becoming gradually less effective over time as China scales up alternative currency and financial settlement systems.

I. Introduction

For decades, Taiwan’s deepening economic ties with China and the rest of the world have helped maintain peace and stability in the Taiwan Strait. Mutual trade and investment have spurred rapid economic growth and—at least until recently— appeared to diminish the likelihood of military conflict.

The long-standing guardrails around the China-Taiwan status quo have weakened. Intensifying US-China geopolitical tensions, China’s increased use of military and economic tools to put pressure on Taiwan, Beijing’s draconian handling of Hong Kong, and evolving Taiwanese perspectives on their national identity and relationship with the mainland have all contributed to rising tensions. Taiwan’s presidential elections set for early 2024 increase the risk of escalation, as do both a rancorous US debate on China and political anxiety in Beijing in the face of a deteriorating economic outlook.

As concerns grow, so does awareness of the global economic stakes of a Taiwan crisis. Prior Rhodium Group research estimates that more than $2 trillion of global economic activity would be at risk of direct disruption from a blockade of Taiwan annually.¹ This is a likely underestimate of the short- and long-term economic fallout of a full-blown crisis. In all cases, the scale of these likely global impacts—ranging from widespread goods shortages, mass unemployment, and a possible financial crisis—underscores the need for clear-eyed analysis about the costs of a conflict. 

In this context, policymakers and business leaders around the world have begun discussing the potential role of sanctions and other economic countermeasures in a military crisis. The G7’s coordinated use of sanctions against Russia in the wake of its invasion of Ukraine have highlighted the range of tools on the table. In Washington and other G7 capitals, as well as in Beijing, leaders are now considering the potential for, and implications of, sanctioning China. Yet G7 coordination in a Taiwan crisis would involve a different set of challenges. China’s economy is ten times larger and more globally interconnected than Russia’s, raising questions about the viability of joint economic countermeasures.

Given these open questions, the purpose of this report is to provide a data-driven and objective first look at the potential for a coordinated G7 response to a Taiwan crisis. It evaluates different economic statecraft tools and considers the global economic repercussions from their use. Based on an extensive series of in-person roundtable discussions in the United States, the European Union, and the United Kingdom, interviews held with G7 policymakers and experts, and our own independent economic analysis, the report sets out the order of magnitude of what is at stake and the coordination that would be required for sanctions options to be effective.

While few US, European, and Chinese officials want to see tensions escalate in the Taiwan Strait, the past year has shown that situations previously regarded as highly unlikely can quickly materialize into a devastating reality. Understanding the scenarios and risks of using the tools of economic statecraft is not only a useful exercise, but also a critical step in ensuring all sides understand the full impact of actions that may be undertaken in a crisis.

II. The role of economic statecraft in a Taiwan crisis

A sense of heightened risk in the Taiwan Strait and the use of sanctions against Russia has led decision-makers around the world to reflect on the potential use of economic countermeasures against China in a Taiwan crisis. US lawmakers have already proposed legislation mandating sanctions on China in the event of an invasion of Taiwan.² Surveys of European countries underline an increasing—if still minority—willingness to sanction China if it were to take military action against Taiwan.³ Officials in Beijing are asking these questions as well, with China’s State Council reportedly considering the potential for Western sanctions in a Taiwan crisis.⁴ The economic fallout from sanctions on Russia have also led business leaders and major banks to conduct contingency planning exercises exploring their exposures to a cross-strait crisis, including sanctions on China.

In defining what sanctions to use—if any—policymakers are likely to take a series of factors into consideration: what goals they are looking to achieve, what options are on the table to achieve those goals, and their relative impacts, costs, and limitations. This section reviews these factors and lays out the most likely options on the table.

Goals of economic countermeasures

Economic countermeasures—defined broadly here to include financial sanctions, export controls, and other restrictions on economic activity—can have a variety of objectives. They may aim to deter aggression, either by promising punitive economic actions in response to a transgression (deterrence by punishment) or by denying an adversary the technology or resources to engage in aggressive activity in the future (deterrence by denial). They may also aim to degrade an adversary’s ability or willingness to sustain aggression after it has begun.

The aim of economic countermeasures may evolve over time. The United States had long imposed export controls to limit the flow of military and dual-use technology to Russia. Immediately prior to Russia’s full-scale invasion, the United States and allies threatened sanctions on Russia in a bid to deter military action. After the invasion, the focus of sanctions shifted to degrading Russia’s ability and willingness to continue the war. Sanctions may also have had a signaling effect that G7 countries were aligned and willing to bear prolonged costs in support of Ukraine.

As in the case of Russia, the United States and allies have limited the flow of arms and military technology to China in part to blunt its ability to engage in aggression against Taiwan long before a potential crisis. The proper design of these long-term restrictions is a matter of contentious debate in the field of export controls and technology policy, but is not the focus of this paper.

Some G7 partners are already communicating to China that actions short of an invasion could trigger economic countermeasures

Economic countermeasures might also be considered after a full-scale invasion of Taiwan to degrade China’s ability to sustain the conflict. In fact, interviews and roundtables highlighted near consensus about the fact that sanctions would be imposed on China were it to use military power to seize Taiwan. However, if the case of Russia is any guide, these sanctions take time to have an effect. Recent studies suggest that absent military intervention from the United States and allies, Taiwan is unlikely to withstand a full-scale invasion for the length of time necessary for sanctions alone to meaningfully degrade China’s military capacity.⁵

Some level of sanctioning might therefore also be contemplated in a crisis below the level of invasion, to deter further aggression. Some G7 partners are already communicating to China that actions short of an invasion could trigger economic countermeasures. These actions are the core focus of this report. While we do not identify specific triggers for economic action below invasion—because these are still intensely debated—they might include a military quarantine scenario, where the PRC restricts the free movement of ships or planes to Taiwan; acts of overt economic coercion such as wide-ranging punitive restrictions on cross-strait trade; and major cyberattacks or other disruptions to telecommunications networks on the island. Taiwanese officials have described some of these below-invasion scenarios as the most likely and pressing military risks to Taiwan’s sovereignty.⁶ Some of these “gray zone” actions, besides, come with high global economic costs that could warrant efforts by G7 nations to deter Chinese actions.⁷

Current economic statecraft tools

In looking to achieve these goals, G7 leaders have a range of tools available. Many economic countermeasures have been deployed in the context of previous crises (Table 1), including Russia’s 2014 annexation of Crimea and 2022 full-scale invasion of Ukraine, making them useful starting points to assess potential future action.

In understanding whether these tools could also be deployed in a major cross-strait crisis, it is important to remember that some tools are already being used against China today, both by the United States and other members of the G7. Actions include, among others:

• Export controls including product-based and end-user-based controls on certain strategic technologies, such as semiconductors, integrated circuits, and supercomputing technology.⁸
• Restrictions on the trading of debt and equity instruments in certain military-related companies under the Non-SDN Chinese Military Industrial Complex Companies List.⁹
• Sanctions imposed on persons involved in the repression of minorities in Xinjiang, as well as small Chinese banks aiding Iran and North Korea in sanctions evasion.¹⁰
• US and EU coordination of sanctions against Chinese firms involved in supporting Russia’s war on Ukraine.

While these measures are applied at a much smaller scale than they would be in a Taiwan Strait crisis, they illustrate the fact that G7 nations have already shown willingness to use economic measures against China when Chinese actions or policies were considered problematic. Importantly, these measures have been selective. From manufactured goods to inputs for electric vehicles, to machine tools, and pharmaceuticals, China is deeply embedded in global supply chains in a way wholly more complicated than Russia’s energy exports. At the same time, China’s reserves, capital controls, the state-owned banking sector, and abundant fiscal space provide the Chinese economy with critical buffers and economic defense mechanisms.

Tools in a future crisis

In imposing sanctions in a Taiwan crisis, G7 partners would seek to amplify existing measures taken against China and focus on asymmetric dependencies. Policymakers will likely look to the same types of targets described in Table 1, with varying intensity depending on the level of escalation, namely:

1. Sanctions on China’s financial sector
2. Sanctions on individuals associated with the leadership of the Chinese Communist Party (CCP) and People’s Liberation Army (PLA)
3. Restrictions on industrial companies in sectors relevant to China’s defense industrial base

We take these three types of tools as our baseline for likely G7 countermeasures in a Taiwan crisis and analyze each in depth.

While these are the most likely sets of tools identified by experts based on past actions, future crises may bring new tools to the table too. Conversations with US and European officials made clear that Russia’s invasion of Ukraine reshaped the contours of what was possible in the realm of economic statecraft. Just as blocking Russia’s central bank reserves and implementing an oil price cap were initially considered unrealistic, crises may spur discussions around new tools. Roundtable discussants raised options ranging from targeting casinos in Macau, which are regarded as havens of capital flight for China’s elite as well as illicit finance and money laundering; to imposing controls on China’s digital industries and firms, which power much of the country’s urban and consumer economy; to limiting access to International Monetary Fund (IMF) Special Drawing Rights, and stopping repayments of dollar-denominated Belt and Road Initiative (BRI) debt. We do not explore these potential countermeasures in this study. However, some of the ideas discussed by stakeholders illustrate the range of additional tools that could be brought to bear in a crisis.

III. Sanctions scenarios and their costs

In this section we examine three likely channels of G7 sanctions—on China’s financial system, on certain individuals and entities, and on industrial sectors. We provide an assessment of China-G7 economic value at stake through use of each type of tool, and evaluate implementation challenges, possible effectiveness, and risks.

Economic countermeasures aimed at China’s financial system

In a Taiwan crisis, G7 leaders could consider deploying economic countermeasures targeted at China’s financial system. Financial sector sanctions are a central pillar of the G7’s recent sanctions program aimed at the Kremlin. These measures include actions to block transactions with major Russian banks, freeze their assets, and deny them access to the global dollar payments infrastructure.

This section explores the economic implications of sanctions on China’s financial system, considering two primary options: a targeted sanctions program to limit dollar financing to small banks involved in funding military-related activities, and a comprehensive sanctions program targeting China’s four largest banks and its central bank with the aim of cutting China off from global financial markets.

Global economic links: Finance

For an economy of its size, China has relatively limited external financial sector ties. China is the world’s second-largest economy and has the largest volume of international goods trade, yet it ranks eighth and ninth in the world in terms of total external assets and liabilities.¹¹ Nonetheless, these ties have critical global importance. As of the end of 2022, China held 95 percent of its $3.3 trillion in reserves in foreign currency (with the remaining held in gold).¹² China does not report the exact composition of its foreign exchange reserves, but it is known to hold at least $1.1 trillion in US government bonds through US custodians, and more routed through custodians in Belgium,¹³ as well as about $300 billion in corporate debt and equity.¹⁴ The remainder of China’s foreign currency reserves are held predominantly in euros, Japanese yen, and pounds sterling.¹⁵ In addition to China’s official reserves, China’s banking sector holds $1.5 trillion in cross-border assets according to State Administration of Foreign Exchange statistics, most of which is held in G7 currencies.¹⁶ 

Global bank holdings of assets within China’s banking system are much lower. On average, only 3 percent of global central bank reserve holdings are in RMB-denominated assets.¹⁷ G7 banks hold $112 billion in claims on Chinese banking institutions such as loans, deposits, and debt instruments, which is only 1 percent of total cross-border bank claims.¹⁸ While this means that global banks, on average, are not heavily exposed to China in terms of explicit bank assets, it also means that Chinese banks primarily borrow from Chinese domestic savers and do not depend heavily on foreign borrowing to maintain their balance sheets.

Global exposures to China’s banking system are much greater when considering China’s role facilitating cross-border financial flows, particularly trade. When Chinese importers and exporters do business abroad, they typically do so in foreign currencies: 77 percent of China’s total $6.8 trillion in goods and services trade is settled in currencies other than the RMB, primarily US dollars and euros.¹⁹ To facilitate these cross-border payments, Chinese banks maintain correspondent accounts at global banks, which debit or credit dollar and euro payments to the Chinese correspondent accounts on behalf of the foreign customer or supplier. Maintaining these correspondent accounts is a key part of the financial infrastructure underpinning global trade.

Chinese banks also finance other important cross-border flows, including $384 billion in repatriated income from foreign businesses and investments, $330 billion in inbound and outbound direct investment, and $381 billion in cross-border portfolio investment.²⁰

Scenarios

With these financial sector linkages in mind, we consider two potential sanctions scenarios: one in which G7 countries would impose limited sanctions on a small bank with linkages to China’s military or technology sector, and another where they would deploy full-scale sanctions on China’s central bank and China’s Big Four banking institutions.

Limited sanctions scenario

One potential scenario would involve imposing blocking sanctions on a small Chinese bank with limited financial ties to the global financial system and with links to China’s military or dual-use technology sectors. The nominal purpose of these sanctions would be to constrain the flow of foreign financing to military-relevant economic activities.

Actions of this kind have been imposed by the United States before. In 2012, the US Treasury Department sanctioned China’s Bank of Kunlun for providing financial services to six Iranian banks sanctioned by the United States for involvement with Iran’s weapons program and international terrorism.²¹ In 2017, the United States issued a final rule under Section 311 of the USA PATRIOT Act severing China’s Bank of Dandong from the international dollar financing system for its role in helping the Democratic People’s Republic of Korea (DPRK) evade sanctions.²²

The Bank of Kunlun and Bank of Dandong were relatively small and had limited ties to the global financial system. The financial impact from these actions on the global financial system was minimal. In the case of the Bank of Dandong, for instance, the bank processed $844 million in cross-border transactions in 2016 just prior to being identified as an institution of “primary money laundering concern,” a modest sum in the broader picture of global financial flows.²³ While these banks were cut off from the global dollar financing system, they remain connected to the rest of China’s banking sector. As raised in our roundtables, this enables them to continue providing financial services for US sanctioned entities, including Iran and the DPRK.

In a Taiwan crisis scenario, policymakers would face a similar challenge. G7 countries could impose blocking sanctions on small banks, freezing any foreign assets held in G7 jurisdictions and prohibiting domestic individuals and entities from transacting with those banks. However, even if the sanctioned banks lost direct access to correspondent banks in the United States and Europe, they would still have access to financing channels from other Chinese banks, and China’s military-industrial enterprises could still easily access dollar financing, if needed, from other channels in China’s state-run banking system. Rather than make a substantial impact on China’s financing flows, the primary impact of these types of sanctions would be limited to conveying an intent to escalate financial sanctions further, potentially on larger, more systemically important institutions.

Full-scale financial sector sanctions scenario

At the other extreme, the United States and allies could take much more drastic measures against China’s financial system by, for example, imposing blocking sanctions and denying SWIFT access to China’s central bank, its finance ministry, and China’s Big Four banks, which collectively hold one-third of China’s total banking assets.²⁴

The economic impact of such moves would be dramatic, both for China and for the world. This would effectively freeze China’s foreign exchange reserves held in overseas custodial accounts, making them unusable for the defense of China’s currency or to meet short-term obligations to finance China’s imports or external debt repayments. The bulk of overseas assets of the Big Four banks —amounting to around $586 billion—would be frozen.²⁵ This represents a floor, not the ceiling, of the global economic disruption from these actions, which are many magnitudes higher.

G7 assets in China would also be at risk. It is likely that China would freeze the (relatively small) renminbi-denominated holdings of G7 banks. Chinese banks, facing a sudden shortage of foreign exchange due to asset freezes, would likely fall into technical default on G7 bank-issued debt, totaling around $126 billion.

Sanctioned banks would also be cut off from the international dollar payments system. Chinese banks do not systematically report the scale of their cross-border transaction settlements, so we are left to estimate the scale of disruption if China’s Big Four banks were sanctioned. Starting from China’s balance of payments statistics on cross-border trade and investment, we estimate what share of that activity is attributable to the Big Four. We assume that the Big Four banks’ role in facilitating cross-border trade and investment is proportional to their share of foreign asset ownership in China’s whole banking sector, indicating approximately $3 trillion in trade and investment flows could be put at risk, primarily from disruptions to trade settlement. This is only a rough estimate and is likely an undercount, but it illustrates the scale of economic activity at risk from full-scale sanctions on China’s largest banks.

Over the long term, Chinese importers and exporters could move to other, unsanctioned banks for trade settlement and finance, but the immediate disruption to global trade would be substantial and smaller banks would likely struggle to backfill the enormous demand for trade-facilitating financial services in the short term. Eventually, Chinese importers and exporters would adapt to financial-sector sanctions by turning to a different set of banks and potentially engaging in more renminbi-denominated transactions (see Box 1 on China’s international payments alternatives). But the vast majority of China’s exports would be impacted in the short term, as it would be extremely difficult for Chinese companies to receive US dollar- or euro-denominated payments for goods.

$3 trillion in trade and investment flows could be put at risk, primarily from disruptions to trade settlement.

Freezing China’s official foreign exchange assets would also have substantial global spillovers. An asset freeze of China’s dollar reserves would suddenly make dollars in China scarce, driving down the value of the renminbi relative to the dollar. Beijing could fight this depreciation pressure in the short term through strict capital controls and exchange rate interventions, but ultimately would need to allow the renminbi to depreciate to ease outflow pressures and stabilize China’s balance of payments.

A weaker exchange rate would make goods imports more expensive and reduce China’s global economic throw weight. Disruptions to China’s export trade would also entail substantial economic hardship and financial stress for Chinese companies and suppliers to global markets. However, assuming that Chinese exporters and importers eventually found other non-sanctioned banks to legally conduct trade with foreign counterparties, China would still avoid a balance of payments crisis. China presently runs a large current account surplus, providing a consistent flow of dollars into its financial system. In fact, devaluation of the renminbi would ultimately make Chinese exports more competitive relative to other countries, which would push some of the impact of sanctions on to exporters in those countries. Other emerging market currencies, including those of US allies, would be likely to depreciate sharply against the US dollar as well. Countries that depended upon exports to China, such as Angola and Brazil, would see those export markets contract sharply.

The imposition of broad-based financial sanctions on Chinese banks would create significant dislocations within the global financial system and would likely require a coordinated policy response among developed market central banks in order to manage the fallout. Global supply chains would be upended while exporters and importers routed activities to unsanctioned banks. Countries that rely on dollar financing— to finance trade with the United States and Europe, for instance—would face a surge in financing costs, requiring the Federal Reserve to pump dollars back into the global economy through central bank swap lines. But even if swap lines with China were prohibited, these dollars would find their way back into China’s economy due to its trade surplus with the rest of the world.

Takeaways

While it is likely that a financial sanctions package would be on the table in the case of a major Taiwan crisis, avenues for sanctioning China’s financial system face limitations. A lower-scale response that targeted small banks involved with financing military activities would limit the negative impact on the global economy, but it would have little effect on Chinese behavior or military activities because other financing channels would remain open. On the other extreme, a full-scale sanctions response targeting China’s central bank and most of the country’s major commercial banks would have massive economic spillovers—for China’s economy, but also for the global financial system and the global economy. Second-order consequences could include a tightening of global trade financing conditions; weakness in emerging market currencies and balance of payments problems in emerging markets; major supply chain disruptions and interruptions to global manufacturing of consumer goods; and inflationary short-term impacts from interrupted China-world trade.

Sanctions on China’s financial sector could end up falling somewhere between these two extremes, with sanctions placed on midsize banks, for instance. Impacts from these sanctions on trade and financial markets would be more moderate than in the case of a maximal sanctions scenario, but these face many of the same limitations as more comprehensive sanctions.

Fundamentally, the long-term strategic benefit of financial-sector sanctions is unclear. Imposed on small banks, they would have minimal impact on China’s ability to finance military activities. At a large scale, sanctions would disrupt trade with China in the short run, but they would not fundamentally change China’s position within global manufacturing supply chains. Over time, China’s terms of trade would probably improve along with a weaker exchange rate. The symmetrical impact of such sanctions on China and the rest of the world reduces the credibility of such broad-based financial sanctions as a deterrent.

Box 1: How Well-Developed Are China’s International Payments Alternatives? 

Over the past five years, China’s Ministry of Finance and the People’s Bank of China (PBOC) have established several platforms to facilitate cross-border transactions and reduce reliance on dollar-based payment systems. Given the increased interest from across the Global South in alternative payment systems to the dollar in the wake of G7 sanctions on Russia, it is likely that in the next five years more of the Chinese systems could be used as a means of sanctions evasion.

In 2015, China launched its Cross-border Interbank Payment System (CIPS) to function as a settlement and clearance mechanism for renminbi transactions. An alternative to the dollar-based Clearing House Interbank Payment System (CHIPS), CIPS is supervised by the PBOC, and participants have the opportunity to message each other through the CIPS messaging system.

Data on CIPS usage suggest that transaction volumes have more than doubled in that period, growing by 113 percent.²⁶ However, while China is making significant progress in developing international payment alternatives, it lags behind the established global payment ecosystem.²⁷ Research indicates that CHIPS has ten times more participants and settles forty times more transactions compared to CIPS.²⁸ These incumbents have well-established networks, widespread acceptance, and trust among global users.

Perhaps the most significant payment alternative is China’s development of its Central Bank Digital Currency (CBDC), the e-CNY, which began in 2017. The retail CBDC project focuses on enabling individuals and businesses to use the e-CNY for everyday transactions. Interestingly, the PBOC has over 300 staff working on their CBDC project, and only about one hundred working on CIPS.²⁹ However, this retail CBDC project may have limited ability to help internationalize the yuan and facilitate its use as a means of sanctions evasion given its domestic focus and the lack of infrastructure for cross-border use.

The same cannot be said, however, of China’s wholesale CBDC ambitions. China’s wholesale project aims to streamline interbank transactions and improve its cross-border financial system efficiency. Project mBridge is a joint experiment with the Hong Kong Monetary Authority, Bank of Thailand, Central Bank of the United Arab Emirates, and Bank for International Settlements to create common infrastructure that enables real-time cross-border transactions using CBDCs. In October 2022, the project successfully conducted 164 transactions in collaboration with twenty banks across four countries, settling a total of $22 million, with almost half of all transactions in the e-CNY.

This initiative demonstrates China’s active involvement in exploring innovative solutions for international payments, particularly in the context of cross-border transactions which do not use dollars or euros. This system, though not yet ready for full launch, could help countries bypass dollar-denominated systems like SWIFT or CHIPS and develop an alternative financial architecture.

The biggest challenge for new China-based cross-border payments architecture is liquidity. China maintains capital controls on yuan and offshore clearing, and settlement of yuan is severely limited in comparison to the dollar, euro, pound, and yen. Removing these capital controls to provide liquidity pools for offshore clearing and settlement in yuan will come with some financial instability in Chinese markets, which is undesirable to leadership in the short term.

However, even if certain transactions will be more costly to execute, the recent history of sanctions evasions shows actors are willing to pay a premium to have specific transactions avoid dollars and US enforcement. China is investing significant resources in scaling up these capabilities.

Economic countermeasures aimed at individuals and entities associated with CCP and PLA leadership

Sanctioning the leadership and key associates of adversarial governments, criminal organizations, and terrorist groups is a well-established mechanism deployed by G7 nations and international organizations, including the United Nations. These measures are meant to pressure the targeted individuals, organizations, and governments to change their behavior or policies, while freezing their assets and restricting their ability to raise, use, and move funds.³⁰. In the event of a Taiwan crisis, G7 countries could impose targeted financial sanctions on Chinese government and military officials as well as other politically connected elites to attempt to deter further escalation and increase economic pressure on General Secretary Xi Jinping and his close allies.

Sanctions targeting Russian government and military officials and elites have been a central part of the G7 and allies’ sanctions strategy to counter Russia’s aggression toward Ukraine. Since the 2014 invasion of Crimea, G7 allies have collectively sanctioned more than 9,600 Russian-linked individuals, with a specific focus on government and military officials, oligarchs, and others with links to the regime as well as their family members and close associates who received asset transfers before a sanctions designation.³¹ As of March 2023, members of the Russian Elites, Proxies and Oligarchs (REPO) Task Force—a coalition of G7 nations, Australia, and the European Commission—have blocked Russian assets valued at more than $58 billion, including both financial accounts and assets such as real estate and luxury goods.³²

Separately, some G7 nations have imposed unilateral sanctions on PRC officials in response to human rights abuses and PRC actions in Hong Kong. As of May 2023, the United States had designated forty-two government officials, including former Chief Executive of the Hong Kong Special Administrative Region Carrie Lam and other PRC government officials, in response to actions undermining Hong Kong’s autonomy.³³ In March 2021, the EU also made a rare use of its Global Human Rights Sanctions Regime to sanction four high-ranking Chinese officials for their involvement in human rights abuses against ethnic minorities in the Xinjiang Uyghur Autonomous Region, with sanctions including travel bans and asset freezes³⁴—a move complemented by economic countermeasures taken the same day by the United States, the United Kingdom, and Canada.³⁵

It is highly likely that G7 nations would consider multilateral targeted designations against Chinese government and PLA officials and their associates in a major Taiwan crisis, given their relative success coordinating multilateral sanctions to counter Russia’s invasion of Ukraine.³⁶ The following section explores economic ties at stake and potential sanctions scenarios.

Global economic links: Individuals abroad

Assessing the scale of overseas assets covered by a potential sanctions regime on Chinese government, party, and military officials is extremely complex. There is limited available public information on the wealth of Chinese officials, in large part because that wealth is concealed via layers of personal networks and investment vehicles, and is often managed by third parties. These third parties invest on behalf of officials in domestic and overseas properties, publicly listed companies, and other investments—often in offshore jurisdictions such as the British Virgin Islands (BVI), the Cayman Islands, and Samoa. These offshore company structures often open bank or brokerage accounts in other jurisdictions, thereby further obscuring the relationship to the ultimate beneficiary.

For the purpose of this study, the authors used data derived from investigative reports and leaks of financial information such as the Panama Papers, which combined give a broad sense of the scale of assets connected to some of the highest-ranking figures of China’s leadership. In 2012, Bloomberg reported that Xi’s extended family held more than $400 million in business holdings and real estate.³⁷ The same year, reporting by the New York Times identified $2.7 billion in assets linked to former Premier Wen Jiabao and his close network.³⁸ Leaks of financial information including the offshore accounts analyzed by the International Consortium of Investigative Journalists in 2014 confirmed the existence of shell companies incorporated in the British Virgin Islands that are linked to the relatives of Wen and Xi, although the value of assets linked to these companies is unknown.³⁹ The leaked information also contained evidence of BVI-incorporated companies held by relatives of former Premier Li Peng and former President Hu Jintao, among others. Despite the opacity surrounding the overseas assets of the elite of the CCP, these single cases are potential indications that relevant, sanctionable assets likely represent tens of billions of dollars in aggregate.

This figure could grow quickly if the targets of financial sanctions were extended beyond high-level CCP and PLA leadership to include politically linked private business leaders. The estimated net worth of the top 200 wealthiest people in China is around $1.8 trillion.⁴⁰ Twenty-nine of those business leaders are current members of the National People’s Congress (NPC) or the Chinese People’s Political Consultative Conference (CPPCC), with a combined net worth of $278 billion. Much of this net worth is, however, linked to business activities taking place in China, rather than within G7 jurisdictions.

Twenty-nine of those business leaders are current members of the National People’s Congress (NPC) or the Chinese People’s Political Consultative Conference (CPPCC), with a combined net worth of $278 billion

Scenarios

A scenario involving sanctions on Chinese officials could proceed in several stages, with a first set of actions targeting a narrow and lower-level set of party, government, and military officials with direct links to a Taiwan crisis. Further actions could expand these sanctions to close associates of designated individuals, a longer list of officials, or ultimately to a broader set of politically connected business elites. Under the most extreme of scenarios, these sanctions could be widened to include China’s highest-level leaders in response to major developments in the Taiwan Strait.

Sanctions on a narrow set of CCP, government, and military officials 

One likely scenario would involve sanctions—asset freezes and travel bans—imposed on a narrow group of CCP, government, and military officials with clear responsibilities over actions taking place in the strait. China’s current minister of defense, Li Shangfu, is already under US sanctions⁴¹—but designations could be extended to cover select members of the Central Military Commission or high-ranking PLA commanders. These could also include close advisers to these officials or to China’s high-level leaders on Taiwan-related issues.

The nominal purpose of these sanctions would be largely symbolic, and a means to condemn Beijing’s actions. Their effectiveness in changing behavior is likely to be extremely limited and could contribute to a hardening of positions. Most of this group of designated officials would likely be highly aligned with Xi’s decisions on Taiwan. Narrowly crafted sanctions on officials might also generate limited financial outcomes, given that these individuals are already under tight political scrutiny in China and unlikely to be allowed major overseas holdings. The scope of sanctionable assets might grow marginally larger, however, if close associates and family members are included, especially children of government officials studying in G7 countries, as well as close aides and the third parties handling their investments. Similar to the Russian case, these individuals may become a focus for the G7 if asset transfers occur ahead of designations.

Sanctions on a wider range of CCP, government, and military officials as well as business elites 

In response to an escalation in the Taiwan Strait, G7 countries could decide to progressively expand sanctions to cover a longer list of government, CCP, and PLA officials. The list could also include certain business elites with known links to China’s leadership, who lend their public or financial support to China’s actions, or those who are active in sectors linked to China’s military-industrial base. The United States has already designated several Chinese executives and companies for breaking US law by providing support to North Korea, among other violations.⁴²  

In addition to asset freezes and travel bans, G7 governments might impose restrictions on professional and financial services provided to these elites, including wealth management or business advisory services.⁴³ While Chinese clients overwhelmingly rely on the expertise of wealth managers based in Hong Kong, a small percentage of other managers are located in Switzerland (1.6 percent), the UK (1.6 percent), and the United States (1.1 percent).⁴⁴ 

The purpose of this second round of sanctions would be to attempt to pressure these officials to push internally for a change in policy. Assuming intelligence about their overseas assets were available to G7 implementing authorities, these broader sanctions could end up covering tens of billions of dollars in overseas assets. The costs to designated officials could be high: besides the financial implications of an asset freeze, even the public revelation of foreign assets could be politically damaging.

Our roundtable participants noted that sanctions on individuals amid a Taiwan crisis could potentially produce a stronger response than has occurred with recent designations of Russians. Whereas many Russian officials have been under sanction since 2014 and have had time to adapt, such sanctions on China would be mostly new and immediately impactful to those designated.

Still, it remains unclear whether sanctions on China’s business elites would compel a change in policy. Business leaders arguably have the most to lose from Chinese aggression against Taiwan to begin with, since disruptions in trade and investment with Taiwan and G7 partners will affect businesses first and foremost. The waning influence of the private sector in governance due to crackdowns on the technology and financial sectors under Xi raises further questions about business elites’ ability to influence policy outcomes toward Taiwan.

Sanctions on China’s high-level leaders

In an extreme escalation in the Taiwan Strait, sanctions could end up targeting China’s highest-ranking officials including most members of the Political Bureau of the CCP’s Central Committee and Xi himself. If Russia sanctions are any indication, this third circle of sanctions could also include China’s ministers of foreign affairs, science, and technology or finance, the PBOC governor, or high-level members of China’s legislative bodies (the NPC and CPPCC). These sanctions would similarly be largely symbolic.

Takeaways

The G7’s response to Russia’s invasion of Ukraine demonstrates that coordinated multilateral financial sanctions on political and business elites are now a central tool in G7 economic statecraft. By design, these sanctions have the benefit of having relatively low immediate economic impacts on G7 economies, concentrating costs on a small number of targeted officials. In principle, these sanctions also have the benefit of avoiding indiscriminately targeting China’s broader populace.⁴⁵ Though in practice they often end up inadvertently affecting the broader population or the national economy, as foreign banks and private-sector entities reduce exposure to a broader range of individuals or entities than the ones directly sanctioned.

Their effectiveness as deterrence tools in a Taiwan crisis is in question, too. Narrow sanctions on CCP, government, and PLA officials would probably end up targeting political leaders already aligned with Xi’s decisions on Taiwan. Chinese officials may conceal their offshore assets through complex personal networks and corporate structures that are potentially painful and costly to unravel. They also require tight coordination and information sharing among sanctioning parties, in order to locate and act against sanctioned individuals’ assets across jurisdictions. (The foundation for this cooperation does exist, however, as a result of recent sanctions on Russia).

Broader sanctions on business elites could freeze greater overseas wealth, but this may have limited impact on policy outcomes. Private business leaders are already incentivized to disfavor Chinese aggression toward Taiwan and have diminishing political sway after years of power centralization under Xi. Yet because they are an important signaling tool, sanctions on Chinese officials would very likely be considered in a major Taiwan crisis.

Economic countermeasures aimed at China’s industrial sectors

Finally, G7 leaders may consider deploying export controls and other economic statecraft tools against Chinese companies or industries linked to China’s military or defense industrial base.

These actions featured prominently in the G7 sanctions program on Russia, with a variety of trade and investment-related measures imposed on companies and industries linked to mining, electronics, aviation, and other sectors. The United States implemented stronger sector-wide export controls on certain industrial and electrical equipment, added military-linked companies to the US Commerce Department’s (export-control) Entity List, and designated numerous companies on the SDN list.

Currently, Chinese firms with ties to the PLA and specific companies utilizing dual-use technologies already face sanctions and export controls. This signals additional businesses operating in these sectors as likely targets in a Taiwan crisis. In a crisis scenario, a number of economic countermeasures could be used to limit the flow of potential dual-use goods to China’s military and restrict the operation of sectors critical to China’s defense industrial base.

This section describes the economic linkages between potentially targeted sectors and the global economy, as well as the economic assets and flows that could be implicated under an economic statecraft program. To bring more granularity to our analysis, we use a case study approach that explores the potential for restrictions on China’s aerospace sector.

Our findings point to significant economic risks from a broad sanctions package, as well as deep interdependencies between China and G7 economies in potentially targeted sectors. This suggests that, if deployed, countermeasures would likely target narrower industries—or single firms within industries—where China depends on imported G7 technology and where global dependence on Chinese exports is small. Even then, sanctions could come with substantial costs to G7 technology exporters in the sanctioned industries.

Global economic links: Industries and supply chains

A number of Chinese industries could become the target of G7 countermeasures in the context of a major Taiwan crisis, due to their linkages to China’s defense sectors. Among them, chemicals, metals, electronics, aviation, and shipbuilding already feature prominently in US lists of Chinese military-industrial companies, including the Non-SDN Chinese Military-Industrial Complex Companies list and the Department of Defense’s Chinese Military Companies list—making them likely potential targets for future action.⁴⁶  

Collectively, these five industries already comprise over ten percent of Chinese gross domestic product, produce over $6.7 trillion in annual revenue, and employ over 45 million people.⁴⁷ They also are deeply linked to the global economy: in 2018, Chinese companies in these industries imported goods valued at $686 billion, and exported goods valued at nearly $1.1 trillion.

These sectors are also linked to the global economy through investment. Collectively they have been the destination for $107 billion in direct investment from the United States, United Kingdom, and European Union since 2000, and Chinese companies in these sectors have invested at least $179 billion abroad, either through acquisitions or greenfield investment, according to Rhodium cross-border FDI monitoring. Bloomberg data and Chinese official data suggest that foreign holdings of listed Chinese companies and their subsidiaries in these sectors amount to about $120 billion, and these firms have at least $76.9 billion in dollar-denominated debt instruments currently outstanding.⁴⁸

Scenarios

G7 countries have a range of economic countermeasures that could be brought to bear against select Chinese industries in the event of a Taiwan crisis. Here we consider two potential scenarios, a maximalist export controls scenario targeting major industries with comprehensive export controls, and a targeted sanctions scenario using China’s aerospace industry as a case study.

Maximalist export controls scenario

In an extreme scenario, G7 countries could impose strict export restrictions on trade with China on a range of major industrial sectors, such as chemicals, metals, electronics, and transportation equipment. These sanctions, though highly costly, would not be entirely unprecedented. In the case of Russia, the United States and other G7 countries imposed restrictions on exports in the oil and gas, metals and mining, defense, and technology sectors through a combination of tightened export controls and property blocking rules.

The disruptions to China from such sanctions would be substantial: G7 exporters are the source of 18 percent of the imported content these industries in China consume, totaling $153 billion based on trade in value-added data that estimates the origin and value of production activity along supply chains. G7 countries also account for 43 percent of China’s export market in these industries, putting $225 billion in Chinese manufacturing activity at risk. Altogether, over fifteen million jobs in China are estimated to depend on exports in these sectors. Many more jobs would be put at risk from the loss of imported inputs into Chinese production processes.

These dependencies run both ways, however, and impacts on the sanctioning countries would also be extremely high. The $153 billion in goods that G7 countries export to these industries in China support approximately 1.3 million jobs across the G7; and China itself is the source of 25 percent of G7 imports in these industries.

Even these substantial figures far underestimate the total economic impact from a total ban on trade between G7 economies and these industries in China. The value-added approach provides a useful estimate of the value that different countries contribute to well-functioning global value chains. But disruptions from a sudden stop of trade in these industries—in particular in hard-to-replace critical components—would result in massively greater economic disruption until alternative sources were fully brought up to speed.

Exports from China to the G7 would be disrupted as well. Trade restrictions on foreign inputs to these industries would affect Chinese production and exports. China could also take retaliatory action banning exports from these and other sectors to the G7.

In some cases, alternatives to disrupted trade flows might be found quickly, putting the efficacy of trade restrictions in doubt. A ban on G7 exports of iron ore to China, for instance, would disrupt only a small volume of trade unless other partners such as Australia, which exported $72 billion of iron ore exports in 2022, were also to join. Even so, these supplies could in large part be replaced by exports from other countries such as South Africa and Brazil.⁴⁹ Additionally, the G7’s challenges in halting the export of high-end Western technology to Russia following its invasion of Ukraine demonstrate that such regimes can be porous.⁵⁰

The deep interlinkages between Chinese and global industries mean potential economic disruptions from targeting certain sectors could be significant. Altogether, a conservative accounting of the trade flows disrupted by export controls in these sectors amounts to at least $378 billion in disrupted trade.⁵¹  

Except under extreme circumstances, it is unlikely that G7 leaders would be able to agree to trade restrictions on this scale. Germany, for instance, is deeply invested in and dependent on China in the chemicals industry. The French, UK, and US aviation industries have huge sales to China (see case study below), and Japan and non-G7 members South Korea and Taiwan are deeply connected with mainland China in electronics. These linkages would make agreeing on a broad package extremely difficult. Broad trade restrictions would also be indiscriminate in their impact on China’s citizenry, a fact with serious ethical implications and potentially political ones, as a broadbased export-control regime could in fact strengthen popular support for the government rather than undermine it.⁵²

Finally, a broad export-control package would have major spillovers to the global economy due to global value chains that depend on imports of Chinese intermediate goods (electronics, for instance) that would be disrupted by strict controls. These considerations make measures of this scale highly unlikely, except under the most extreme circumstances.

Targeted sanctions scenario

Due to the costs of a maximalist approach, economic countermeasures against China’s industrial sectors are more likely to be narrower in scope, targeting specific companies or subsectors with high technological dependencies on G7 countries and relatively low global dependency on Chinese exports. The key feature of these countermeasures would be asymmetry: imposing restrictions that disproportionately affect China’s economy. Importantly, asymmetry does not imply costlessness. Any effective trade restriction inevitably results in costs to the sanctioning economy and the global economy as a whole.

China’s aerospace industry, which depends on foreign-sourced engines and parts, provides a case in point. In a potential sanctions scenario, the United States and G7 partners could impose blocking sanctions and export restrictions on China’s two largest aerospace companies, the Commercial Aircraft Corporation of China (COMAC) and the Aviation Industry Corporation of China (AVIC). These companies depend heavily on inputs from overseas suppliers. Of the eighty-two primary suppliers to China’s first narrow-body jet, the COMAC C919, only fourteen are from China (and seven of those are Chinese-foreign joint ventures).⁵³ China’s most critical vulnerability is engines: all three of its domestically manufactured commercial aircraft rely on foreign-produced engines, and China’s domestic jet engine manufacturers are widely believed to be far behind Western competitors in terms of technological sophistication.⁵⁴

In a scenario in which blocking sanctions and export restrictions were placed on AVIC and COMAC, all exports of aerospace goods to these firms could be prohibited, amounting to approximately $2.2 billion in aerospace parts trade at risk.⁵⁵ However, the ultimate impact of such measures on China’s aerospace ambitions would be much greater. China has begun mass production of its ARJ21 regional airliner–which depends on GE engines–and exported its first model to Indonesia last year. COMAC’s flagship C919 narrow-body jet marked its first commercial flight in May 2023, and the country has aspirations to sell over 1,200 over coming years. Restricting the sale of aviation parts to COMAC and AVIC would substantially disrupt China’s civil aviation ambitions.  

$33 billion of G7 aerospace exports to China could be disrupted through retaliatory measures.

While the impact of these measures would be particularly acute for China, the costs on foreign aerospace companies would also be substantial. China could respond to restrictions by halting aerospace exports to G7 countries. China exported $1.2 billion in aircraft parts to G7 countries in 2018, including inputs to for eign airliners. While most are low-tech inputs, they can be difficult to replace in the short run: a shortage of wire connectors that coincided with widespread lockdowns in China in 2022 led to US production delays for the Boeing 737.⁵⁶ China could also respond by delaying purchases of Airbus and Boeing planes. In total, approximately $33 billion of G7 aerospace exports to China could be disrupted through retaliatory measures.

Foreign aerospace companies also have substantial tie-ups with AVIC and COMAC. Since 2000, US and British companies and those based in EU member states have invested an estimated $3.7 billion in China’s aerospace sector, according to Rhodium’s cross-border FDI tracking. A substantial number of these projects are connected to AVIC and COMAC, including Airbus’s A320 final assembly line in Tianjin, which produces six aircraft per month, about 10 percent of Airbus’s average monthly production.⁵⁷

AVIC and COMAC also have invested in global aerospace companies. AVIC, for instance, acquired Austrian FACC AG, which produces aerostructures and other components for Airbus, Boeing, and other global firms. In a scenario where COMAC and AVIC were put under blocking sanctions, these operations would likely be forced to wind down or divest

Finally, foreign investors would be exposed to losses in equity and debt in AVIC. Foreign equity holdings in twenty-four listed subsidiaries of AVIC companies totaled $1.4 billion, or 1.4 percent of their combined market capitalization as of April 2023.⁵⁸ Dollar-denominated debt issued by AVIC and subsidiaries amounted to $3.8 billion, approximately 21 percent of its total debt issuance.⁵⁹  

Sanctions on China’s leading aerospace companies and export controls on the components they import would be a heavy blow to its civil aerospace ambitions, making them a plausible economic countermeasure in a Taiwan crisis. However, the impacts on foreign aerospace companies would be significant given the high degree of trade and investment ties to China, making these countermeasures costly and potentially difficult to coordinate in a crisis. Targeted sanctions on other sectors where G7 countries hold asymmetrical technological advantages could also be considered, but these all come with non-negligible costs to the sanctioning economies as well.

Takeaways

China is deeply connected to the global economy in sectors that would potentially be targeted for economic countermeasures in a Taiwan crisis. The expansive nature of these ties would make broad export controls and trade restrictions extremely costly and likely hard to justify except in the most extreme circumstances.

Targeted sanctions on specific firms and technology choke points are more plausible, but they come with substantial costs to foreign companies. Our case study, with export controls placed on China and full blocking sanctions imposed on China’s leading aerospace manufacturers, shows that tens of billions of dollars in aerospace goods trade, inbound and outbound direct investment, and portfolio holdings in China’s aerospace sector would be put at risk. While China would face substantial challenges in achieving its goal of developing a strong domestic commercial aviation industry, foreign aerospace companies would lose out on billions of dollars in exports and sales to China and risk seeing billions of dollars in direct investment lost.

IV. Practical challenges in sanctions development

Beyond identifying specific tools and appropriate targets for economic countermeasures, policymakers will confront a range of complex coordination issues around implementing sanctions in a Taiwan crisis. Discussions with participants in our roundtables highlighted areas of consideration in developing economic countermeasures to deter aggression against Taiwan.

Understanding Taiwan’s perspective. A crucial factor in designing G7 economic responses to possible aggression against Taiwan should be the policy preferences of Taiwan itself. Depending on the nature of the crisis and political conditions in Taiwan, Taiwanese officials might not support economic countermeasures against China and opt for a de-escalatory response. Given the depth of economic ties between China and Taiwan, certain economic countermeasures against China could be highly costly for the Taiwanese economy. Public opinion would likely be divided on the question of how to respond. With only mixed Taiwanese support, G7 coordination on economic countermeasures could be difficult to achieve. Strong Taiwanese support on the other hand would make coordination easier, so long as Taiwanese actions were not seen to have precipitated the crisis.

Defining clear redlines and triggers across the G7. A key barrier to coordinating sanctions among G7 partners and with Taiwan arises from the difficulties in agreeing on what Chinese acts of aggression should trigger economic countermeasures. While some actions might be seen by all parties to have crossed redlines–such as a military quarantine of Taiwan—Chinese coercion against Taiwan often takes the form of “gray zone” measures that are more ambiguous and brush up against but do not clearly cross redlines.⁶⁰ Getting G7 nations to agree to impose economic countermeasures against China in response to such actions will be more challenging. The roundtables highlighted different levels of tolerance for escalatory action measures among G7 partners.

The specific drivers of a crisis would matter as well: European experts note that a crisis that was seen to be provoked by the United States or Taiwan would make G7 alignment more difficult, especially given divergent views among EU member states about how to respond to a cross-strait crisis.

Coordinated signaling in order to deter. The challenges involved with identifying redlines and agreeing on responses in advance also complicate efforts to signal resolve to China. Successful deterrence depends on the would-be aggressor knowing what actions would provoke a response and believing that the defender’s threats of retaliation are credible.⁶¹ The ambiguous nature of Chinese escalatory actions and the potential for disagreements among partners over how to respond in the moment of crisis make establishing deterrence through the threat of economic countermeasures a significant challenge.

Participants in roundtables disagreed about the best signaling approach, with some arguing that clarity about redlines and consequences is essential, and others arguing that providing too much specificity could instead encourage aggressive behavior and focus China’s countersanctions and sanction-proofing work. Providing clarity on what Chinese actions would elicit a punitive response could encourage Beijing to take actions just below such thresholds.

Building out necessary tools. Our roundtables highlighted the fact that G7 countries joining a sanctioning coalition may need additional legal tools to carry out effective countermeasures on China. In the wake of enhanced export controls on Russia, for instance, the EU faced challenges restricting reexports of export-controlled products through third countries to Russia, as doing so would require additional legal authorities.⁶² And differences in UK, EU, and US regulations have complicated the efforts of multinational companies to wind down their operations in Russia.⁶³ For effective action and deterrence, such authorities would need to be shored up.

Scoping a cost mitigation strategy. Even limited economic countermeasures against China would have global economic spillovers. This means any sanctions program would likely need to be paired with measures to support industries at home as well as third countries affected by lost trade and investment with China. Sanctions triggering a devaluation of the renminbi would negatively affect countries dependent on commodity exports to China. A stronger dollar resulting from global investors seeking liquidity and safe assets in a crisis would put additional stress on countries with substantial dollar-denominated debt. G7 countries would need to manage the global spillovers of sanctions with additional dollar liquidity, loan extensions and forgiveness, and other tools to support the global economy in a period of economic stress.

Factoring in the market reaction. Any G7 economic statecraft response would have to contend with additional disruptions to global supply chains from Chinese aggression against Taiwan and the resulting market impacts. Russia’s 2022 invasion of Ukraine caused market gauges like the S&P 500 to fall by around 4 percent, and the initial market impact of a Taiwan crisis could be significantly larger due to the size and importance of the economies involved. US officials have estimated a disruption to the exports of Taiwan Semiconductor Manufacturing Company alone could cost the global economy between $600 billion to $1 trillion a year.⁶⁴ Roundtable participants stressed that G7 actions would have to avoid aggressively compounding the inevitable supply chain and market effects of a crisis. The initial shock could undermine domestic political support for sanctions that would incur additional economic costs.

Conclusions and recommendations 

Policymakers in G7 capitals are increasingly discussing Taiwan crisis scenarios, and starting to explore the range of options available to them in responding to Chinese actions against Taiwan, both beyond and below the level of invasion. While our work shows that maximalist countermeasures would be highly costly and therefore unlikely except in the most extreme circumstances, G7 countries may consider a set of more limited tools that target areas of asymmetric Chinese dependence on foreign technology and critical inputs. 

That options are available, and that G7 leaders are discussing them, does not mean that deploying them in an aligned fashion would be easy. Coordination on economic countermeasures will be critical to effective deterrence, but could be hard to achieve given the difficulty to define red lines in a conflict that is likely to be marked by ambiguity and uncertainty. Given these limitations, economic countermeasures can only be one part of a broader deterrence effort and toolbox that also includes diplomatic and military channels.

From our research, roundtables, and interviews, a set of recommendations emerged for policymakers considering the use of economic countermeasures in a Taiwan crisis:

• G7 partners and Taiwan should scale up private coordination and signaling. G7 discussions about the role of economic countermeasures in a Taiwan crisis are still in the early stages. Given the challenges involved in agreeing upon red lines and appropriate countermeasures, pragmatic discussions around contingencies must be a priority. This includes creating effective private channels of communication among G7 partners and key stakeholders on emerging trends, financial ties, and shared vulnerabilities. Meanwhile, G7 partners should privately message to China the extent they are willing to go in using economic tools to counter Chinese aggression toward Taiwan. Coordination with Taiwanese officials is also crucial.
• The G7 should coordinate beyond its membership. This report assumes that most or all of the current coalition that has imposed sanctions against Russia would align on measures in a Taiwan Strait crisis. Roundtables and consultations with like-minded capitals in the Asia-Pacific region have suggested this is a reasonable assumption. However, even more so than in the case of Russia, exchanges outside the G7, including the rest of the G20, will be necessary given the scale of economic disruption at stake.
• Economic asymmetries need to be better understood. Policymakers argued that the most likely economic countermeasures would focus on areas where China is asymmetrically dependent on foreign goods, technology, and finance. Further research is needed to identify these areas and the potential costs, vulnerabilities, and limitations of targeting them in a crisis.
• Take practical legal steps now to boost the credibility of G7 deterrence. Discussants noted that successful deterrence requires making clear that G7 nations are ready to act decisively in a crisis. This may require legal steps, including: shoring up of the EU’s framework for export controls; advance preparation of US executive orders specifying and granting sanctions authorities to the Office of Foreign Assets Control; preliminary analysis on the potential impact and spillovers of proposed packages; and the construction of communication channels among US government stakeholders such as the Federal Reserve, Commodity Futures Trading Commission, Securities and Exchange Commission, Office of the Comptroller of the Currency, Financial Crimes Enforcement Network, and appropriate bilateral, plurilateral, and multilateral counterparts. This may include preparing the legal and regulatory landscape across G7 jurisdictions to ensure appropriate authorities are in place to deter or respond to a crisis.
• Invest in other forms of deterrence. Economic countermeasures should be considered as part of a whole-of-government and multilateral strategy as they have costs and limitations that can make them less effective on their own. These tools will be more effective when paired with traditional tools of deterrence in both the military and diplomatic realms.
• Keep lines of communication open. Bilateral and plurilateral communication is the best tool to de-escalate in a crisis. Recent breakdowns in military-to-military communication channels between the United States and China are of serious concern given elevated tensions in the region. Maintaining open communication lines and regular exchanges with Chinese counterparts is a key element in any risk-mitigation strategy.
• Balance credible threats with credible assurances. Effective deterrence requires credible threats to be matched with credible assurances. The G7 should make clear to Beijing it has no desire to change the status quo in the Taiwan Strait. Efforts to maintain the status quo and shore up traditional diplomatic, military, and economic tools to ensure peace and stability in the Taiwan Strait should be the priority. 

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About the authors

Charlie Vest is an associate director on Rhodium Group’s corporate advisory team. He manages research and advisory work for Rhodium clients and contributes to the firm’s research on US economic policy toward China. Vest holds a master’s degree in Chinese economic and political affairs from UC San Diego and a bachelor’s degree in international affairs from Colorado State University. Prior to joining Rhodium, he worked in Beijing as research manager for the China Energy Storage Alliance, a clean energy trade association.

Agatha Kratz is a director at Rhodium Group. She heads Rhodium’s China corporate advisory team, as well as Rhodium’s research on European Union-China relations and China’s economic statecraft. She also contributes to Rhodium work on China’s global investment, industrial policy and technology aspirations. Kratz holds a Ph.D. from King’s College London, having studied China’s railway diplomacy. Her previous positions include associate policy fellow at the European Council on Foreign Relations and editor-in-chief of its quarterly journal China Analysis, assistant editor for Gavekal-Dragonomics’ China Economic Quarterly, and junior fellow at the Asia Centre in Paris.

Acknowledgements

This report was written by Charlie Vest and Agatha Kratz with support from Juliana Bouchaud in collaboration with the Atlantic Council GeoEconomics Center. The principal contributors from the Atlantic Council GeoEconomics Center were Josh Lipsky, Kimberly Donovan, Charles Lichfield, and Niels Graham.

The GeoEconomics Center and Rhodium Group wish to acknowledge a superb set of colleagues, fellow analysts, and current and former officials who shared their ideas and perspectives with us during the roundtables and helped us strengthen the study in review sessions and individual consultations. These individuals took the time, in their private capacity, to critique the analysis in draft form; offer suggestions, warnings, and advice; and help us to ensure that this report makes a meaningful contribution to public debate. Our gratitude goes to Dave Shullman, Jörn Fleck, Logan Wright, Daleep Singh, Jeremy Mark, Richard Aboulafia, Annie Froehlich, Julia Friedlander, David Barboza, Chris Skaluba, the Centre for Financial Crime and Security Studies at the Royal United Services Institute (RUSI), and Atlantik-Brücke.

This report is written and published in accordance with the Atlantic Council Policy on Intellectual Independence. The authors are solely responsible for its analysis and recommendations.

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The rise of sustainable investing in the private sector

Mobilizing private sector capital to boost sustainable development and ESG priorities makes sense given the numbers. With the top 500 asset managers holding $131.7 trillion in Assets Under Management (AUM) and the combined market capitalization of the top ten global companies reaching over $10 trillion in 2022, the private sector is well-positioned to contribute. Moreover, sustainable investing, mostly in renewable energy, was the fastest growing Foreign Direct Investment (FDI) theme in 2021—with 70% directed to developing countries. Up until 2021, financial markets have also experienced large shifts toward sustainable investing, with ESG fund issuance increasing by 53% to $2.7 trillion in 2021, while the green, social, sustainable and sustainability-linked bond market rose $1 trillion, grabbing 10% of the global debt market share. Sustainable companies also issued $48 billion in new equity, while sustainable lending reached close to $717 billion in borrowing. For example, in Indonesia, companies like Pertamina Geothermal Energy are looking to issue green bonds to help grow its business but also facilitate the transition to clean energy.  

Meanwhile, multinational corporations (MNCs) are integrating sustainability metrics into their supply chains, based on the Science Based Targets Initiative (SBTI). Financial and reputational risks from poor ESG practices can negatively impact a company’s future profits and resilience, which filter down to its local value chain. Many MNCs, including, Nestle, PepsiCo, and Unilever, are working towards preventing this by establishing and adhering to SBTI targets to increase sustainable practices within their global supply chains. Others, including Starbucks, are diverting funds to support climate and water projects in developing countries in an effort to conserve or replenish 50% of the water they deplete through their operations, including the agricultural supply chain. 

Together, ESG investing and SBTI targets should contribute significantly to sustainable development and lower the cost of hitting the SDGs. However, last year revealed several barriers that threaten that potential.

Roadblocks to investing in sustainable development

Sustainable finance faced challenges in 2022 as increased global regulatory scrutiny and divergent ESG standards led to a dip in ESG investing. Reuters reported that in 2022, sustainable investments reversed course for the first time in a decade, with sustainable bond sales decreasing by 30% and green bonds down 23%. Overall, ESG performance declined by nearly 9%, as international investment in ESG, especially climate change, declined.

Varying ESG rating standards, methodology, and data sources, that are often reclassifying sustainably labelled products, contributed to lower levels of ESG investing in 2022. Several ESG labelled securities were downgraded due to criteria conflicting with both major ratings agencies, while conflicting or overly prescriptive requirements led to a decline in support for ESG related shareholder proposals and the withdrawal of several financial industry members from regional ESG alliances. With over 600 ESG data providers, globally, it is not surprising a lack of consistency and standardization leave investors confused about the true risks and rewards from sustainable finance. Recent research reported that 20 of the 50 largest global asset managers assess their sustainable finance products using four or more ESG rating providers, while the other 30 use internal models for the same purpose. Underlying biases in ratings can often exclude developing countries struggling to attract sustainable finance due to inherent country-specific risks, like fossil fuel dependence, budget constraints, and high sovereign debt from external shocks, market access, and lack of technological innovation. However, some asset managers, like Abrdn, have developed in-house ESG ratings system based on data and metrics from external sources, like the World Bank and IMF, to consider unique factors when evaluating alignment with the SDGs for companies listed in their Emerging Markets Sustainable Development Corporate Bond Fund. 

Global regulations for ESG have also complicated cross-border sustainable investing, potentially leading to an increase in compliance costs and reduction in the number of eligible sustainable funds for firms.  Although evolving European, UK, and US frameworks regulating ESG have similar objectives, the approaches towards sustainable investing vary among the jurisdictional regulations and oversight bodies, especially around labelling and reporting. This disparity has also encroached on the Asia-Pacific financial industry, where many banks are starting to require local asset managers to comply with European ESG standards despite the existence of similar local regulations.  An analysis of ESG and sustainable-labelled funds identified that less than 4% meet the standards of all three jurisdictions, while 85% do not comply with any of them.  Additionally, different jurisdictional requirements and contradicting assessments of how to measure sustainable supply chains brought an additional level of uncertainty to MNC’s ESG initiatives in FDI. Companies are starting to realize they may not have fully assessed the impact of carbon emissions on its operations in other countries, specifically in the developing market.  Streamlining allowing for flexibility in the global ESG regulatory framework will be critical to ensuring sustainable investments increase and assist with countries in meeting their ESG goals. 

A way forward

To help meet the SDGs, the World Bank recently announced the creation of a roadmap that focused on three main objectives, including increasing private sector funding, improving country-level engagement and analysis, and establishing a global taxonomy for sustainable investment tools. UN Deputy Secretary-General Amina Mohammed recently warned that “the SDGs will fail without the private sector,” because private sector actors can “invest in the transitions necessary to accelerate development progress and get the SDGs back on track.” The private sector has not only the financial capacity, but also the commitment, to fuel sustainable investing, but faces barriers to keep up the momentum. The IMF and World Bank have an incredible opportunity to address the current ESG investing challenges. The World Bank roadmap is an important first step, but more will be needed to ensure globally consistent standards and data for ESG. The potential for greenwashing or indiscriminate exclusion of countries can be avoided by working with governments and ratings providers, and by improving country-level engagement to both align metrics and to integrate unique country risks in sustainable investing and supply chains. With many firms already leveraging IMF and World Bank data, creating a formal framework will encourage the expansion and scaling up of private sector ESG financing for regions in urgent need of funding.

Nisha Narayanan is a Non-Resident Senior Fellow with the GeoEconomics Center.

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Then, she managed to pull off a coup of sorts. By suggesting that the EU “de-risk” its relationship with China she simultaneously appeared tough on Beijing in the context of Europe and nudged the US discourse away from more hawkish talk of “decoupling.”

However, next week’s speech will prove even trickier. (As there is much at stake, squabbles over what does and doesn’t go into the EU Economic Security Strategy speech have already reached the media.) The Commission, which will author the forthcoming EU Economic Security Strategy, must tread carefully so as not to alienate member states who care deeply about their economic relations with China. Yet, it must simultaneously move toward a clearer objective for the EU-China relationship and coax its members toward a more “realpolitik” view of the world. None of that will be easy.

Europe’s economic security

It is the first time the Commission will issue a document on economic security. Its prerogatives on trade and market regulation used to not be so directly affected by geopolitics. Now, the global struggle for access to and control over strategic economic resources is defining the world’s geopolitical fault lines. So, it is right for the EU Commission to try to approach economic security as comprehensively as possible, combining strategic vision and attention to technical detail. Such an integral approach should at least allow the EU to assess emerging risks and threats to the EU’s economic security in a more systematic way.

The harsh reality in EU policy making is that process often dominates content. This is both a blessing and a curse. Economic security is about securing access to and control over strategic economic resources. What is “strategic” is of key importance to the security of the EU and its member states. While talk about economic security nowadays often focuses on high tech, such as semiconductors, it also includes being able to feed the European population, having access to natural resources, and having an industrial base and a well-educated workforce. Furthermore, it requires secure infrastructure—ports, roads, waterways, railways, telecommunications—to get the resources to their destination in the EU.

Clearly, as economic security shapes geopolitical dynamics, the EU’s understanding of it should not be limited to a set of working-level policies. An adequate approach to economic security must link the more tangible, technical aspects with higher order, strategic and geopolitical issues, which are often more abstract. One’s understanding of how economic security relates to geopolitical dynamics at the strategic level should guide and inform the more technocratic issues like investment screening, export controls, financial-economic sanctions, anti-coercion, and their associated risk assessments.

Economic security is also closely related to other dimensions of policy making, including defense policy and international finance. The EU, or its member states, depend on military power for secure access to and control over strategic economic resources. That is why European discussions about the military aspects of strategic autonomy matter to economic security. And financial geopolitics play a major part in determining the EU’s economic security, as the “real economy” is highly dependent on global finance and capital flows. It demands a constant intellectual effort to appreciate how economic security interacts with these and other policy dimensions.

Lacking a more comprehensive view, European policy makers are at risk of reacting in a fragmentary and ad hoc manner to complex economic security challenges. Sound ideas and strong knowledge form the basis for good political discussions and effective decision making on economic security. The EU Economic Security Strategy therefore needs to define the development of European knowledge and ideas about economic security as a necessary element. Member states themselves should also deepen their knowledge about economic security to help shape the Commission’s understanding.

Three hurdles to clear

To arrive at a more comprehensive approach to economic security, the European Commission will have to address at least three hurdles.

First, it will have to foster consensus about how to approach economic security among the different Directorate Generals (DGs) involved. These DGs tend to have different perspectives on the economy, some being more interventionist-minded, others being more free-market minded. Also, the Commission and the Council, constituted of the EU member states, will have to reconcile their views. Whereas the Commission tends to have the lead on economic issues, the Council’s member states have the lead on foreign and security policy. Moving ahead on economic security, at the intersection of both fields, may demand significant intra-EU diplomacy. The EU Economic Security Strategy should lead to the establishment of a European forum where the nexus of economics and security can be discussed on an ongoing basis between all relevant stakeholders.

Second, the strength of any strategy tends to depend on its clarity, or the definition of objectives and means. The Commission will thus have to combine strategic clarity with diplomatic consensus, which is a balancing act. Moreover, the Commission wants to publish the strategy document quickly, while strategic clarity tends to emerge only after time. The risk is that clarity is achieved on rather small and pre-existing technocratic issues, while the higher, more strategic issues are left ill-defined. The EU Economic Security Strategic should therefore call for long-term strategic clarity on economic security, as a compromise between diplomatic consensus in the short run and strategic clarity in the longer run.

Third, and perhaps most importantly, a comprehensive European approach to economic security requires a stronger European geopolitical or “realpolitik” reflex. The importance of economic security has been long underestimated and misunderstood in Europe as the EU policy makers did not tend to view the world in terms of power politics and national security dilemmas. An effective EU approach to economic security requires a context or culture of more strategic and geopolitical reasoning. The EU will be less at risk of an inadequate, fragmented approach if it has more access to outside, independent, and informal views, and knowledge about economic security to inform its decision making. The Commission should therefore use its Economic Security Strategy to stimulate a more thorough academic and intellectual debate about the intersection of economics, security, and geopolitics.

Good policies are based on sound ideas and strong knowledge. The EU’s Economic Security Strategy will be most relevant if it stimulates intellectual debate and strategic clarity. The Commission may operate pragmatically in the short run by seeking consensus on the more technocratic issues, while at the same time laying the groundwork for the next phase. The greatest challenge is to attune the EU’s traditional technocratic reflexes with the strategic exigencies of a geopolitical context dominated by great power competition.

Dr. Elmar Hellendoorn is a nonresident senior fellow with the GeoEconomics Center and the Europe Center.

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How are these growing economic ties impacting Moscow’s ability to withstand G7 sanctions and maintain its invasion of Ukraine—and where do Beijing’s interests diverge from Moscow’s? 

Below we outline six trends that have defined the two countries’ relations since the invasion of Ukraine. Russia’s access to the yuan has bolstered its wartime economy. However, when it comes to trade and financial support, Beijing has been less accommodating. 

Chinese yuan is Russia’s friendliest currency.

China is mitigating the impact of sanctions on Russia by providing Moscow an alternative currency for transactions. Chinese yuan supplanted the dollar as Russia’s most traded currency in early 2023. The switch came after the United States imposed sanctions on a few banks in Russia that were still allowed to make cross-border transactions in dollars. As the Group of Seven (G7) sanctions constrain Russian financial institutions’ ability to transact in the world’s leading reserve currencies, like dollars, euros, and yen, the yuan is arguably the only relatively stable, widely traded currency issued by a non-sanctioning authority that enables Russia to make international transactions.

Central bank currency swap lines play a major role in increasing the circulation of the yuan in the Russian economy. Although China’s capital controls make it difficult for foreigners to obtain yuan, Beijing has supported Russia’s growing yuan marketplace by backing currency swap facilities. Through these swaps, Russia and China’s central banks exchange rubles for yuan. Major Russian commercial banks then tap into their central bank’s accounts to introduce the yuan into the Russian economy. Furthermore, as China’s banks have accumulated Russian assets, they have also likely increased the amount of yuan in local circulation.

Russia’s linkages to the Chinese financial system also allow it to mobilize its currency reserves. G7 countries froze most Russian reserves held by sanctioning jurisdictions. However, Russia has been able to access its central bank reserves held in China (nearly 18 percent before the conflict), which are largely denominated in yuan. As a result, Russia has been able to use yuan-denominated reserves to conduct foreign exchange transactions to manage the value of the ruble. Moreover, Russia increased the permitted share of yuan in its National Welfare Fund up to 60 percent last year and plans on selling more yuan from the wealth fund to make up for the lost energy revenues and cover budget deficit. 

Vital trade links

Russia has compensated for lost market share in the West by exporting more energy to China. Beijing has increased spending on Russian energy from $57 billion in the year prior to the invasion to $88 billion in the year after and allowed Moscow to make up for the lost revenues in the EU market. Russian crude oil exports to China could increase even further in 2023, as China’s state-run refiners have been increasing purchases of Russian oil, and Beijing has signaled that it may allow a further ramp-up. However, China maintains informal quotas on crude oil imports to limit exposure to any individual energy exporter. These sit at 15 percent of overall imports or around two million barrels a day per country. Another component of China’s energy imports from Russia is natural gas. Natural gas is more dependent on existing infrastructure and is thus harder to rapidly increase in imports. Russia is expected to deliver 22 billion cubic meters of natural gas to China through the Power of Siberia pipeline in 2023, eventually increasing to full capacity of 38 billion cubic meters in 2027. However, even though Russia has pushed for the construction of the Power of Siberia 2 pipeline, Beijing has shown hesitation and has, in fact, negotiated a new pipeline through Central Asia. Whether Russia keeps exporting more oil or natural gas to China will depend on Beijing’s decisions on quotas or new pipelines, making Russia asymmetrically dependent on its economic partnership with China.

Russia has imported electronic equipment from China to offset the effects of export controls but is struggling with obtaining advanced technology—even from Beijing. Integrated circuit imports from China have increased from $67 billion in 2021 to $170 billion in 2022, but most electronics exports from China to Russia are made up of basic computers and transport equipment. Notably, Beijing has banned the export of advanced Loongson microprocessors. The West’s imposition of export controls on advanced semiconductors against China in October 2022 signals that Beijing will become even more protective of advanced technology and less likely to transfer them to Russia. 

China is not the only country whose trade with Russia has increased. Although Beijing has provided a lifeline to the Russian economy, countries such as India and Turkey have also expanded trade with Russia. In fact, India has become the second largest destination of Russian crude oil exports after China. Meanwhile, Central Asian and Caucasus countries’ exports of electronic equipment to Russia ballooned in 2022 and Serbia, Turkey, and Kazakhstan have provided semiconductors to Russia throughout the last year. China might be the largest economy supporting Russia but other countries’ trade relations with Russia should be as closely monitored as Beijing’s. 

Limits in the ‘no-limits’ partnership

China has generally avoided steps that could trigger secondary sanctions or that greatly increase its own strategic dependence or risk exposure to Russia. For example, Chinese banks have not become creditors to the Russian government. Likewise, China has hedged against dependence on Russian energy imports and has restricted the flow of advanced technology to Russia. The notion of a “no limits” partnership remains rhetorical for now.

Maia Nikoladze is the assistant director at the Economic Statecraft Initiative within the Atlantic Council’s GeoEconomics Center. Follow her at @Mai_Nikoladze.

Phillip Meng is a young global professional at the Atlantic Council’s GeoEconomics Center.

Jessie Yin is a young global professional at the Atlantic Council’s GeoEconomics Center.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The criticism stems from the kingdom’s connection to the 9/11 attacks, its track record on human rights, and the high-profile killing of US-based journalist Jamal Khashoggi in 2018, very likely at the direction of Saudi Crown Prince Mohammed bin Salman. Some critics have started to search for potential regulatory tools to block the deal. Merger review, both in the United States and Europe, seems the most likely path. However, there are competing views on whether courts would be persuaded by anti-trust arguments given how highly concentrated professional golf already is and how most US professional sports leagues operate as de facto monopolies.

Several members of Congress, including Senator Ron Wyden (D-OR), Senator Mitt Romney (R-UT), and Congresswoman Maxine Waters (D-CA), have issued public calls for the Committee on Foreign Investment in the United States (CFIUS) to review the deal. CFIUS is an interagency committee that evaluates the national security implications of foreign acquisitions of US businesses. If CFIUS finds a national security risk, it can negotiate mitigation agreements with transaction parties to restructure deals in ways that sufficiently reduce those risks. It can also recommend that the US president prohibit the transaction. CFIUS has traditionally been restrained in its approach; only seven transactions have been prohibited through the CFIUS process since 1975, though a good deal more were voluntarily abandoned by parties after realizing that CFIUS found a national security risk that it did not deem mitigable. 

So is CFIUS the answer to the prayers of those who wish to stop the PGA Tour/LIV Golf merger? Probably not. To understand why CFIUS is likely not able to stop this deal, even if US lawmakers may view the deal as distasteful, it’s necessary to understand CFIUS’s jurisdiction—which it likely has over this deal—and the investment prohibition authorities that CFIUS provides the US president.

1. The committee is wary of overextending its authority

First, CFIUS has jurisdiction over any foreign acquisition of a controlling stake in a US business, regardless of the US business activity. It also has the ability to review non-controlling transactions that confer special rights—such as access to non-public technical information or board observer status—if foreign entities invest in critical technology, critical infrastructure, or sensitive personal data of US businesses. The cross-sectoral nature of CFIUS jurisdiction contrasts with the investment screening authorities of many other advanced economies, which often only allow review of transactions in specified sectors, such as critical infrastructure or defense materials.

Thus, as long as the merger deal—which apparently exists only conceptually at the moment—directly or indirectly confers a controlling stake of PGA Tour to PIF, CFIUS will be able to review the transaction. CFIUS likely would also be able to review even a non-controlling stake if the PGA Tour meets the definition of a sensitive personal data business. CFIUS operates mostly through a voluntary notification process, but it can also pull a concerning transaction into its orbit through a “non-notified” review.

Just because CFIUS has jurisdiction to review does not mean that it will block the transaction. CFIUS is designed to be a tool of last resort and to only intervene when national security is threatened. To act, the committee would have to find a risk arising from the transaction that threatened to impair US national security. While national security is not defined in the statute, the committee process is designed to be fact-based, deliberative, and restrained. Highly attenuated risk scenarios are unlikely to persuade the committee to recommend action. 

Moreover, the committee is conscientious not to overextend its authority in order to retain process legitimacy, as it operates largely through the voluntary cooperation of transacting parties. It is careful to stay within its statutory authority to prevent legal risks that could narrow its ability to act in the future. And, as the United States is actively encouraging partners and allies to enact and strengthen their own investment screening mechanisms, it does not want to give the impression that broad use of such power is legitimate, for fear that doing so could lead to other countries harming US businesses operating abroad.

2. Data collection risks can be mitigated

The CFIUS process revolves around determining whether a transaction creates a national security risk, and if so, whether that risk can be adequately mitigated through a legal agreement with the parties. CFIUS evaluates the vulnerabilities to national security that a US business generates and the likelihood that the foreign entity will exploit those vulnerabilities or make it easier for a third party to do so. 

One potential security vulnerability is the PGA Tour’s collection of fans’ data on its fans through ticket sales and its smartphone app. Since the 2018 legislative update to CFIUS, the committee has been increasingly concerned about how acquiring a US business could aid a threat actor in the collection, use, and sharing of sensitive personal data. Data collected on smartphone apps can be particularly concerning if the app allows for real-time geolocation of individuals and if the app’s data collection does not adequately protect vulnerable populations. However, these concerns can easily be mitigated by preventing PIF or its agents from having access to such data. It is highly unlikely that the business rationale for the merger depends on PIF or LIV Golf being able to access these data, so it is likely a mitigation term to which the parties would agree.

3. Real estate concerns can be mitigated, too

Another issue is the roughly thirty golf courses the PGA Tour owns and operates through its Tournament Players Club (TPC) network. Some of these golf courses are located close to sensitive US government sites such as military bases. CFIUS views such “co-location” as risky because it can create opportunities for surveillance. In 2012, for example, US President Barack Obama prohibited a Chinese investment in an Oregon wind farm over concerns that Beijing could use access to wind turbines to surveil a particularly sensitive military site close by. Again, however, the deal could easily be structured in a way in which PIF did not have access rights to these courses or the ability to choose venders to operate or maintain these locations.

4. Soft power is a soft argument

Some have argued that CFIUS should consider the “soft power” implications of golf tour ownership from which the Saudis could benefit. However, it is unlikely that CFIUS will be willing to make strong claims about national security risks on this basis. Nor should it. Soft power by its nature is diffuse. This means that the consequence of soft power on US national security is difficult to clearly express. A poorly articulated consequence reduces the ability of the committee to act. After all, the committee must find a “risk to national security arising from the transaction” to mitigate or recommend a presidential prohibition. Vague claims to “sportswashing” and generally burnishing a regime’s brand do not meet this threshold. If CFIUS could block transactions on bad vibes alone, then it could pretty much block anything. And that would undermine the argument that CFIUS is a fact-based, non-partisan committee that narrowly and soberly assesses national security risk. This would have substantial negative consequence for the legitimacy of the process in the eyes of business, the public, and allies and partners.

In sum, there are many reasons to be angered by, or at least uncomfortable with, the PGA Tour/LIV Golf merger. Anti-trust may represent a legitimate hurdle to its execution. But CFIUS is not a trump card to prohibit every problematic foreign transaction, and it certainly is not an appropriate tool for blocking this particular merger given what we know about it. Rule of law means the law is not just a tool but also a constraint. And here, the rule of law will likely bind the United States against using CFIUS to block a transaction some lawmakers are wary of but does not rise to the level of a clear national security risk. 

Sarah Bauerle Danzman is a nonresident senior fellow with the GeoEconomics Center’s Economic Statecraft Initiative. She is also an associate professor of international studies at Indiana University Bloomington where she specializes in the political economy of international investment and finance.

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On Wednesday, June 5, 2023, Carla Norrlöf, a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, testified to the US House Committee on Financial Services Subcommittee on Financial Institutions and Monetary Policy. Below are her prepared remarks for the committee on preserving the US dollar’s status as a global reserve currency. Some charts and figures in the original prepared testimony are not included in this version.

Dear Committee Members, thank you Chairman Luetkemeyer and Ranking Member Beaty for inviting me to testify on the important topic of dollar dominance and the preservation of the dollar’s status as a global reserve currency. I am honored. Despite numerous challenges, dollar dominance has persisted for nearly eighty years. Why does the dollar continue to play such a prominent role, is the dollar likely to reign supreme over the long term, and what are the most important threats on the horizon?

The extent of US dollar dominance and its preservation has become a principal theater for the great power struggle between the United States, China, and Russia—placing the future of liberal international order in the balance. The dollar is the only truly global currency in the world, and is widely used for transactions, pricing, settlement, and investment by governments and private actors outside the United States. These roles offer the United States economic, political, and social privileges. Economically, Americans benefit from the ease and convenience of transacting in dollars, from seigniorage, monetary flexibility, and safe-haven benefits in times crisis. Politically, the dollar offers the United States a non-military instrument of coercion with which to police international order. Socially, the United States gains status and prestige. Preserving the dollar’s status as the global currency is therefore in the United States’ interest, and potentially in other countries’ interest.

Dollar dominance refers to the disproportionate use of dollars in the world economy, a condition which has prevailed during the entire postwar era. The absolute dominance of the dollar is unlikely to change in decades to come, though the dollar’s relative dominance has receded from peak levels. Even though the dollar remains dominant, a relative weakening of the dollar’s status is considered a harbinger of the long-term power shift to the East, hastening the onset of a multipolar order in which the United States is less capable and less influential.

Assessing dollar dominance

The precise meaning of dollar dominance in this regard remains unsettled. How strong must the dollar be relative to other currencies used for international purposes for the international currency system to be characterized by dollar dominance? This question is rarely tackled head on. The lack of a common focal point makes it very difficult to determine whether dollar dominance is truly threatened and how to discern a multipolar currency system if, and when, one comes to pass. Using metrics over the various functions of an international currency, for example the reserve currency function, it is possible quantify dollar dominance according to established criteria—for instance polarity or systemic concentration. Polarity is a term traditionally used by international-relations scholars to assess the international balance of power based on military might. But the concept is sometimes used to describe the international distribution of economic power. Polarity is particularly well-suited for characterizing the international currency system because great-power currency capabilities can be used to enforce international agreements and police international order.

Strictly speaking, polarity is the number of great powers in the international system. In a unipolar currency order, one great power enjoys preponderance and has no close rival. In a bipolar currency order, two great powers predominate and have distant rivals. And in a multipolar currency order, more than two great powers wield relatively equal influence. Yet this still leaves open the question of how to measure polarity.

Over the course of half a century, the dollar’s reserve currency role was strongest in the years following the collapse of the Bretton Woods dollar standard when President Nixon abandoned the promise to convert dollar reserves into gold—the 1971 Nixon shock. Regardless of which measure of dominance is used—polarity or systemic concentration—the dollar is significantly lower today than it was in 1973. However, the dollar’s reserve currency role is stronger than it was in 1990 when the Cold War ended. In a fifty-year perspective, the dollar reached a low point at that time, a period otherwise considered to mark the onset of America’s unipolar moment. Clearly, the level of reserve currency holdings in a single year, or within a limited time frame, is not a good predictor of US ascendancy or decline in any broader sense. Point estimates of reserve currency holdings are not a good predictor of dollar dominance either. That is because the liquidity creating role, assumed by the issuer of the first international currency, requires adjustment of expansionary policies, resulting in cycles of trade deficits when demand for dollar assets is typically high and deficit adjustment when dollar demand tends to fall. Depending on the measure used to assess dollar dominance, the most recent downward dollar cycle began in 2016 (polarity) or 2017 (concentration). According to both measures, an upward cycle began in 2020 and stabilized despite the 2022 sanctions against Russia.

The dollar’s many international roles

The dollar’s reserve currency role is used synonymously with the dollar’s ability to fulfill the range of currency functions—as medium of exchange, unit of account, and store of value—for governments and private actors. This shorthand reflects the view that governments’ willingness to accumulate dollar reserves is a condition for the longevity of the dollar system. For example, in times of crisis, when dollar shortages occur, private actors rely on their central banks to supply them with dollar assets, sometimes via swap lines extended by the Federal Reserve. Private actors’ willingness to use and hold dollars is necessary for the dollar system’s reach and entrenchment, but private entities coexist within a decentralized system. Their actions are not as consequential as those of official actors because each single entity typically holds a small slice of dollar assets. Even the considerable dollar assets held within large financial institutions consist of deposits by separate entities without any means or incentives to coordinate actions apart from inadvertently via the price mechanism. Unlike official actors, private actors’ choice of foreign currency is exclusively an economic decision. Moreover, they are unlikely to act collectively with the aim of disrupting the system. The reserve currency role is where the United States has the biggest lead relative to its nearest currency rival, the euro-zone.

How the dollar became dominant

The dollar rose to the top of the international currency hierarchy after World War I, superseding the British pound which regained its number one position in the interwar years before permanently losing currency primacy to the United States after World War II. After World War I, devastated European countries began relying on the United States for loans to rebuild their war-torn economies. The United States gradually became banker to the world with New York emerging as a financial center on a par with London. The stock market crash of 1929 and the ensuing Great Depression hit the United States hard, and the international role of the dollar declined between the two world wars. The 1944 Bretton Woods Agreement created a dollar-based system in which all currencies were pegged to the dollar and the dollar was pegged to gold, convertible at the rate of thirty-five dollars an ounce. World War II decimated European industry, which the United States helped rebuild through the Marshall Plan with large-scale investments and merchandise exports to Europe.

The United States’ strong economic lead after the two world wars, Europe’s dependence on the United States to resuscitate its ailing economies, along with the 1944 Bretton Woods agreement on the dollar-gold standard created the conditions for dollar dominance. Dollar primacy continued even as the United States broke away from the system which established the dollar’s prominent role. The Bretton Woods system capped US trade deficits at levels compatible with the United States’ ability to liquidate foreign dollar holdings through gold conversion. When the United States shook off the constraints reflected by gold conversion, the dollar system did not end. The 1971 Nixon shock simply decoupled the dollar from gold and replaced the gold constraint on US trade deficits with inflation and dollar depreciation.

The role of trade and oil

The dollar’s international role initially coincided with US trade surpluses as European countries absorbed American goods. As the European economies grew, demand for US assets grew, and the trade dynamic was reversed. US trade deficit pressures started to undermine the Bretton Woods dollar standard as predicted by the economist Robert D. Triffin. In his testimony to the US Congress, Triffin pointed to the contradiction between the United States’ liquidity provision and confidence in the dollar. The United States exported dollar assets, which were held abroad as foreign reserves, creating the liquidity needed to fuel economic growth. Dollar exports generated foreign investment in the United States leading to trade deficit pressures. In this case, the large supply of dollars undermined confidence in the dollar, particularly the United States’ ability to honor dollar conversion into gold, potentially jeopardizing the dollar standard. On the other hand, had the United States not accepted to run trade deficits the main source of international liquidity would run dry, which risked undermining international economic growth with destabilizing consequences. The United States’ liquidity provision was required for continued growth but in conflict with the long-term prospects of the dollar’s international role. Triffin predicted the breakdown of the Bretton Woods dollar system, and the dilemma remains relevant for the relationship between the United States’ liquidity creating role and confidence in the dollar. In the 1970s, oil and other commodities began to be priced in dollars, creating incentives for official and private actors to settle payments in dollars and therefore store value in dollars.

Threats to dollar dominance

The dollar remains dominant due to economic fundamentals and the history of using dollars, favoring future use because everyone else is using dollars. Supporting the dollar’s international role are factors such as the size of the US economy, its commercial and financial markets, the liquidity, depth, breadth and openness of US financial markets, the dollar’s convertibility, relative stability, and sound macroeconomic policies. The economic policies underpinning issuance of the primary international currency has not been flawless, but the historical record does not need to be perfect for the historical record to support the dollar’s continued use. The network effects of plugging into the dollar system due to the liquidity, depth, and breadth of the market for dollars creates an incumbency advantage, which is hard to overcome. In the absence of major economic or geopolitical upheaval, inertia disincentivizes a major switch to alternative currencies. Political factors could also impinge on the dollar’s role. For example, strong political institutions and property rights protection contribute to shoring up confidence in the US economy. Security ties to the United States are also said to have favored dollar use in the early Cold War days. US sanctions to uphold the liberal international order invite dollar support from states backing the order. On the flip side, an erosion of US political institutions, a weakening or reduced need for US security guarantees, or alternatively a sanctions backlash would likely reduce dollar support.

Unless political developments within the United States or US foreign policies radically shake confidence in the United States and access to dollars, economic factors are more likely to determine the fate of the dollar system.

US decline

The United States’ relative economic decline has been debated for at least sixty years. In the 1960s, Organski predicted China’s inevitable rise as a systemic leader and noted India’s likely emergence as a great power. In the 1980s, Paul Kennedy famously predicted that the United States would lose the superpower competition with the Soviet Union due to military overstretch. And an emphasis on competition in the era of economic interdependence led to repeated warnings about the United States’ ability to maintain its edge over rising economic powers, notably Europe and Japan.

The United States has declined relative to other great powers along various dimensions but remains the absolute strongest power across most dimensions. China’s gross domestic product (GDP) is nearly eighty percent of US GDP, and its goods imports are roughly equivalent to US goods imports. However, China’s financial markets are nowhere near the size or sophistication of US financial markets and China’s yuan accounts for less than three percent of foreign exchange reserves. The euro area is a closer competitor to the dollar. Euro area GDP is approximately sixty percent of US GDP, goods imports account for some ninety percent of US goods imports, and euro area financial markets are both advanced and large. The euro is the second strongest reserve currency, accounting for approximately twenty percent of foreign exchange reserves compared to the dollar’s sixty percent share.

US domestic economic policies

While the dollar enjoys an extraordinary lead over other international currencies, it is not invincible. Poor domestic policies could shake confidence in the dollar. Structurally, the United States’ liquidity-creating role—providing dollar assets to the rest of the world—and the ability to invest in the United States can interact unfavorably with low savings in the United States, resulting in large deficits, rising public and/or private debt. Unlike the euro-zone, however, the United States does not face the prospect of involuntary sovereign default because the dollar is a convertible sovereign currency. The recent specter of US default, a possibility which arises periodically, is entirely voluntary and due to a self-imposed debt ceiling. In the United States, the upper bound of the debt limit is rather determined by foreigners’ willingness to hold dollars, at worst resulting in inflation and depreciation. Although the United States cannot be forced to default, such an adjustment process may not be benign.

Geopolitical challenges

There have been few deliberate attempts to unseat the dollar as the first international currency. In the early twenty-first century, Iraq and Iran discussed switching oil pricing from dollars to euros with a view to reducing dependence on the dollar system, a response to US sanctions and interventions in the Middle East. More recently, an anti-dollar counter-coalition centered around the BRICS countries has emerged. The inclusion of China and Russia, and large emerging economies, presents a more potent challenge to dollar dominance than in the past. If sanctions, or some other development, leaves other countries dissatisfied, the counter-coalition could grow and pose a more acute defiance against the dollar system.

Rising US public debt, high inflation, and other key developments are unfolding in a strategic setting reminiscent of the Cold War environment. The most striking parallel is the return of great-power rivalries and policymakers’ preoccupation with security concerns, which are taking precedence over economic efficiency. Fears about economic decoupling, deglobalization, and fragmentation abound. On the monetary front, the worry is that countries anticipating US sanctions will move preemptively to reduce their dependence on the dollar.

China and Russia have been especially energetic in pushing alternative currencies and building a multinational financial infrastructure for trade and investment in renminbi and rubles. For example, China’s Cross-Border Interbank Payment System (CIPS) acts as a clearing house similar to the US Clearing House Interbank Payments System (CHIPS). CIPS processes a mere fifteen thousand transactions per day, amounting to the dollar equivalent of fifty billion, whereas CHIPS processes twenty-five thousand transactions per day, with a value exceeding $1.5 trillion. The CIPS initiative has nonetheless laid the groundwork to clear and settle more cross-border exchange in renminbi. When China launches a financial messaging system capable of working independently from the Society for Worldwide Interbank Financial Telecommunication (SWIFT), it will have its own complete, autonomous architecture for settling cross-border transactions denominated in its own currency.

For its part, Russia has already taken steps to bypass SWIFT, creating its System for Transfer of Financial Messages (SPFS) after its illegal annexation of Crimea in 2014. Russia’s central bank claims that demand for SPFS has increased significantly since last year’s full-scale invasion of Ukraine. At the time, however, the system had only around four hundred users.

Still, owing to new payments infrastructure and various bilateral agreements, pursuing trade and investment in non-Western currencies has become somewhat easier. Russia and China have agreed to trade in renminbi; and, reviving the Cold War-era rupee-ruble mechanism, Russia and India were planning to trade in their own currencies following Russia’s invasion of Ukraine. However, that effort was recently discontinued, with both countries settling on using the United Arab Emirates’ dirham instead. All told, such use of alternative currencies by third countries remains small. While the renminbi is being used to settle a Russian investment in a nuclear-power plant in Bangladesh, other examples are scarce.

Governments are also making plans to move away from pricing oil in dollars, although the significance of this development is easily overstated. Oil may be one of the world’s leading export products, but it ultimately accounts for a small share of global trade.

More broadly, because international currencies are, by definition, used by third countries, adopting a trade or investment partner’s currency will not necessarily raise that currency’s international role, even if it does reduce the greenback’s relative role in cases where those transactions were previously denominated in dollars.

Those predicting the end of dollar hegemony also point to China’s own use of bilateral swap lines to allow foreign central banks to acquire renminbi in exchange for their own currency. Making renminbi available to foreign governments is a prerequisite for its use by public and private actors, and the ability to act as lender of last resort in times of crisis is a key reserve-currency function.

China has also been maneuvering to expand its institutional footprint, such as by introducing an emergency renminbi liquidity arrangement under the auspices of the Bank for International Settlements (BIS). Similarly, the basket of currencies underpinning the International Monetary Fund’s special drawing rights (SDR, the IMF’s reserve asset), now includes the renminbi, alongside the dollar, yen, euro, and pound sterling. And the BRICS (Brazil, Russia, India, China, and South Africa) have also discussed ways to push back against dollar hegemony, such as by issuing a joint reserve currency to bypass the dollar and other major Western currencies (as well as offering an alternative to SDR).

Finally, one of the most eagerly anticipated technological developments in this area is China’s creation of digital payment alternatives. China’s central bank introduced a digital currency, the e-CNY, in 2016 and offered this payment option to participants at the 2022 Olympics in Beijing. When fully implemented, the e-CNY will function independently of other payment and financial-messaging systems. By offering cheaper, faster, and safer transactions, a Chinese digital currency could make the renminbi more attractive and therefore more widely accessible and liquid. Promoting the e-CNY for trade and investment could accelerate renminbi internationalization.

But underlying trade and investment patterns must change before the global currency hierarchy does. Here, the China-centered Regional Comprehensive Economic Partnership, as well as China’s Belt and Road Initiative, could help internationalize the renminbi by multiplying economic interactions and encouraging renminbi use in third-country trade and investment. Still, in the medium term, renminbi internationalization is likely to encounter substantial hurdles, owing to China’s maintenance of capital controls and broader balance-of-payments constraints.

Why sanctions are an unlikely tipping point for dollar dominance

Following Russia’s invasion of Ukraine, geopolitical blowback is widely seen as threatening dollar dominance. To fully grasp what today’s turbulence means for the dollar system, we must however move beyond the motivations of countries targeted by sanctions. Many countries benefit from US currency coercion because they share the core principles behind US sanctions. Countries supporting sanctions on Russia have strong geopolitical incentives to continue holding and using dollars for international reserve and payment purposes. Supporting the dollar reinforces the constraining impact of the sanctions and helps ensure their future effectiveness. The economic incentives these governments previously had to diversify away from traditional currencies, particularly the US dollar must now be weighed against their geopolitical incentives to hold dollars. Together, the coalition arrayed against Russia accounts for more than ninety percent of global currency reserves, approximately eighty percent of global investment, and sixty percent of world trade and world economic output. Overcoming that dominance would be difficult even if every country that has declined to sanction Russia fell in line behind an organized anti-dollar coalition. Moreover, countries not participating in sanctions against Russia do not necessarily disagree with the goals behind them: ending the war in Ukraine and deterring future territorial aggression. The coalition behind the sanctions against Russia is broad, wealthy, and militarily powerful, and its objective of ending Russia’s barbarous war is widely shared, even by those not participating in the sanctions. Geopolitically induced dollar support is rather likely to stabilize dollar holdings.

Having noted the relationship between sanctions and dollar dominance a decade ago, I am not suggesting there is no possible scenario in which sanctions threaten dollar hegemony, simply that the Russia sanctions are highly unlikely to represent such a tipping point. Sanctions should be designed to prevent the unipolar currency order from further eroding. For example, by building broad sanctions coalitions in which participation is strictly voluntary and without forcing countries to choose sides. Sanctions can be costly for third parties. Whenever possible, steps should be taken to alleviate unintended consequences. In addition, sanctions should be reserved for clear-cut cases in which the international order is under threat, as in Ukraine, and should not be used for parochial purposes, as when sanctions were reinstated against Iran in 2018, even though Iran had not broken the terms of the nuclear deal, or when the Trump administration imposed overly harsh sanctions on Cuba. Imposing sanctions to pursue narrow US interests raises legitimate fears among countries that they could be targeted next, motivating them to find alternatives to the dollar. Using sanctions to preserve the central elements of the liberal international order is a goal many countries can subscribe to, or at least tolerate, leaving the dollar as their continued currency of choice.

Other geopolitical drivers

Sanctions risk is not the only geopolitical factor shaping dollar use. In today’s fraught international environment, countries question the wisdom of system-wide economic interdependence and privilege economic ties with friends. As security concerns eclipse economic concerns, the United States and Europe are limiting their economic dependence on foreign adversaries and pushing to relocate manufacturing and supply chains to allied nations in what has come to be known as “friend shoring.” Just as countries are beginning to source goods and inputs from friendly nations, they may very well adopt the currencies of friendly nations. We should therefore expect a return to the Cold War logic in which economic relations more frequently align with security relations. With the United States at the bullseye of the largest security network in the world, the dollar stands to benefit from this shift. As during the Cold War, US security provision may induce allied dollar support.

Concluding remarks

In short, the size of the sanctioning coalition, the number of nonparticipating sanctions supporters, and the number of countries under the US security umbrella, make large-scale currency diversification away from the dollar unlikely, at least in response to the Russia sanctions. To preserve the existing currency hierarchy and limit the long-term trend towards currency multipolarity, the United States must adopt sound economic policies and use economic statecraft to promote the public good of international order from which most countries stand to benefit. The United States cannot afford to alienate key allies, or a large portion of the international community, and simultaneously preserve the unipolar dollar era over the long term. For the first time since the collapse of the Bretton Woods gold standard, we are seeing a systemic limit on the dollar centered economic order and US foreign policy. 

Fellow

Dr. Carla Norrlöf

Nonresident Senior Fellow

Economic Statecraft Initiative GeoEconomics Center

Trade

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Squeezed by sanctions, Russia has turned to Chinese yuan and gold, but both introduced new vulnerabilities and inconveniences.

China Economic Sanctions

Issue Brief Sep 27, 2022

Will economic statecraft threaten western currency dominance? Sanctions, geopolitics, and the global monetary order 

By Dr. Carla Norrlöf

The return of great power rivalry is stoking renewed fears of weakening Western currency dominance. Financial sanctions are becoming the preferred economic tool for accomplishing geopolitical goals.

China Economic Sanctions

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This shift in market sentiment has whittled away the flow of capital into China, underlining how de-risking has become a bottom-line imperative as much as a diplomatic strategy. And it does not bode well for China amid growing anxiety about the country’s economic prospects. 

China’s economy has failed to rebound as expected from Zero-Covid policies, and it faces profound structural challenges: A rapidly aging workforce and slow productivity growth; widening income inequality; and a crippling property crisis. All this adds up to a difficult straits in which local governments and many companies can’t pay their bills. Even though China doesn’t need foreign capital like it did a generation ago, foreigners’ reluctance to invest will reverberate through the economy over time. 

Fund managers—especially those with investment strategies focused on the long-term—are concerned about the political uncertainty created by Beijing’s regulatory crackdown on leading private sector conglomerates and heavy-handed pressure on Western companies. Now the Biden administration is preparing to restrict the flow of US venture capital and private equity to Chinese startups developing sensitive technologies—a step many investors worry is a harbinger of more sanctions to come. Western manufacturers are also taking first steps to leave the country, or at least to implement “China+1” strategies. 

Meanwhile, Beijing has been undertaking its own form of de-risking by imposing strict regulations that have choked off the number of Chinese companies launching initial public offerings (IPOs) in the US. China’s bureaucrats are concerned about exposing secrets supposedly contained in the vast troves of data controlled by companies seeking IPOs. Instead, the government is making it easier for these companies to list in Shanghai and Shenzhen. More IPOs have been launched in those markets over the past year than in any other market—but with less long-term, foreign capital to offset the share-price volatility that comes from China’s army of retail investors. 

The bottom line for many foreign fund managers is that the risk of investing in Chinese securities has soared over the past year and the returns have not kept up. Those returns are out of reach because of the country’s economic doldrums and anemic corporate profits. As a result, many pension funds and other large institutions have stopped buying China altogether. Instead, they are shifting capital to more promising emerging markets like India, where the economic outlook is brighter and politics less of a worry.  

The turn away from Chinese bonds is also a response to the efforts to contain US inflation. As the US Federal Reserve has raised interest rates—and China’s central bank has maintained a loose monetary policy in the face of slow growth—10-year US Treasuries have offered better yields than comparable Chinese bonds. At the same time, the renminbi has weakened against the dollar, potentially making investments in China even less profitable.  

Chinese stocks did well during the first year of Covid as China’s exporters rushed to feed the world’s demand for pandemic supplies. But after hitting peaks in early 2021, the shares popular with investors in New York and Hong Kong fell for 20 months. A key reason was Beijing’s regulatory crackdown on tech platforms like Alibaba Group and ride hailer Didi Global, which Chinese regulators forced to delist from the New York Stock Exchange immediately after a successful IPO in June 2021. Foreign investors returned to buying in late 2022 in expectation of an economic rebound as Beijing loosened its harsh Zero-Covid policies. But by Spring they had returned to selling amid disappointment with the Chinese government’s policies, skepticism about Beijing’s belated promises of support for companies that had been targeted in the crackdown, and worries about worsening US-China relations. 

This evolution is clear from the performance of the Nasdaq Golden China Index, which tracks Chinese companies listed in the US, and the Hang Seng China Enterprises Index in Hong Kong. 

The loss of confidence among US investors outweighed what might have been the salutary effect of last year’s resolution of a dispute between Washington and Beijing over the auditing standards of Chinese companies on Wall Street that had threatened to delist those firms. Trading in some of those shares also has been affected as fund managers shift their investments to some companies’ parallel listings in Hong Kong in anticipation of future delisting—another aspect of the concern about US-China tensions. By the end of March, 53 percent of Alibaba’s “tradeable” shares were registered in Hong Kong, up from 38 percent at the end of 2022.  

Some foreign fund managers remain committed to Chinese stocks, especially hedge funds. But they aren’t necessarily the stable, long-term investors the Chinese government seeks.  

Beijing is not standing idly by: It continues to provide new avenues for foreign investors, most recently opening a channel for them to hedge bond investments and licensing major Western investment banks to operate wholly-owned fund management businesses catering to domestic Chinese investors. But there is a sense among foreign firms that China will prove less profitable than they once hoped. 

Then there are the funds that specialize in early-stage investing: Venture capital (VC) and private equity investors (PE) who provide startups with seed money and help bring them to market. These investors have played a significant role in the development of many leading Chinese technology companies. For example, American VC firms and other foreign investors made 58 investments in China’s semiconductor industry from 2017 to 2020, and China-based affiliates of Silicon Valley VCs provided capital to 67 chip-related ventures in 2020 and 2021. 

But since the Biden administration began exploring restrictions on outbound investment, the pace of Chinese investments from abroad by both groups has declined. The share of VC deals in China that include non-Chinese investors dropped to 15.1 percent last year from 2021, the lowest level since 2017. Meanwhile, PE investments in China by American investors declined 76 percent to $7.02 billion last year from $28.92 billion in 2021.  

While the China affiliates of some VCs continue to raise funds, the imminent White House executive order is expected to continue cutting into this category of investment. Combined with recent Biden administration restrictions on sales to China of advanced semiconductors and cutting-edge chip-making gear, the message to all classes of investors will be clear: Putting money in China is going to become riskier, and de-risking is only going to become more commonplace. 

Jeremy Mark is a senior fellow with the Atlantic Council’s Geoeconomics Center. He previously worked for the IMF and the Asian Wall Street Journal. Follow him on Twitter: @JedMark888.

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However, it’s possible that investors would try to buy more US Treasuries in the wake of default. Why? Because there is no viable alternative. Think back to the start of the Global Financial Crisis or COVID-19. In both situations, the world scooped up US bonds. That’s because there is nothing else like US Treasuries.

In a crisis, investors search for safety. Safe assets have a high likelihood of payout and can be traded easily. In practice, that usually means bonds issued by a handful of stable governments in advanced economies. The problem for any investor looking for safety in the wake of a US default is that the US Treasury market is much larger than any similarly-rated government bond market.

Would the world turn to German bunds, the only other AAA-rated sovereign debt in the G7? Maybe, but as the chart above illustrates, their market is less than 1/10th of the size of the US Treasury market. And German fiscal rules make it basically impossible for them to ever catch-up.

Where else to go? The UK gilt market? Beyond its small scale, you will recall the UK had its own credibility crisis just last year.

China? If you’re looking for a reliable, transparent, liquid market where you can turn your holdings into cash quickly without question, China is not it. 

Japan seems like a reasonable option until you realize the amount of Japanese government bonds (JGBs) available is overwhelmingly influenced by the central bank’s intervention in its bond market.

Where else could investors turn? They could hold more cash, but the opportunity cost of doing so has risen in the form of higher interest rates. They could look for relatively safe private sector assets, like the bonds of large, stable firms. But as the crisis of 2008-09 showed, even highly-rated private sector securities can be risky in a crisis.

There simply are not enough safe assets available for investors to move off of Treasuries. This is one reason why flirting with a default is so maddening. The US government issues something the rest of the world desperately wishes it had.

In the immediate aftermath of a default, Secretary Yellen may calm the Treasury market by promising to continue to pay interest on debt even as other bills go unpaid. But no one should mistake that for a solution. There would be massive fallout both for the US and global economy in this scenario. The bottom line is that in a default, even if US Treasuries have a short-term win, everyone—including the US—will still lose.

Josh Lipsky is the senior director of the Atlantic Council’s GeoEconomics Center and a former adviser at the International Monetary Fund.

Phillip Meng contributed research to this piece. A version of this piece appeared in the GeoEconomics Center’s private Sunday night newsletter  Guide to the Global Economy. To subscribe to the newsletter please email sbusch@atlanticcouncil.org.

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Read on to find out how these powerful democracies are tackling some of the world’s thorniest problems.

This post will be updated as news develops and more reactions come in.

Click to jump to an expert reaction:

Daniel Fried: The G7 brought good news for Ukraine and strong new sanctions on Russia

Josh Lipsky: Unthinkable two years ago, G7 countries are addressing China together

John E. Herbst: Hiroshima makes clear the authoritarian high-water mark has passed

Daniel Tannebaum: Continued alignment on Russia sanctions is impressive, but it’s time to finish the job

Kyoko Imai: The Quad crumbles without a corner

Dexter Tiff Roberts: What will the G7 do when China next attempts economic coercion?

Thomas Cynkin: A breakthrough in fighting China’s economic coercion, but the details must be fleshed out

Steven Tiell: The regulators are coming for your AI

Robert Cekuta: G7 leaders should have gone further on energy security

Bee Yun Jo: US-Japan-South Korea trilateral cooperation is back on track

Jessica Taylor: Can US-South Korea-Japan trilateral cooperation endure beyond a photo op?

Parker Novak: Biden skipping Papua New Guinea was a missed opportunity

The G7 brought good news for Ukraine and strong new sanctions on Russia

The G7 summit generated a lot of support for Ukraine, again demonstrating that persistent predictions of eroding support are off. The G7 Leaders’ statement on Ukraine was strong and, critically, did not push Kyiv toward negotiations on Russian President Vladimir Putin’s terms (a common recommendation from a certain school of thought that seems resigned to Russian victory even as the battlefield seems to favor Ukraine). The rapid coming together of a European coalition to provide Ukraine with F-16 fighter jets, an initiative that the United States in a policy reversal has now joined, was a major step in intensifying military assistance for Ukraine—a big G7 deliverable, as the saying goes. 

There were also new sanctions announced, outlined thematically in the G7 statement and in detail by the United States. These were also a big deal, even as the new sanctions did not include some ambitious proposals. For example, there was no lowering of the oil-price cap, no across-the-board ban on trade with Russia with exceptions (a so-called “white list,” as opposed to the current “black list” approach), and no decision to use the immobilized Russian sovereign assets for Ukraine.

But the announced US sanctions package was broad, well-prepared, and impactful. To cite only a few of the new measures, the Biden administration targeted sanctions evaders from around the world, a labor-intensive process that may hinder Russia’s efforts to escape the vise of restrictions on high-tech exports to Russia. It went after future Russian energy production and export capacity, a clever move that seems intended to lock in pressure on Russia’s critical energy sector for the longer term. The new US sanctions also targeted Russian gold sales (and the European Union seems prepared to target Russian diamond exports), good examples of going after Russian foreign-exchange earnings. 

This was solid work. Sanctions theory usually asserts that sanctions are intended to change behavior. The Russian sanctions regime, however, seems intended to weaken the Russian economy generally, and rightly so. The current sanctions recall (and are more sophisticated than) the Cold War–era sanctions that contributed to the decline and fall of the Soviet Union. Putin, who seeks by war to recreate the Soviet and Russian empires, may yet learn that democracies, for all their messiness, are not as weak and feckless as he supposes.

—Daniel Fried is the Weiser Family distinguished fellow at the Atlantic Council. He was the coordinator for sanctions policy during the Obama administration, assistant secretary of state for Europe and Eurasia during the Bush administration, and senior director at the National Security Council for the Clinton and Bush administrations. He also served as ambassador to Poland during the Clinton administration.

Unthinkable two years ago, G7 countries are addressing China together

China is not mentioned a single time in the G7’s new special statement on economic security—but make no mistake, it is all about China. Japanese Prime Minister Fumio Kishida made the issue of combating China’s economic coercion a priority for Japan’s G7, and with this unified statement the leaders achieved what will likely be the lasting legacy of the summit. The big question coming into Hiroshima was: Could the leaders maintain unity against Russia and harness that collective power in addressing China? The statement is the first concrete sign that the answer is yes. Two years ago, during the United Kingdom’s G7 summit in Cornwall, it would have been hard to believe that European leaders would sign on to a statement that was so specifically directed at Beijing. But after China targeted Lithuania for its support of Taiwan, the calculus on the continent began to shift. Now, all G7 leaders have committed to a new rapid response coordination platform if another country is targeted. They are also speeding up their push for new supply chains and trying to leverage the Partnership for Global Infrastructure Investment as an alternative to the Belt and Road Initiative. 

The statement doesn’t specify what other specific steps the group will take to combat what they describe as the “disturbing rise in the incidents of economic coercion.” And you can be sure that other participants at the G7, including India’s Prime Minister Narendra Modi, will stay away from associating with this statement. Many countries will ask privately, what about the West’s use of sanctions and other tools of economic statecraft? The answer from the G7 is that those tools have a legal basis and are a justified response to violations of international law. The bottom line is that the G7 has shown it will increasingly focus on China and will try to maintain a coordinated policy approach. That’s a major development.

—Josh Lipsky is the senior director of the Atlantic Council’s GeoEconomics Center and a former adviser to the International Monetary Fund.

Hiroshima makes clear the authoritarian high-water mark has passed

G7 summits are usually nerd nirvanas, producing long statements on numerous issues that specialists mine to figure out in which direction the world’s leading democracies are moving, usually incrementally. Hiroshima was different. It was rich in substance and symbolism indicating that the world’s great democracies recognize the dangers, geopolitical and economic, posed by the two authoritarian revisionist powers, China and Russia.

In the summit statement and discussion, the G7 leaders seemed to be moving toward the understanding that China is a predatory power that needs to be kept in check. The statement also laid out a host of measures to further support Ukraine and isolate Russia for its war-crime laden aggression; and by hosting Zelenskyy, it gave the world a clear symbol of the world’s great democracies’ determination to enable Ukraine’s successful defense. To underscore this, the Biden administration used Hiroshima to finally allow the transfer of F-16 fighter jets to Ukraine. What’s more, Hiroshima offered a reminder of just how potent the democratic ideal is in also hosting Indian Prime Minister Narendra Modi, a long-time Putin pal and stalwart of the BRICS group (Brazil, Russia, India, China, and South Africa). It would have been nice to be a fly on the wall in the Kremlin as Putin watched the coverage of Modi’s bilateral meeting with Zelenskyy.

Was it really just fifteen months ago that Chinese leader Xi Jinping and Putin issued their lengthy joint statement in Beijing and the world appeared to tremble at the specter of the marching authoritarian great powers? And today, Xi meets with the five Central Asian leaders while the G7 countries sit with India and Ukraine, and International Criminal Court–indicted Putin wonders if he can attend the BRICS Summit in South Africa in August without being arrested. Were these the extraordinary “changes” that Xi told Putin their two nations were driving when they met in Moscow in March?

—John E. Herbst is senior director of the Atlantic Council’s Eurasia Center and served for thirty-one years as a foreign service officer in the US Department of State, retiring at the rank of career minister. He was US ambassador to Ukraine from 2003 to 2006.

Continued alignment on Russia sanctions is impressive, but it’s time to finish the job

The G7 members continued to show their alignment on new waves of Russian sanctions after meetings in Hiroshima over the last few days. The rhetoric continues to be one threatening those who would evade or circumvent sanctions, or those supporting them, with severe penalties. We’ve certainly seen designations of those who have circumvented sanctions to date, but without material enforcement, is the coalition missing the plot? Having served at the Office of Foreign Assets Control (OFAC) in the US Department of Treasury, I know firsthand the time it takes to bring an enforcement case to conclusion. If the goal is further isolation of Russia, then seeing nearly five billion dollars per month of exports from G7 nations (according to the Atlantic Council’s Niels Graham) is evidence of the scale of Russia’s role in the global economy. I do not mean to say that those who have been trading monthly with Russia have been violating sanctions, but perhaps countries and companies do not feel as much that they need to make a choice.

Hopefully, in time, there will be further rounds of sanctions focusing more broadly on export bans, unless otherwise expressly exempted. This would certainly make life more operationally easier for financial institutions which finance the aforementioned trade. For example, as sanctions were built up on Iran, culminating in the Joint Comprehensive Plan of Action (JCPOA), trade with Iran was certainly viewed largely as off-limits, and further enforcement actions against global banks reinforced the consequences for those who would purposefully violate these sanctions. When the JCPOA was enacted and secondary sanctions lifted, as a condition of the deal, there were initial views that Western businesses, where permissible, would flood the market. There were numerous reports of civil aviation, automotive, and consumer products companies who announced plans to reenter the market. Few, if any, global financial institutions would facilitate this trade, even if it was legal. At one point, then US Secretary of State John Kerry and then UK Foreign Secretary Boris Johnson convened the world’s largest banks to remind them that certain trade was now permissible. But the banks did not bite. The fear of potentially being on the wrong side of the remaining Iran sanctions, and the large-scale penalties that went along with those violations, was a painful reminder that it may not be worth it.

Now, Iran is certainly not Russia. The former is, according to the International Monetary Fund, the twenty-second largest economy in the world, while the latter recently ranked as the eleventh largest. However, for these Russia sanctions to be truly effective, more companies need to fear the downside risk to their organizations if things go wrong and they end up violating sanctions. To be clear, I do not wish for enforcement to occur outside of the truly egregious examples of violations. Enforcement has served as an effective deterrent historically to help reinforce a sanctions agenda. In the Iran example, these were some of the largest banks in the world that paid billions of dollars in settlement costs, and billions more in remediating their historical issues. There is another reason why enforcement is critical in a new sanctions regime, especially one as challenging to implement as with Russia. It is at times hard for companies to know whether they’re doing it right. Some of the best guidance out of OFAC used by firms was borne from enforcement actions, where organizations could apply the lessons learned to themselves and ask if they had done something similar. At the most basic level, if continued rounds of new sanctions are launched without material examples of violators, assuming they exist, can we really say they’re effective?

—Daniel Tannebaum is a nonresident senior fellow at the Atlantic Council’s Economic Statecraft Initiative in the GeoEconomics Center and a partner in Oliver Wyman’s Risk and Public Policy Practice, where he leads the firm’s Global Anti-Financial Crime Practice.

The Quad crumbles without a corner

Biden’s decision to abruptly end his Asia trip and pull out of the Quad Leaders’ Summit reflects poorly on US credibility and reinforces doubts about its resolve. The leaders of Australia, India, Japan, and the United States were expected to meet in Sydney on May 24 to enhance cooperation on critical and emerging technologies, climate change, and maritime domain awareness. However, Biden cut his trip short to deal with domestic debt ceiling negotiations, which are undermining US foreign policy at a pivotal moment for the Indo-Pacific region.

The Quad Summit was intended to signal unity in the face of Chinese attempts to challenge the existing regional order. Instead, China will be further emboldened to assert territorial claims, expand naval capabilities, and militarize islands in the South China Sea. This is a diplomatic gift to Xi, and Chinese state media outlets will jump at the opportunity to tear Washington down. In its messaging to the region, Beijing will claim that a country failing to keep its own government afloat is unfit to lead.

China is right about one thing: Building trust requires consistency, reliability, and simply showing up. Withdrawing from diplomatic trips to Asia due to political emergencies has become an unfortunate pattern for the United States, as presidents George H.W. Bush, Bill Clinton, and Barack Obama all did so.

Furthermore, US foreign policies are at risk of a 180-degree shift every four years, as shown by the political re-emergence of Donald Trump—who ditched the 2017 East Asia Summit in the Philippines because it started late.

Nonetheless, the United States has been deemed the unofficial leader of the Quad. Although the four leaders met on the sidelines of the G7 meeting in Hiroshima, the meeting only lasted fifty minutes and was a clear indication that the Quad framework had been pushed to the wayside.

Perhaps another country ought to take control. With India overtaking China as the most populous country in the world, Modi is asserting himself. India’s prime minister is proceeding full steam ahead with his visit to Australia, which includes a public event, a bilateral with Australian Prime Minister Anthony Albanese, and meetings with leaders in the business community. But India’s democratic backsliding under Modi means that other Quad members must exercise caution in their engagement.

While the four countries sought to resuscitate the Quad Leaders’ Summit by bandwagoning onto the G7, it is evident that this was a missed opportunity to not only strengthen Quad partnerships but more importantly signal commitment to Indo-Pacific countries.

—Kyoko Imai is an assistant director with the Indo-Pacific Security Initiative in the Atlantic Council’s Scowcroft Center for Strategy and Security.

What will the G7 do when China next attempts economic coercion?

While some are criticizing the “G7 Leaders’ Statement on Economic Resilience and Economic Security” for lacking detail on how countries intend to respond to economic coercion (coercion from China, of course, even if Beijing is never mentioned by name), just the fact that the disparate G7 members, all of which have significant trade and investment relations with China, were able to put out such a strong statement is a big accomplishment. “We will work together to ensure that attempts to weaponize economic dependencies… will fail and face consequences” is just one of numerous tough lines in the document.

If there was any doubt whether China is taking the statement seriously, just check out its irate response. Late Saturday, Beijing lashed out at the United States, calling it the “real coercer” that “politicizes and weaponizes economic and trade relations” with its use of sanctions. It went on to warn the G7 to stop “bludgeoning other countries” and “stoking bloc confrontation.” We will have to wait to see what concrete steps are taken by the G7 the next time one of its members or partner countries faces business pressure from China (the Coordination Platform on Economic Coercion that the G7 mentions indeed lacks specificity). But the statement released at the close of the Hiroshima summit is nonetheless a big first step toward confronting this growing challenge head on.

—Dexter Tiff Roberts is a nonresident senior fellow with the Atlantic Council’s Indo-Pacific Security Initiative and Global China Hub.

A breakthrough in fighting China’s economic coercion, but the details must be fleshed out

Perhaps the signal achievement of the Hiroshima G7 Summit was agreement on a “Coordination Platform on Economic Coercion” to counter Chinese economic coercion, highlighted through a stand-alone document.

Despite the obvious utility of such a mechanism, this outcome was long in coming. Japan and the United States have urged coordination among the leading industrialized democracies to counter Chinese economic coercion. However, European G7 countries have been reluctant, fearful of antagonizing Beijing. They exceeded expectations by joining consensus not only on a general statement of principles opposing economic coercion, but on a coordinating mechanism to take concrete actions.

Now that the G7 has moved past admiring the problem and reached consensus on the need for a coordination platform, the devil will be in the details of implementation. A good starting point may well be mapping out supply-chain vulnerabilities by industry and sector, alerting countries and corporations that might be affected, and helping them devise and implement “de-risking” strategies that would render them more resilient to supply-chain disruptions by China.

This could be an important means of G7 outreach to Global South countries, sensitizing them to the perils and pitfalls of economic dependence on China and demonstrating the benefits of upholding international order and the rule of law in cooperation with developed industrial countries and multilateral institutions.

Another important element will be devising joint approaches on mitigation via ready-made tools to counter economic coercion by providing support and relief for countries targeted by China. Flexible response options include, inter alia, stockpiling critical materials or commodities that China could restrict, providing export credit insurance to encourage alternative exporters to meet demand when China restricts exports, and enacting temporary tariff reductions to compensate when China restricts imports. Similarly, the G7 could consider retaliatory measures, although that may be a bridge too far at this juncture.

Whichever tools are adopted, the G7 decision to work together through a common coordination platform may be seen in retrospect as a watershed moment for countering Chinese economic coercion.

—Thomas Cynkin is a nonresident senior fellow in the Indo-Pacific Security Initiative and a former career US diplomat, serving in Japan and elsewhere.

The regulators are coming for your AI

The G7 has lobbed the latest of three notable salvos in signaling that governments around the globe are focused on regulating Generative Artificial Intelligence (AI). The G7 ministers have established the Hiroshima AI Process, an inclusive effort for governments to collaborate on AI governance, IP rights (including copyright), transparency, mis/disinformation, and responsible use. Earlier in the week, testimony in the United States highlighted the grave concerns governments have and why these discussions are necessary.

“Loss of jobs, invasion of personal privacy at a scale never seen before, manipulation of personal behavior, manipulation of personal opinions, and potentially the degradation of free elections in America.” These are the downsides, harms, and risks of Generative AI as Senator Josh Hawley (R-MO) recapped after the Senate Judiciary Committee hearing on May 16, saying “this is quite a list.”

Just last week, the European Union (EU) AI Act moved forward, paving the way for a plenary vote in mid-June on its path to becoming law.

Make no mistake, regulation is coming.

Read more here:

GeoTech Cues

May 22, 2023

The regulators are coming for your AI

By Steven Tiell

The Group of Seven (G7) has lobbed the latest of three notable salvos in signaling that governments around the globe are focused on regulating Generative Artificial Intelligence (AI). The G7 ministers have established the Hiroshima AI Process, an inclusive effort for governments to collaborate on AI governance, IP rights (including copyright), transparency, mis/disinformation, and responsible […]

Technology & Innovation

—Steven Tiell is a nonresident senior fellow with the Atlantic Council’s GeoTech Center. He is a strategy executive with wide technology expertise and particular depth in data ethics and responsible innovation for artificial intelligence.

G7 leaders should have gone further on energy security

When it comes to energy security, the G7 Leaders’ Hiroshima Communique falls short. While paying extensive, needed attention to slashing greenhouse gas emissions and rightfully condemning the negative impacts on global energy security stemming from Russia’s expanded invasion of Ukraine, the communique could do better in addressing the changing geopolitics of energy and meeting the world’s need for assured, predictable, and affordable energy.

The communique is strong on the imperative to decarbonize and limit the rise in global temperatures. Fighting climate change requires radical changes in how the world gets and uses energy. However, energy security, affordability, and access are also important.

While last year Europe built oil and gas stocks as the EU, the United States, and others sanctioned Russia, it was the warmer-than-normal winter that was key to the continent avoiding serious energy shortfalls and economic pain. Significant new natural gas supplies to replace Russia’s will not be on stream for another year or more; tight, expensive energy supplies will remain a reality. Next winter may not be as obliging. Continued international action is essential.

Another serious factor tightening the market is rising energy demand. Emerging economies, especially China and India—not the mature, industrialized West—now drive the demand side of the ledger. Their decisions about whether they use coal and other fossil fuels to generate electricity or to decarbonize have global impacts. The G7 needs to keep engaging them.

A third energy security issue demanding attention concerns the billions of people without access to energy today. One of the Sustainable Development Goals is to “ensure access to affordable, reliable, sustainable, and modern energy for all,” but those without it rose by twenty million in 2022 to nearly 775 million. As many as three billion people lack a safe way to cook, leading to millions dying each year from household air pollution. Moreover, another two billion people are expected to join the world’s population between now and 2050. All of them will need access to reliable energy.

While focusing on pushing the energy transition ahead, the 19,000-word G7 communique is too often silent on other pressing realities. Working, as the communique says, “to holistically address energy security, climate crisis, and geopolitical risk including expansion of global use of renewable energy in order to… keep a limit of 1.5°C within reach” is a worthy objective. But it may prove inadequate in meeting other pressing energy security challenges.

It is essential the United States, its G7 partners, and other governments widen the aperture. The realities of a growing world population looking for greater access to energy should be taken into account. Solutions need to be developed, including new technologies. Governments will need to recognize that some countries will remain more dependent on fossil fuels than others. Countries that already face high borrowing costs and other difficulties in obtaining needed financing, for example, will face difficulties financing lower carbon energy solutions. 

G7 leaders need to keep a focus on a changing, dynamic global energy security picture, and push on a wider range of policies and actions.

—Robert Cekuta is a former principal deputy assistant secretary for energy at the State Department and was the US ambassador to the Republic of Azerbaijan.

US-Japan-South Korea trilateral cooperation is back on track

Six months after their previous meeting in November, the leaders of South Korea, the United States, and Japan resumed their talks on the last day of the G7 summit—where highly anticipated topics included enhancing real-time information sharing on North Korea’s ballistic missiles, as well as the possibility of Japan joining the South Korea-US Nuclear Consultative Group announced during South Korean President Yoon Suk Yeol’s visit to Washington last month. Although the meeting was short, given tight schedules at the summit, the brief sideline meeting is the culmination of real progress in getting trilateral relations back on track.

Most importantly, the three leaders did get to discuss “new coordination” over North Korea’s “illicit nuclear and missile threats,” according to the White House statement. This manifests how working-level discussions are ongoing and making real progress. As Biden invited Yoon and Kishida for a formal trilateral meeting in Washington, more fine-tuned outcomes will be available in the near future. Second, their appearance in the setting of Hiroshima was symbolic in and of itself. The leaders of South Korea and Japan put forth “courageous” efforts (as Biden put it) to mend ties during their bilateral meeting just before the trilateral sideline meeting, which showcased their unity and just how much their ties have improved in the past few months.

Moreover, as Yoon clarifies and realigns South Korea’s approach to global issues—agreeing to push back against China’s “coercive behavior” and provide more non-lethal aid to Ukraine—the trilateral meeting signals a resumed heyday of trilateral security cooperation.

— Bee Yun Jo is a nonresident fellow in the Indo-Pacific Security Initiative and an associate research fellow at the Korea Institute for Defense Analyses. She is also an evaluation committee member of the South Korean Ministry of Foreign Affairs and an advisory committee member of the the ministry’s Department of Arms Control and Nonproliferation.

Can US-South Korea-Japan trilateral cooperation endure beyond a photo op?

The decision by Kishida, Yoon, and Biden to meet despite the compressed timeline of Biden’s abbreviated Asia-Pacific trip displayed the leaders’ strong desire to communicate that increasing trilateral cooperation is a priority. However, significant hurdles remain to advancing this cooperation.

Amid North Korea’s efforts to improve its nuclear and missile capabilities, the three countries have notably increased cooperation on combined military readiness and intelligence sharing. However, there is a limit to their working together, as shown by South Korea’s rejection of Japan joining the South Korea-US Nuclear Consultation Group and Seoul’s hesitation to expand the grouping’s military cooperation beyond North Korea.

As anticipated, the G7 Leaders’ Statement on Economic Resilience and Economic Security highlights continued cooperation toward strengthening the semiconductor supply chain. The United States is trying to form a semiconductor alliance (known as the Chip 4) with semiconductor heavyweights South Korea, Japan, and Taiwan. But despite the group’s increased alignment on export controls, this alliance has not yet come together. With US-South Korean-Japanese trilateral military cooperation solely focused on North Korea, it is unclear whether the grouping would be able to coordinate a response in the event of a critical threat to the supply chain outside of the Korean peninsula. For instance, the idea floating around some national-security circles that the United States should blow up TSMC’s foundries on Taiwan in the event of a cross-strait conflict displays a clear lack of discussion of contingency options. Earthquakes and climate change–driven weather events also threaten the supply chain, but it is unclear how the prospective Chip 4 would cooperate to come up with flexible response options as their respective semiconductor industries continue to compete.

The picture also remains unclear for US-South Korea-Japan cooperation on strategic stability. The South Korean public so far appears unmoved in its disapproval for Yoon’s overtures to Japan, and it does not appear that Kishida will expend political capital to match Yoon’s effort. Meanwhile, amid international concerns the United States is becoming even more protectionist, the US public remains predominantly concerned with the economy, making it difficult for either Republicans or Democrats to shift from an increasingly “America First” approach. But perhaps the biggest hurdle for this group is how to balance the need to cooperate among each other on Chinese threats against the need to maintain an off-ramp from tensions to cooperate with China as well.

—Jessica Taylor is a nonresident fellow in the Indo-Pacific Security Initiative, a logistics officer in the US Air Force Reserve, and a Ph.D. candidate in Princeton’s School of Public and International Affairs Security Studies Program. She served in South Korea from 2019 to 2021 as an international relations strategist for the headquarters command staffs of United Nations Command, ROK/US Combined Forces Command, and US Forces Korea.

Biden skipping Papua New Guinea was a missed opportunity

First, let’s acknowledge the things that the United States has gotten right as it’s stepped up its engagement in the Pacific Islands over the past year. It is following through on promises to expand its diplomatic footprint, opening new embassies in the Solomon Islands and Tonga and reestablishing the US Agency for International Development’s regional mission in Fiji. Senior officials have lavished attention on the region with high-level visits, and last September’s United States-Pacific Islands Country Summit was the first ever hosted in Washington. Crucially, compacts of Free Association with the Federated States of Micronesia and Palau are also being finalized.

US President Joe Biden’s now-scrapped visit to Papua New Guinea (PNG) was meant to be a culmination of these efforts and send a powerful signal to Pacific Islanders about the US commitment to the region. Instead, it underlines skepticism about the United States’ ability to follow through on the promises it has made and its staying power. The concurrent cancellation of Biden’s visit to Australia for the Quad summit only reinforces this; as a headline in the Sydney Morning Herald put it, “Biden’s 11th hour Quad snub a disappointment, a mess, and a gift to Beijing.”

Will this do long-term damage to US efforts in the Pacific? Perhaps not. But, in the immediate term, the optics are dreadful. After the visit to PNG was canceled, National Security Adviser Jake Sullivan said Biden plans to host a major summit with leaders of the Pacific Islands “within this calendar year.” It is important to follow through on that promise. In addition, Secretary of State Antony Blinken announced a visit to Port Moresby on May 22.

This episode showcases a key challenge bedeviling the United States on the world stage—that of internal political dysfunction hindering its conduct of a consistent foreign policy and projecting an unappealing image across the world. If the United States is going to succeed in the Pacific—and elsewhere, for that matter—it not only needs to deliver on its assurances, but also get its domestic house in order. 

—Parker Novak is a nonresident fellow with the Atlantic Council’s Global China Hub.

The post Experts react: A ‘game changer’ G7 summit in Japan appeared first on Atlantic Council.

SWIFT was founded in 1973 with 239 original members and over the years has grown to incorporate 11,696 banks sending more than 44 million messages around the world every day. But the core idea has stayed the same: Banks need a uniform and standard way to communicate with each other about transactions, and SWIFT is the answer. Every member gets a unique code—with details about country, location, and even bank branch. When a bank wants to transfer money to another bank, it simply enters the code through the SWIFT network, tells the other bank the amount, and then the actual money changes hands.

But here’s the rub—SWIFT is only a messaging service. It does not provide bank accounts or hold funds for banks in any capacity. The banks actually transfer the funds through a different entity. In order to send money across borders, individuals usually need to use a trusted network of banks, which settle transactions through a series of mutually held accounts. Think of SWIFT like a very elite Gmail, but once you tell your friend you want money, they have to switch over to Venmo to actually pay you. That’s why ‘banning’ a bank from SWIFT does not mean that the institution cannot get money from other banks. It just makes it more complicated and costly to do so.

In 2020, global businesses transferred approximately $23.5 trillion across borders—and it cost them over $120 billion to process the transactions. That’s like paying a tax the size of Morocco’s entire gross domestic product. Plus, these payments often take days to settle. It’s a lot of money for slow service, and that cost gets passed on to consumers.

How banks move money around the world

Interactive graphic by Sophia Busch, Alisha Chhangani, and Nancy Messieh.

What if SWIFT helped build something faster and cheaper? What if you could create a network that could combine both messaging and settlement and become a one-stop shop for international payments? That’s what China has been working on since 2016 with its Cross-Border Interbank Payments System, or CIPS, and most recently with its wholesale central bank digital currency (CBDC) experiment, the mBridge Project.

Both the CIPS and mBridge projects can be utilized for cross-border wholesale (meaning bank-to-bank) purposes. Importantly, the mBridge project is a cross-border CBDC initiative. The idea for both is that large sums of money could be sent between banks internationally, without using SWIFT for messaging or the dollar-based payments clearance hub, the Clearing House Interbank Payments System (CHIPS), for settlement. Already Hong Kong, the United Arab Emirates, and Thailand have partnered with the People’s Bank of China on the mBridge project, and in October 2022, they settled twenty-two million dollars across borders. This was the first successful test of cross-border bank-to-bank digital currency involving real money. As Atlantic Council research on CBDCs has shown, mBridge is just one of more than a dozen wholesale CBDC projects globally, many of which accelerated after Russia’s invasion of Ukraine and the Group of Seven (G7) sanctions response. Over time, if these systems are successful, they could create alternative financial transfer networks and provide a useful conduit for countries aiming to avoid the bite of Western sanctions.

SWIFT is not sitting idly by. The technology teams at its headquarters outside of Brussels are piloting their own cross-border CBDC system, partnering with major private banks and central banks including the Banque de France and the German Bundesbank. They are also experimenting with new, faster types of global transfers between banks. But transforming SWIFT from a messaging system to a new cross-border settlement system that can handle all types of assets (both traditional and digital) is going to take years and millions of dollars. Where to start?

The first step is for the board that governs SWIFT to give it the green light to innovate. As SWIFT members are eager to point out, they are a “private cooperative” and answer to their shareholders. But it’s not so simple. SWIFT is overseen by the National Bank of Belgium and the European Central Bank alongside the central banks of Italy, the Netherlands, Switzerland, Sweden, Canada, Japan, the United Kingdom, and the United States.

These countries have responsibility for providing SWIFT with strategic guidance and helping direct its technology planning. But so far no central bank has publicly come out in support of a major modernization effort. That’s a mistake.

It is understandable for Western central banks to feel sanguine about SWIFT’s current dominance. After all, the vast majority of global transactions currently touch SWIFT at some point. But look closer and you can see the ground shifting. Last month, Bangladesh agreed to pay a Russian company that is helping the country build a nuclear power plant in Rooppur. What’s interesting is how it is paid. Since Russian banks are largely banned from SWIFT, Bangladesh used a bank account at a Chinese bank that transferred yuan to Russia through CIPS. 

Bangladesh is not alone. Transaction volume on CIPS has more than doubled since 2020, and the number of direct and indirect participants in its network has also increased. More and more of these transactions will develop outside of SWIFT, and governments will understand less and less of what’s happening. Part of the motivation is geopolitical, given the way the dollar and euro are being weaponized against Russia. But a large part of it is simply technological: There are faster and cheaper ways to exchange money between countries, and if SWIFT does not figure out how to do it, someone else will.

Even if it is somewhat late to the game, SWIFT has a massive incumbent advantage. With its network of more than eleven thousand banks, SWIFT can build on a system that the world already relies upon instead of creating something new from scratch. China and Russia have to build a rival from the ground up and that takes time. SWIFT’s network is familiar and trusted: Think of it like an individual customer—why switch to a whole new bank if my current one is going to offer all the same features? If there are disputes, or mistakes, they can be settled in European courts.

Plus, SWIFT has something no one else can offer. It is the gateway to interacting with banks in New York, London, Tokyo, Paris, and Frankfurt. The argument for the new SWIFT is simple: If you want to be interoperable with the dollar, the euro, the pound, and the yen—which together are used in more than 85 percent of global transactions—this is the place to do it. If the G7 works in tandem to set technical and regulatory rules of the road for this new network it will, over time, become the de facto global standard, just like the original SWIFT of the 1970s.

The new SWIFT will have to do multiple things at once: communicate and settle between thousands of banks all over the world, find a way to transfer traditional commercial bank money as well as money on a blockchain, and do it all before a network of regional systems springs up to challenge its effectiveness and increase the fragmentation of money and finance.

Doing this right requires a massive investment in innovation from the Western banks that guide SWIFT. The United States is going to have to spend money and bring its own technological solutions to the table. There are major risks involved with faster settlements, including the need for adequate liquidity to complete the transaction, and it will require new regulations to ensure the system is trusted and secure. The recent Silicon Valley Bank crisis, accelerated by a social media–fueled bank run, should provide a lesson on the perils of moving money quickly in the digital age. And while SWIFT rebuilds, it will need to maintain its current operations. Remodeling a house while living in it is a tricky proposition.

But the bigger risk is doing nothing. This year SWIFT will turn fifty. For decades, SWIFT was the pace setter in the race for the future of money. Its technology connected the world’s financial institutions and helped ensure a system with Western protections on rule of law, privacy, and anti-money laundering provisions became the global standard. But all that is changing. If the United States and its allies want to create and promote the technological standard for the decade ahead while ensuring the effectiveness of sanctions, it’s time to start moving, well, more swiftly.

Josh Lipsky is the senior director of the Atlantic Council’s GeoEconomics Center and a former IMF advisor.

Ananya Kumar is the associate director of digital currencies at the Atlantic Council’s GeoEconomics Center.

The post Not so fast: The case for a new SWIFT appeared first on Atlantic Council.

Over the past year, bank deposits fell by almost $1 trillion while assets under management (AUM) of the MMFs increased by $700 billion. MMFs were growing before the banking turmoil, too: AUM has increased by $1.7 trillion since the beginning of 2020, to $5.7 trillion at present. Since MMFs largely invest in US Treasury bills, their status as a safe and attractive alternative to bank deposits would be threatened if the national debt ceiling stalemate cannot be resolved in time. A debt ceiling breach would put in doubt the government’s ability to meet its obligations, as soon as June 1. This is known as the X-date when the Treasury Department will have exhausted all extraordinary measures to avoid breaching the $31.4 trillion debt ceiling. Even if the stalemate is resolved at the last moment, as market participants currently expect, the increase in the probability of government default would elevate uncertainty and further unsettle financial markets which have already been under stress. The tail-end risk of a messy and prolonged debt ceiling stalemate is higher this time around than previously—and money markets will be the first to react if a deal isn’t reached in time.

Why money market funds are at risk

MMFs are vulnerable to disruptions in the Treasury market since they hold a lot of Treasury bills. In particular, government MMFs—with $4.4 trillion in AUM—split their portfolios almost evenly between Treasury bills and lending to the Fed via the Overnight Reverse Repo facility. Under this facility, MMFs can lend money to the Fed on an overnight basis, taking US Treasury securities as collateral and agreeing to sell them back at predetermined rates. The Fed reserve repo facility has grown substantially in recent years, reaching $2.2 trillion in volume at present.

As the X-date approaches, one-year US sovereign Credit Default Swap (CDS) spreads (equivalent to the insurance premiums investors pay for protection against default) have jumped to more than 160 basis points—a record high compared to less than 20 basis points during normal times. That exceeds the CDS spreads for Mexico, Brazil and Greece. Investors have also avoided T-bills maturing right after the X-date, pushing up their yields. For example, at the latest auction on May 4, yields on one-month T-bills maturing on June 6 jumped to 5.76 percent, or 240 basis points higher than two weeks ago. Such a sharp and abrupt increase in yields has reduced the prices of fixed income instruments like T-bills, leading to mark-to-market losses at MMFs. Depending on their portfolio composition and risk management practices, some MMFs could suffer losses noticeable enough to discomfort their clients who expect stable values of these funds.

Furthermore, if the debt ceiling is not raised in time to avoid default, the US credit rating would be downgraded to Restricted Default (RD) and affected Treasury securities would carry a D rating until the default is cured. Even if the government prioritizes the servicing of its debt ahead of other obligations to avoid default—a politically controversial move—that would not be consistent with an AAA rating. One major agency, S&P, already downgraded the US in 2011.

In short, possible mark-to-market losses and credit downgrades of Treasury securities, the main assets held by MMFs, would generate anxiety among MMF clients, probably prompting some to move their money elsewhere. (Much of it might flow to the top banks, further accelerating the consolidation of the US banking system.) While any outflow could be dampened to some extent by the gating arrangements and liquidity fees employed by MMFs to manage the outflow in an orderly way, this would nevertheless heighten uncertainty and a sense of nervousness in financial markets already struggling to cope with the regional banking crisis, high interest rates, and a credit crunch. Adding a run on MMFs to heighten market turmoil might trigger a more severe recession than hitherto expected. For that reason, the negative financial and economic impacts of the current debt ceiling stalemate could be more substantial than those of the previous episodes in 2011 and 2013.

Uncertainty at just the wrong time

MMFs can respond to the uncertainty surrounding the status of Treasury bills after the X-date by lending more to the Fed through the reverse repo facility, whose daily volume could rise substantially in the weeks ahead. However, the more MMFs lend to the Fed, the more liquidity is being withdrawn from the financial system, compounding the effects of Quantitative Tightening (QT) which the Fed has been implementing since June 2022 to reduce its holding of government securities by $95 billion per month. This would make it more difficult to assess the overall effects of the Fed’s tightening policy stance—both for the Fed itself and for market participants, elevating uncertainty about future economic prospects.

The political wrangling over the national debt ceiling has heightened uncertainty at the wrong time and is helping to raise the odds of a severe recession. Beyond the near-term outlook, the recurrence of the debt ceiling “mini crises” would erode the reliability, predictability, and trustworthiness of the US government—possibly causing it to eventually lose its AAA rating and raising its funding costs. More fundamentally, the practice of using the debt ceiling as a political tool to change or terminate federal programs approved by previous Congresses reflects bad governance in the US—notwithstanding the fact that the US public debt/GDP ratio is too high and needs to be reduced over time. The inability of the US to adopt a sustainable fiscal policy in an orderly manner will exact an increasingly noticeable cost by diminishing the efficiency and credibility of the US government, with negative implications for the whole economy.

Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The post The US debt ceiling stalemate threatens money market funds—and financial stability appeared first on Atlantic Council.

1. What do the results tell us about the Turkish electorate? What factors are driving their votes?

The outcome was a choice for many Turks between pain tolerance (Erdoğan’s poor economic performance and heavy hand domestically) versus risk tolerance (an ideologically diverse coalition with untested personalities, scant unifying principles other than opposing Erdoğan, and a lot of policy unknowns). A comparison with the 2018 results shows progress for the opposition in a sense—the ruling Justice and Development Party’s (AKP) vote share and parliamentary seats dropped, the Republican People’s Party’s (CHP) share rose, Erdoğan’s vote share dropped over 3 percent—but the opposition also underperformed expectations. Polls prior to the election generally showed Kılıçdaroğlu ahead by several percentage points, and if we tally the 2018 total of opposition candidates (CHP; Good Party, or Iyi; and Peoples’ Democratic Party, or HDP), their 46.33 percent exceeded the 44.45 percent garnered by Kılıçdaroğlu as a unified candidate with ex officio HDP support. 

—Rich Outzen is a nonresident senior fellow at the Atlantic Council IN TURKEY and a geopolitical analyst and consultant.

With a turnout of almost 90 percent, the Turkish people proved their commitment to the democratic process. There were, in fact, two elections on May 14: One for the Turkish parliament, Turkey’s legislative organ under a presidential system, and a second one to select the next Turkish president. The results showed an electorate still highly divided, but also showed an increase in nationalist votes. Compared to previous elections, the AKP votes decreased from 43 percent to 35.4 percent. Its alliance partner, the Nationalist Movement Party (MHP), surprisingly protected its vote share, in contrast to pre-election polls. The end result appears to be the People’s Alliance (AKP plus MHP) as the majority group in the parliament, securing 321 seats. This number will be sufficient for a legislative majority, but short of the 360 seats needed to make a constitutional amendment. On the other hand, the main opposition Nation Alliance, led by the CHP and Iyi, secured only 213 seats.

Despite the general expectations, it was surprising to see that the recent economic policies of the government—which led to high inflation, low reserves, and a foreign exchange crunch—were not determinant for those who voted for the AKP. This suggests that the recent economic incentives Erdoğan announced, and nationalist motives combined with Erdoğan’s leadership style, played a bigger role in their votes. The increasing nationalist votes were also reflected in the surprisingly strong showing by third-place presidential candidate Sinan Oğan, who secured 5.3 percent of the vote when pre-election polls projected him only at only 1-2 percent.

As a final note, with the exception of the hard-hit Hatay province in southern Turkey, the recent earthquake in Turkey did not make the expected impact on the electorate’s decision, according to the current results. Again, half of Turkey thinks that securing stability rather than a change will be better for the country.

—Defne Arslan is senior director of the Atlantic Council IN TURKEY program. 

Across Turkey, Erdoğan’s vote total in 2023 decreased between 1-5 percent in most provinces compared to the last presidential election in 2018, in which he took 52.6 percent of the vote, enough to avoid a runoff. That modest decline does not match the high hopes of the opposition, buoyed by many but not all polls heading into the election. Despite years of economic struggle and runaway inflation, Erdoğan was able to hold on to the loyalty of most of his base and end up just shy of 50 percent. The results remind us again that the Turkish electorate leans heavily right, with right-wing parties winning over 60 percent of the parliamentary vote. It also hints that the electorate is not convinced in the opposition’s vision for the country or its ability to solve the challenges facing the country. In its campaign, the AKP heavily played on the achievements realized in the past twenty-one years under its rule, from its signature infrastructure projects to health care reforms and defense industry development, which may have resonated with voters more than intangible promises and change promoted by the opposition.

—Grady Wilson is an associate director at the Atlantic Council IN TURKEY.

2.  What do you make of the composition of the new parliament, and what impact will it have on the ultimate winner of the presidential race?

Adding up the current numbers as broadcasted by news outlets (no official numbers are out yet), AKP will have 266 seats and CHP will have 169 seats, of which 37 seats actually belong to four other coalition partners. These include political parties led by Ahmet Davutoğlu, Ali Babacan, and Temel Karamollaoğlu. In addition, the Green Left Party (YSP) will have 62 seats, the MHP 50 seats, the Iyi 44 seats, and two others parties with a total of 9 seats. These numbers put the People’s Alliance (AKP plus MHP) at 312 seats and Nation’s Alliance (a CHP-led group of six parties) at 213 seats. These numbers give the majority to the AKP-led alliance.

Two options appear possible for the runoff:

• The Turkish electorate could consolidate around nationalist votes. They may prefer continuity of the current status quo: a president supported by a majority in the parliament.
• Turks can decide it is risky to consolidate too much power around the AKP and consolidate, instead, for Kılıçdaroğlu.

—Defne Arslan

The Turkish electorate remains a center-right electorate. Kılıçdaroğlu did not attract enough of the winnable center-right votes to win and, in my view, that was the key to the outcome. Over 20 percent of the parliament will consist of explicitly nationalist parties (MHP, Iyi, BBP), and Oğan’s surprising 5 percent in the presidential race shows the persistence of anti-Erdoğan nationalist voters who also rejected the primary opposition candidate. It is possible that the more explicit support to Kılıçdaroğlu from the heavily Kurdish HDP, and Erdoğan’s instrumentalization of it by accusing his opponent of being adjacent to the Kurdistan Workers’ Party (PKK) terrorist group, worked by driving some potential nationalist votes from the opposition to Oğan or the MHP. 

Despite Western predictions that the Kurds of Turkey would be kingmakers in a tightly divided electorate, it did not pan out that way. The HDP/YSP (sympathetic to the PKK) drew only 8.8 percent, down roughly 3 percent from 2018, and dropped from 67 to 62 parliamentary seats. Even in the Kurdish-majority areas of the southeast, the race was competitive, with Erdoğan’s alliance ahead of the HDP/YSP in half the provinces and the opposition CHP pulling five parliamentary seats while HDP/YSP held roughly half the provinces.

—Rich Outzen

One of the most surprising results from the election is the resilience of the second largest party in the People’s Alliance, the MHP. Once again (as they did in 2018), the MHP surpassed all pre-election predictions, taking about 10 percent of the vote and guaranteeing the People’s Alliance will continue its control of parliament. Meanwhile, the CHP and Iyi underperformed. The results will not help the opposition’s morale going into the runoff.

—Grady Wilson

3. What is your take on allegations of Russian influence in the election?

Despite the fact that foreign policy was almost absent from the agenda of the current Turkish elections, the Russian factor became a major issue in domestic politics just days before the voting with the opposition leader Kılıçdaroğlu saying he had evidence of Russian interference in the upcoming elections. Erdoğan denied the accusations and added that cooperation with the Russian Federation was no less important for Turkey than with the United States. Though no evidence of Russian meddling has been shared so far, Moscow’s influence on the Turkish domestic politics may go far beyond deep fakes and cyber-attacks in the aftermath of the voting when the newly elected Turkish president will have to deliver on electoral promises, pay for Russian gas, get to the negotiation table with the Assad regime, and stabilize the economic situation. Whatever the name of the president, Russia is likely to remain a major factor in Turkey’s foreign and domestic politics.   

—Yevgeniya Gaber is a nonresident senior fellow at the Atlantic Council IN TURKEY, a Ukrainian foreign-policy expert, and a nonresident senior fellow at the Center in Modern Turkish Studies at the Norman Paterson School of International Affairs at Carleton University.

4.  What is your expectation for the second round given that the first round showed Erdoğan with a significant lead?

There was a negative market reaction to results this morning, Turkish credit default swaps, which are an indicator of the country’s economic risk, rose by 70 basis points to 576. The Turkish lira depreciated despite the controlled foreign exchange markets. The Turkish stock exchange fell, too, led by banking sector stocks—after a significant jump last week in expectation that the opposition, which promised to deliver more conventional economic policies supported by structural reforms, would win. The market reaction might have been more severe if there were more foreign investors in Turkish markets, but there are very few now. The outcome shows that if current economic policies continue, then Turkey will continue to suffer from reserve losses and a high inflation rate, which is no longer sustainable. For this reason, we might now expect to see a shift in Erdoğan’s rhetoric toward new economic policies, while also increasing his tone to attract nationalist votes.

—Defne Arslan

In the absence of any major unforeseen developments, it is very difficult to see Kılıçdaroğlu making up the difference in the second round. He would essentially need 90 percent of the vote that went to Oğan, who took 5.3 percent of the vote.

—Grady Wilson

What did come as a surprise to many is an unexpectedly high level of support for the third-place candidate, Oğan, who has built his electoral campaign on nationalistic and anti-migrant rhetoric. Having gained more than 5 percent of the votes, he has turned from a marginal outsider to a joker with a trump card for the runoff as both front-runners fell short of the support required to win the election in the first round. As both Erdoğan and Kılıçdaroğlu will try to mobilize constituencies for the May 28 voting, it is the voters of Oğan—Turkish nationalists with largely anti-Western sentiments but supportive of the parliamentary system in Turkey—who may play the decisive role. The unexpectedly high level of support for the nationalistic MHP aligning with the ruling AKP party adds to the feeling that observers may have underestimated the level of anti-immigrant sentiments in a Turkish society that is hosting more than 4.5 million Syrian refugees amidst a deep economic crisis. 

—Yevgeniya Gaber

Turkey has had an impressive, though for the West disappointing, exercise in democracy. The verdict—pending completion of the second round—seems to have been “better the devil we know.” Erdoğan’s attempts to sow doubt about Kılıçdaroğlu’s proximity to PKK-adjacent Kurds, his lack of international expertise (the CHP leader does not speak English or have foreign-policy experience), and his deference to Atlanticism seems to have worked. Erdoğan’s distribution of pre-election money and promises seems to have worked, as well. 

Kılıçdaroğlu was an unimpressive campaigner, though a thoroughly decent man. His coalition proved too scant on policy details, proved vulnerable to charges of being weak on security and not ready for prime time. Worst-case scenarios of obvious cheating or civil unrest seem not to have materialized. The Turks have affirmed their essentially risk-averse and conservative outlook embodied in the statement “böyle geldi, böyle gider” (as it came, so also will it go).

—Rich Outzen

The post Four questions (and expert answers) about the Turkish presidential election runoff appeared first on Atlantic Council.

China reopened its borders in the first quarter of 2023 and rolled out the rhetorical welcome mat for foreign investors. This included pledges to promote foreign investment and imports, restoration of suspended long-term visas, and high-level visits by Chinese leaders abroad and foreign leaders in China. But an aggressive public campaign to allay concerns about the direction of China’s economy has not been underpinned by a convincing shift in policy. The restructuring plan that emerged from the “Two Sessions” meetings in March did not reassure the private sector, nor did it suggest that Beijing is poised to tackle the root causes of its macroeconomic malaise.

Meanwhile, pressure on foreign companies (Bain & Company, Mintz Group, Deloitte, Micron and others) further dampens business confidence. Heightened geopolitical tensions with the US also cloud the picture. Turning a cold shoulder to perceived American hostility, Beijing sought to warm relations with Europe: it had success with French President Macron, but faced setbacks at the European Commission, including a universally condemned comment by China’s ambassador to France that some European nations aren’t sovereign.

The bottom-line assessment for Q1 2023 finds that Chinese authorities were active in three of the six economic clusters that make up the China Pathfinder analytical framework: financial system development, competition policy, and portfolio investment. There were fewer developments in the innovation, trade, and direct investment clusters. In assessing whether China’s economic system moved toward or away from market economy norms in Q1, our analysis shows a negative picture. 

At the 2023 Two Sessions, the government released a major restructuring plan, involving the establishment of new departments, consolidation of responsibilities, and an overhaul of the financial system. While the extensive nature of this restructuring may suggest the government is focused on maximizing efficiency in the economy to boost growth, the reality is more complex and less positive. Rather than implementing policies that address systemic problems in the country’s economy—such as the fragile property sector, the loss of consumer and business confidence following destabilizing zero-COVID measures and unpredictable government intervention in different sectors, and high levels of local government debt—the restructuring plan overall does not enhance transparency and only increases Party control within the bureaucratic system.  

Restructuring plan centralizes authority and consolidates party power in China’s bureaucratic system

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Why does population matter for global politics? After all, a Malthusian perspective would warn that more mouths to feed will strain a country’s capacity to provide for its citizens, and that failure to do so will engender political instability and economic impoverishment. Yet, with all due respect to the reverend, the empirical record of the past two centuries makes clear that the opposite is true. Large populations fueled the Industrial Revolution and the incredible economic growth enjoyed by the West. While vast inequalities persist—even grow—global economic productivity has expanded unimaginably over the period, allowing more people to live longer, healthier lives than ever before.

If you are bullish on India’s prospects in the coming century, as indeed it appears the consensus in US government circles is, then India’s rise to number one on the population charts is evidence that its best days are yet ahead. If that is the case, then by pursuing a strategic partnership with India, above all other considerations, the United States is backing the right horse to maintain its own relevance. It is commonplace for policymakers to laud India’s “demographic dividend,” which is a wonky shorthand for the fact that India’s huge population is also a young population, with 52 percent of its citizens under the age of thirty. Young people are a valuable resource for any economy. They are in the prime of their working lives, they are avid consumers and fuel the larger economy, and eventually they will have children of their own and buy even more stuff. Countries in Western Europe, as well as Japan and increasingly China, are increasingly skewing older and facing tighter labor markets and greater pressures on public-sector entitlement programs such as pensions (see the turmoil in France) or health care. But India’s younger population promises a huge—and growing—consumerist middle class and a seemingly unending supply of college graduates itching to enter the workforce.

There is, however, a problem. There are too few jobs in India to absorb these aspiring workers. Some economists have labeled India’s record “jobless growth.” The numbers are stark and sobering. To absorb the demand for employment, the Indian economy must create over a million new jobs each month. It presently is creating well fewer, and job creation is slowing even further. Resentment over poor job prospects begets frustration that spills into violence. Nor is this a problem that can be solved by pulling on available policy levers such as India’s oft-maligned labor laws.

The challenge is more systemic and structural, and it lies in the absence of a vibrant manufacturing sector that can absorb the millions of young people entering the economy each year. Rapid population growth is a relatively modern phenomenon globally, and the historical record makes clear that industrial manufacturing was the key to absorbing labor productively. Indeed, the vast reserve army of cheap labor enabled much of the Industrial Revolution as low-wage workers abandoned their farms and took their places on the assembly lines of Manchester and Detroit. India, however, skipped this mass industrial revolution stage. Its growth has been fueled by a booming services sector that specializes in information technology. As China established itself as the factory of the global economy, India aspired to be its back-office business processing hub. While this stimulated the growth of a robust middle class of educated English-speaking office workers, it laid bare the lack of similar opportunities for the tens of millions of young job seekers competing for scarce white-collar positions.

Ashoka Mody, a Princeton economist, argues that the failure of India’s education system is to blame for the current mess. Other culprits include the government’s hesitant and often contradictory approaches to foreign investment and international trade, and its protectionist tendencies that stifle innovation and prevent India from playing a meaningful role in global supply chains in the way that China, Vietnam, Malaysia, and even Bangladesh have. The current moment of hostility between Beijing and Washington, and the ensuing misguided espousal of decoupling, China+1, near-shoring, friend-shoring, and re-shoring policies emanating from Washington appears to offer a glimmer of hope for India’s beleaguered manufacturing sector. Manufacturing could shift from China to India as the United States and others look to reduce dependence on Chinese exports and supply chains. But it is unclear that New Delhi will be able to seize the advantage at a scale required to meet the job needs of its young population. Doing so would require political courage to embrace structural economic reforms and the challenges of global trade to force India’s businesses to be genuinely competitive internationally. If India could manage this, it might be able to harness its population to foster the high rates of economic growth required to make up lost ground on China, though this past lost decade of growth has arguably already set that goal beyond reach.

India’s demographic dividend is thus a demographic time bomb, papered over for now by the success of its information technology sector, largely untapped middle class, rising geopolitical centrality, and masterful public relations by its cheerleaders. But a failure to harness the energies of the world’s largest population is not just a tremendous missed opportunity. It is a millstone weighing down India’s future. A frustrated, underemployed youth population turns restive quickly, and the government’s tactic of distracting it with majoritarian populism and anti-minority scapegoating will not succeed forever. Worse, it will erode the one undeniable achievement of independent India: the building of a diverse, secular, democratic republic against all odds. 

The backsliding has already begun: India is no longer rated a liberal democracy by reputed international organizations, and public opinion surveys indicate that the Indian public’s commitment to democratic norms is worryingly shallow. For the United States and its allies, who have been reminded time and again of just how little influence they wield over India’s foreign policy, these trends should ring alarm bells. For the first time since the era of colonialism, the majority of the world’s population no longer lives in liberal democracies. Indeed the world’s two largest countries, accounting for more than a quarter of all human beings alive today, are actively illiberal and working against the international economic order so painstakingly erected after World War II to cement Western hegemony. If demography is destiny, then the UN’s announcement, while confirming what many knew to be inevitable, still changes everything.

Irfan Nooruddin is the senior director of the Atlantic Council’s South Asia Center and the Hamad bin Khalifa Al Thani Professor of Indian Politics in the School of Foreign Service at Georgetown University.

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Commentators have urged major countries to clearly identify the high-tech areas which require heightened government control to safeguard national security, and to ensure that, as Wolf writes, “security-oriented interventionism should be as precise and non-protectionist as possible, with a view to continuing to gain from the economies of scale granted by cross-border trade.”

Those concerns and proposals are well intended but will likely remain aspirational until policymakers can come up with economically credible and politically acceptable policies to deal with the root causes of fragmentation. The two most important are the resentment and resistance of the people left behind by globalization and the crisis of trust between major countries.

Globalization won’t work until we assist those left behind

Globalization has significantly lifted overall economic growth and helped many emerging market countries develop, bringing hundreds of millions of people out of poverty, but it has had a mixed impact in developed countries.

In developed economies, globalization has greatly benefitted consumers, owners of capital, and technologically skilled workers while depressing wage growth, exacerbating income inequality, and displacing low-skilled workers. It has hollowed out manufacturing sectors and communities which used to be the bedrock of the middle class and social stability. The numerous so-called losers have become the springboard for populist political movements that are pushing back against globalization. Some of the ire against globalization mistakes the true cause of job loss—technology has played a bigger role than trade—but that doesn’t change what needs to be done.

It is wrong-headed to blame the dismal outcome in developed countries on globalization. Instead, the blame should be put on the failure of national efforts to educate, train, and generally prepare workers to be able to compete internationally in a technologically driven world. In particular, many developed countries have implemented trade adjustment assistance (TAA) programs when they concluded free trade agreements to mitigate labor displacement impacts. In the US, the TAA program was launched in 1962. However, TAA programs, especially in the US, have been grossly inadequate, not well conceived and poorly executed, difficult for intended beneficiaries to access, and generally ineffective.

The US TAA program focused in its earlier years on workers able to document their displacement by trade with countries that had a free trade agreement with the US. It was later expanded to cover the impact of outsourcing—but it was always inadequate relative to the scale of the problem. In the US, 8 million manufacturing jobs were lost from a peak of 19.5 million in 1979 to a trough in 2010.

Only about a third of manufacturing workers who were displaced between 2001 and 2008 were eligible to apply for TAA benefits (including income assistance to extend unemployment benefits for up to 130 weeks and training for up to one year). Of those who applied, about one third actually received benefits.

Inadequate as it was, the US TAA program was better than nothing. Sadly, it was terminated in July 2022. By contrast, the European equivalent program has been expanded into the European Globalization Adjustment Fund to deal with all displacement effects of globalization. Active labor market adjustment programs in Europe have been much better funded than in the US—for example Germany spends 0.66% of GDP and France spends 0.99 percent, while the US spends only 0.11 percent. While Europe has done better than the US, it has not done nearly enough either. And its programs have been criticized as “narrow, piecemeal… hard to access at scale” and “reactive”.

Until there are credible efforts in developed countries to enable the people left behind by globalization and technological changes to participate in the benefits of inclusive growth, popular resentment and resistance to open and free trade will persist, especially in the US—leading to more protectionism, not less.

How to deal with the crisis of trust

The world is also suffering from a crisis of trust. As ably demonstrated by the NYT’s Thomas Friedman, that is especially true between the US and China and it is pushing them further apart. This collapse of trust has several dimensions. As China and several other emerging market countries have developed their economies, they want to reshape the rules facilitating international relations, including trade, which were established decades ago by developed countries. Today, those developed countries account for less than half of the global economy. The US as an incumbent leading power has viewed these developments with an increasing sense of national insecurity and has tried to protect its position.

Furthermore, international trade in goods has progressed from benign “shallow goods” like textile and garments, footwear, and similar consumer items to high-tech “deep goods” like electronics/IT and telecom enabled by semiconductors which have dual uses—civilian and military. Naturally cross-border trade and investment in such high-tech dual use goods have become areas of competition and conflict between the two superpowers.

Fundamentally, the problem is the absence of a mutually agreed framework allowing for the peaceful coexistence between two different and largely incompatible political and economic systems—represented by the US and China. Clearly the postwar institutions, especially the World Trade Organization, have shown signs of fractures and dysfunction, and need to be changed. Until the issues causing the crisis of trust are addressed, it is futile to simply call for international cooperation to restore the practices of global open free trade.

As the world becomes more fragmented politically and economically, the costs will mount and the risk of military conflict will rise. There will be calls to reverse such a dangerous trend. The way to do that is to address domestic challenges and build more inclusive economies in order to create the necessary internal political support for international cooperation. This will allow countries to figure out how to reconcile their different political and economic systems. The fact that these two challenges are interrelated makes their solutions much more difficult to conceive and implement. But there is no alternative but to try.

Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The intersection of tropical-tolerant research and demographic growth

US technology multinationals are increasingly looking to Africa for AI and other emerging technologies for a number of reasons. First, technology corporations such as IBM, Google, and others have created R&D labs in Africa (often run by African diaspora professionals). Second, building a base in Africa gives technology corporations access to innovative ideas, cutting edge startups, AI researchers and more. Additionally, the opportunity to scale R&D innovations attuned to the needs of the region is particularly important since it has a fast-growing youth population. One in five people on the planet will be African in thirty years, so if a business wants to be first to market, a local African presence is imperative.

One key reason is the opportunity to scale R&D innovations attuned to the needs of the region. Google opened its first African AI lab in Ghana. Why did Google do this? A few technology corporations, like IBM, Google, and others, have created R&D labs in Africa as they begin to understand the landscape of African research and innovation. Due to their knowledge and experience on both the local and global scales, some have hired African diaspora professionals to run these labs. IBM maintains research facilities in Kenya and South Africa, while Google operates an AI facility in Ghana. Why did they decide to reside there? They undoubtedly want to find out what fresh ideas startups, AI researchers, and other organizations are working on, as well as new trends that can be made into products. This kind of foresight is wise for business, but it will be necessary moving forward. One in five people on the planet will be African in thirty years, so if a business wants to be first to market, a local Africa presence will be essential to cater to this growing demographic market.

Utilizing AI and emerging technologies in healthcare and medicine

The tropical regions of Africa are a hotbed for many emerging diseases that pose a threat to global health. These regions also have a high incidence of poverty, which limits access to quality healthcare. As a result, there is a great need for new medical technologies that can be used to prevent, diagnose, and treat existing and upcoming diseases. AI and other emerging technologies have the potential to transform healthcare in Africa by providing early detection of disease outbreaks, developing more effective treatments, and improving access to quality care. Additionally, these technologies can help reduce the cost of healthcare delivery by automating tasks and improving efficiency.

US technology multinationals are investing in AI and other emerging technologies because they recognize the potential impact these technologies can have on global health. By commercializing and scaling R&D innovations from Africa, the private sector, technology multinationals, and academic institutions are partnering to improve the lives of millions of people across the continent and other frontier markets. Zindi, a start-up based in Cape Town, South Africa, called upon African data scientists to develop solutions to address the COVID-19 crisis when it was at its peak. Similarly, Christian Happi—a Professor of Molecular Biology and Genomics, as well as director of the ACEGID at Redeemer’s University in Nigeria—has assembled a team of data scientists who are utilizing AI and other advanced technologies to sequence the SARS-CoV-2 virus.

The opportunity for US technology multinationals in Africa

Due to the continent’s variety of entrepreneurial ecosystems, particularly tech incubators, accelerators, and co-working spaces, US technology multinationals are turning to Africa and other frontier markets as a proving ground to test AI and other emerging technologies solutions. These entrepreneurial ecosystems are starting to serve as a testing ground for new ideas that, for a variety of reasons, such as a lack of base-load power or the high cost of Internet data, would not take off in a developed market. The continent also has a growing population of young people who are embracing digital technologies, which presents a significant opportunity for companies that are looking to expand their customer base and broaden their workforce.

African critical minerals used in emerging technologies

Several critical minerals, such as cobalt, lithium, graphite, platinum metals, etc., serve as essential materials for everyday tech such as consumer electronic products—thus far an untapped market for powering the global emerging technology ecosystem. Additionally, Africa’s natural resources also offer the opportunity to make the African continent a leading player in the global green transition to electric vehicles that run on batteries. This is a market that China has largely cornered, however, due to African governments realizing the potential to generate more revenue from these critical minerals, African countries have recently started to ban unprocessed raw commodities being used in emerging technologies. For instance, Zimbabwe recently instituted a raw lithium ban and other African countries are starting to realize the opportunity to navigate geopolitical competition between the world’s industrial powers to capitalize on their critical minerals for their own development–foreign direct investment, value-addition, and increased job creation.

The challenge of scaling R&D innovations in Africa

The challenge of scaling R&D innovations is that they require significant investments of time and money to bring to market, and these investments are often riskier than traditional businesses. For US technology multinationals, the opportunity to scale their R&D investments in Africa is an attractive proposition. The continent has a vast population with a growing middle class, and its resources are largely untapped. However, doing business in Africa comes with its own set of challenges, including infrastructure constraints and political instability. Nevertheless, for companies willing to invest in the continent, the rewards could be significant.

There are significant challenges associated with scaling R&D innovations in Africa, including:

• Infrastructure: Many African countries do not have the basic infrastructure required to support large-scale R&D operations. Challenges include unreliable base-load power, telecommunications, and transportation.
• Skilled labor: In many African countries, education levels are low and there is a lack of trained personnel who can work in R&D facilities.
• Political instability: There are political risks associated with doing business in Africa. These risks include instability, corruption, and government interference.

The benefits of an Afro-centric R&D innovation strategy

There are many benefits to pursuing an Afro-centric R&D innovation strategy, including the ability to scale innovations more effectively across frontier and emerging markets. By focusing on developing technologies that can be adapted to work in tropical climates, US technology multinationals can gain a first mover advantage in the African market and tap into a vast untapped customer base. Additionally, this strategy can help build long-term relationships with local partners and suppliers, which is essential for successful business operations in Africa. The natural environment in Africa, which includes semi-arid temperatures, deserts, and tropical climates, can also be a suitable testing ground for innovations that could thrive in developed markets. Moreover, US companies can position themselves as global leaders in the race to develop impactful innovations for Africa by investing in R&D of technologies relevant to the continent’s needs. Finally, by 2030 African youth are expected to constitute forty two percent of the global youth population. This is an enormous demographic who will be tech savvy, ambitious, and hungry for economic opportunity.

Conclusion

US technology multinationals have recognized the potential for scaling up Afro-centric R&D innovations in Africa. With access to a large and growing digitized population, as well as an abundance of data resources untapped for AI, this continent offers enormous opportunities for responsibly advancing AI and other emerging technologies. By leveraging local knowledge and expertise, US technology companies can develop new products and services designed specifically for African markets while also contributing to the development of innovative solutions applicable globally in emerging and developed markets.

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The post Why US technology multinationals are looking to Africa for AI and other emerging technologies: Scaling tropical-tolerant R&D innovations appeared first on Atlantic Council.

Accra is hardly alone in its enthusiasm for gold. Since 2008, emerging-market and developing countries have more than doubled their central bank gold reserves, led by Russia, China, Turkey, and India.

The end of gold demonetization?

Developing and emerging-market countries’ growing gold purchases have reversed a selloff in gold reserves—led by advanced economies—since the 1990s.

Starting in the mid-1940s, the Bretton Woods system linked most advanced economies’ currencies to gold, so treasuries and central banks accumulated large reserves to back them. But the system’s collapse in 1971 eliminated gold’s direct monetary purpose as a guarantor of currency value. Meanwhile, central banks’ success in controlling inflation in the late 1980s suggested that gold was no longer needed to rapidly raise capital for currency market interventions. And as interventions became less frequent, it became harder for central banks to justify large reserves in the 1990s.

Consequently, advanced-economy governments (which held 85% of all government-held gold in 1990) offloaded nearly one-fifth of their gold reserves from 1990 to 2007. Some, like the United Kingdom, swapped gold for foreign currencies. Others tried to get more creative: the Swiss government proposed establishing a foundation for Nazi-era victims with sale proceeds, although they eventually filled state coffers after voters rejected the idea. Apart from additional revenue, the sales offered practical benefits like reduced holding costs and lower exposure to gold’s notoriously high price volatility.

Emerging-market and developing economies largely followed advanced economies in demonetizing gold, though they had less of it to sell. Their gold reserves grew less than 10% during this period, even as their non-gold reserves expanded 25-fold.

Emerging markets’ new gold rush

What explains emerging-market and developing countries’ increased enthusiasm for gold since then?

First, the Global Financial Crisis weakened their confidence in the dollar-backed financial system’s stability—catalyzing a trajectory shift in gold purchases. In 2009, for example, China’s State Council announced that it had quietly expanded its gold stockpile by over 70% in previous years. Although China times its disclosures strategically—sometimes years apart—the announcement signaled an accelerated purchase program that persists today.

Second, the logic of returns may explain some diversification into gold. Years of rock-bottom interest rates on advanced-economy bonds increased the attractiveness of assets like gold, which can generate meaningful long-term returns. More recently, some central banks have reasoned that gold’s scarcity preserves its value as elevated inflation erodes Dollar- and Euro-denominated assets—although past returns suggest that gold is not an effective inflation hedge over shorter horizons.

Third, some countries have sought to reduce sanctions risk with gold reserves. Transacting with gold offers key advantages for sanctions evasion: anonymity, low traceability (especially if gold is mixed into alloys), and alternatives to Western financial centers where the US and its allies can more easily restrict trade flows. For example, Russia embarked on a major gold purchase program after US and EU sanctions for its annexation of Crimea in 2014. Since then, Russian entities have conducted gold-denominated transactions through hubs like Dubai to evade sanctions. Although gold’s bulkiness makes it an imperfect medium of exchange, several heavily-sanctioned countries have followed Russia’s lead in increasing gold’s share of foreign reserves.

Greater ambitions for gold

More broadly, countries with fractious US relations trust the dollar-backed financial system less, so it is unsurprising that gold purchases increase with geopolitical distance. Grouping countries by their degree of alignment with the US (represented by votes at the UN General Assembly, where “most aligned” states are in the top quarter of countries by voting alignment, “more aligned” are the next quarter, and so forth) shows that all but the “most aligned” countries have grown their gold reserves since 2008.

An important question is whether China and Russia will employ gold in their efforts to foster alternatives to the dollar—for example, by aiding the internationalization of the Chinese yuan. Outside of China, use of the yuan is hampered by Beijing’s capital account controls; foreign investors are reluctant to hold or trade yuan-denominated contracts without firmer guarantees of its convertibility. However, gold-backed yuan contracts could promise greater convertibility without requiring China to loosen capital controls. The Chinese government has already moved to promote the gold trade, establishing a yuan-denominated gold benchmark index in 2016 that makes it easier for Chinese market participants to exchange gold and influence prices, although further steps have been limited.

For now, emerging markets’ growing interest in gold is more a feature of the existing monetary system than a seismic shift away from it. Gold reserves still make up only 7% of emerging and developing countries’ reserves, and central banks may eventually decide that its clunkiness and price volatility are not worth the trouble. Diversifiers into gold believe that they can reduce their risks, improve their returns, or both. Whether these countries keep buying after inflation subsides will offer a clue into the staying power of gold’s appeal.

Phillip Meng is a Young Global Professional with the GeoEconomics Center.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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1. What does Lula come away with from Beijing?

In addition to the fifteen agreements signed between Brazil and China, Lula also leaves Beijing with a path toward greater cooperation even beyond trade. Given that China is Brazil’s number one trading partner, this visit was an important seal for Lula, wrapping up his first hundred days in office having visited Brazil’s top three economic partners: Argentina, the United States, and now China.

Recent comments by Brazilian Finance Minister Fernando Haddad reflect Brazil’s intent to deepen economic relations with both China and the United States. “Brazil has the size to make bilateral agreements,” Haddad told journalists during the China trip.

—Valentina Sader is an associate director and Brazil lead at the Atlantic Council’s Adrienne Arsht Latin America Center.

2. During the trip, Lula called for BRICS countries to trade in their own currencies and end the dollar’s trade dominance. How real is this threat?

In calling for an end to the dollar’s dominance in world trade during his China visit, Lula was singing to a choir whose theme song is renminbi (RMB) internationalization. His advocacy of a “BRICS currency” to replace the dollar in settling trade transactions among leading emerging-market countries (Brazil, Russia, India, China, and South Africa make up the informal BRICS group) likely won’t come to much—at least in the foreseeable future. Nonetheless, it does underline the opportunities for Beijing to increase the international use of the Chinese currency. As Brazil’s trade with China hit a record $150 billion last year, the RMB emerged as the country’s second-largest reserve currency (representing 5.37 percent of foreign-exchange holdings). That’s an indication of a trend of increasing RMB-real transactions, which likely will continue in the future as the two countries have signed several agreements aimed at expanding trade. However, Brazilian imports and exports continue to be settled overwhelmingly in dollars, and the US currency still occupies over three-quarters of Brazilian reserves.

At the end of March, a Brazilian bank (controlled by a Chinese parent) became the first financial institution in Latin America to join China’s Cross-Border Interbank Payment System, which settles trade deals in the Chinese currency. But most Brazilian companies continue to use the dollar-based SWIFT messaging system. Even as the RMB’s global share of trade transactions doubled to 4.5 percent in 2022, the dollar remained the currency of choice in 84 percent of all trade deals worldwide.

—Jeremy Mark is a nonresident senior fellow with the GeoEconomics Center. He previously worked for the IMF and the Asian Wall Street Journal.

3. What did China gain from this visit?

From what we have seen thus far, Lula and Xi gained crucial “wins” from their bilateral meeting. The two signed fifteen bilateral agreements in everything from agriculture to technology, demonstrating further development of the China-Brazil comprehensive strategic partnership. Lula even visited a Huawei technology development center and received a presentation about how 5G can revolutionize telemedicine and education; this suggests Lula’s willingness to accelerate China’s 5G expansion in Brazil, despite US efforts to slow China’s 5G advance in the region due to espionage concerns.

Both leaders also successfully projected themselves as champions of the Global South, professing their desire to “balance world geopolitics,” advocating for their countries as mediators in Ukraine, and upholding the BRICS mechanism as a counterweight to the US-dominated international system. However, Lula’s most inflammatory statement that BRICS countries ditch the US dollar and trade in their own currencies was likely bluster, especially given the fact that the US dollar still accounts for 60 percent of global central bank reserves.

—Leland Lazarus is a nonresident fellow at the Global China Hub and associate director for national security at Florida International University’s Jack Gordon Institute of Public Policy. He formerly served as special assistant and speechwriter to the commander of US Southern Command and as a US State Department foreign service officer in China and the Caribbean.

4. What do Lula’s visits to both Washington and Beijing reveal about his foreign policy approach?

Differently from the trip to Washington in February, Lula’s visit to Beijing had a more clear and concrete purpose. The trip to Washington was aimed at reestablishing relations and discussing cooperation on common challenges, such as democracy and climate. The visit to Beijing had an important business component. Both were significant in consolidating Lula’s foreign-policy goals.

Brazil will continue its traditional non-alignment, non-interventionist approach to foreign policy, seeking to maintain close diplomatic relations with strategic partners, which include both the United States and China. At the same time, Lula will continue to push for the rethinking of the global order to reflect current times, carving out that relevance for Brazil. A few examples include Lula’s interest in leading peace conversations between Russia and Ukraine, hosting the Group of Twenty (G20) summit in 2024, questioning the reliance on the dollar, proposing changes to the United Nations Security Council, and sending a special foreign policy advisor to Venezuela for meetings with the Maduro regime and its opposition. The question that remains is whether or not Lula is picking the right battles—and if he will have the support, domestically and internationally, to be successful.

—Valentina Sader

5. How can the Lula visit be seen within the context of Xi’s renewed outreach to the Global South?

Lula’s visit to China and meeting with Xi reflects Lula’s desire to again—as in his previous times in office—be at the center of the global stage. And it is a visit that is squarely within China’s priorities to deepen ties with Brazil as part of its quest for greater leadership in the Global South. China is Brazil’s number one trade partner. And this visit is a clear signal that those economic ties will only deepen in the years to come.

What cannot be missed is the difference in pomp and delegation size between the China visit and Lula’s trip to Washington two months earlier. Whereas the US visit was a short, two-day stop without a business contingent, the China trip is twice as long with a large delegation of businesspeople looking for new commercial opportunities now that China has reopened after its COVID-19 lockdowns. It’s also reflective of Lula’s inauguration: China sent then Vice President Wang Qishan—a close ally of Xi—to lead its delegation, while the US delegation was led by Interior Secretary Deb Haaland.

—Jason Marczak is the senior director of the Adrienne Arsht Latin America Center.

The post What the Lula-Xi partnership means for the world appeared first on Atlantic Council.

Public Event Fri, March 31, 2023 • 8:15 am ET

A conversation with Executive Vice-President Margrethe Vestager

AN #ACFRONTPAGE EVENT – Executive Vice-President of the European Commission Margrethe Vestager discussed how Europe is addressing the geopolitical moment and its economic challenges.

Digital Policy Economy & Business Energy & Environment Europe & Eurasia

As the European Union looks to reassess its relationship with China, European Commission Executive Vice-President Margrethe Vestager gave an early preview of what reposturing around economic and technological innovation might look like.

“We have no interest in decoupling from the second largest economy in the world. Rather, we need to build a de-risking strategy in order to manage the relationship that we will have in China,” Vestager said Friday at an Atlantic Council Front Page event in Washington.

It won’t be easy, though. Europe will need to juggle technological, climate, and economic concerns and use all the de-risking tools in its disposal, which Vestager said includes Europe’s new Foreign Subsidies Regulation, international screening and procurement instruments, and outbound investment controls.

Meanwhile, the European Union (EU) and its members will have to carefully balance regulation and much-needed government financing for new technology development while not stifling domestic innovation from private enterprise, which could also have effects on its economic and philosophical rivalry with China. 

That delicate dance was exemplified by the conversation around ChatGPT, as Vestager commended a recent letter from prominent tech leaders calling for a “pause” in developing artificial intelligence (AI) as a sign that society is taking AI concerns seriously, while also urging caution about actually holding off on developing such technology.

“Imposing a pause would be not only difficult to achieve, but maybe also not the way to go, because, as we speak, they’re coding in China,” Vestager said. “What we need is a direction. Where you say, well, this is where we want to go.” 

Across all these competing sectors, Vestager had one clear message: urgency.

“We have very little time, and we can only do it together,” she said of the United States and the EU.

In her role, Vestager addresses critical challenges around economic competition, trade and technology, digital sovereignty, and green energy, all of which she discussed in her conversation with Jörn Fleck, senior director of the Europe Center at the Atlantic Council.

Read on for more highlights.

Addressing the EU-China relationship

• Will the Commission’s repositioning on China going forward be more like Lithuania or more Germany? “I would hope you can expect more Europe,” Vestager said, going on to say that the European approach will need to be specific in its strategy. “I think precision, in what we see as risky, is absolutely key,” she said, alluding to how low-risk products need to be treated differently than sensitive technologies.

• Vestager said Europe should be aggressive in its strategy to combat China as an economic competitor and systemic rival, coming off the heels of Commission President Ursula von der Leyen’s call Thursday to reassess Europe’s diplomatic and economic relationship with China, ahead of her trip to China next week along with French President Emmanuel Macron. In the coming days, Europe “must put much more muscle on the bone of the strategy, so that we can take actions,” she said.

• A critical part of Europe’s pivot will be around reducing its strategic dependencies on China, a lesson gleaned from watching Europe struggle with soaring energy costs amid Russia’s war against Ukraine. “We should only need to learn this once. Now we need to act upon it,” Vestager said. However, other tactics will be needed as well, as Europe can’t succeed with just one approach, but will need to “combine the tools we have.”

• Combating Chinese cyber attacks and technology competition is key, with the acceleration of the digital age presenting unique challenges for democracies around the world. That will include addressing 5G networks but also data integrity and disinformation campaigns that threaten human rights. “We cannot throw away, in just a few years, what it has taken us decade after decade after decade to achieve,” she said.

On technology

• Commending a recent op-ed by US President Joe Biden aimed at keeping “Big Tech” accountable around privacy issues, Vestager noted that the EU has had the General Data Protection Regulation in place since 2016 and is currently investigating TikTok’s use of data. However, she added that such controls are not enough: “As long as this kind of data is for sale, and China can buy it anyway, we still have work to do.”

• She also addressed the challenges of moderating content, citing the EU’s Digital Services Act as one key effort to make sure platforms have systems for taking down illegal content while still preserving freedom of expression by “enabling people to come back if they find that they’re not being fairly treated,” she said.
  
• Platforms must conduct risk assessments to see how they are affecting young people’s mental health and how their service could be misused to undermine democracy, so that they can mitigate those concerns. “We want a digital market that is open, that businesses can get access to data that they would otherwise not have access to… and that they should not fear their data is being used against them,” she said.

• Change in the digital marketplace will be difficult to create without public buy-in, she said: “In my experience, when you change legislation, that is difficult, but what you have changed is perception. When you implement legislation, you want to change behavior—one hundred times more difficult.”

• However, Vestager warned against overregulation that kills healthy competition, as open, dynamic markets, and the innovation they bring, will be critical to advancing core technologies to confront major challenges, from China to climate change. “What we are in the midst of is, of course, a very small window to make sure we get some of the design right for a fully digitized world that honors the basics of our beliefs.” 

• That lesson was exemplified by the AI conversation, in which Vestager said she felt like the European Commission’s work to assess some of the high-risk cases was “on track,” including tools to help developers and regulators, such as the AI Roadmap and AI for Good initiative. Rather than ban AI technologies like ChatGPT, Vestager urged agreement around central questions, such as “what are the guardrails” and “what is the direction of travel, when it comes to AI?”

Climate change

• Commending Europe’s commitments to reach net-zero carbon emissions by 2050, Vestager noted how policies such as the US Inflation Reduction Act and the EU Green Deal Industrial Plan can push clean energy forward. Those initiatives must be mutually reinforcing, though, and also not result in a transatlantic subsidy race that doesn’t accelerate green efforts worldwide. “The paradox is that, while we have this back and forth in the short term, mid- to -long-term, there is enough for everyone,” Vestager said. “We need net-zero industries in the US, in Europe, in India, in China, in every jurisdiction. Otherwise we will fail.” 

• Avoiding disruptions to trade and investments will be essential to making progress on net-zero goals, said Vestager, who underscored the need to reinforce transatlantic supply chains after their weaknesses were exposed during the COVID-19 pandemic. “We need to be able to depend on one another, and we need to be able to trust that we can do that also on a rainy day.”

• Similar to technology, fighting climate change will require a delicate balance between enforcing regulation and encouraging innovation. Political leaders have a responsibility to make the green transition happen, Vestager said, but they also cannot succeed without relying on the free market. “This is why it’s so important to balance how you subsidize, how you incentivize, how you fix the market failures that are out there, in order to not break these market dynamics that are crucial for us all to be successful.” 

Nick Fouriezos is a writer with more than a decade of experience reporting around the globe.

Watch the full event

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He expressed the Chinese Communist Party’s (CCP) surprise and unease over how problems reverberating from the US financial sector hurt China and promised to re-examine the Chinese financial sector’s linkages to the US. He then announced the party’s new strategic priority to refocus Chinese finance on its domestic economy as a way to tackle the crisis and stave off future shocks from overseas.

At the time, the declaration went largely unnoticed. There were too many other problems to deal with. But nearly fifteen years later, as the global economy confronts another wave of bank failures, it’s clear China followed through on Wen’s promise. 

The effects of Silicon Valley Bank’s (SVB) and Credit Suisse’s collapse have reverberated across every major economy—except one. The KBW Nasdaq Bank Index, which tracks the performance of the world’s leading Globally Systemically Important Banks (G-SIBS) is down 17 percent from March 7 to its trough on March 24. China, however, remains an outlier. Why? 

Scars of the Great Recession

2008 was a turning point in China’s liberalization of its financial sector. The crisis exposed what Beijing perceived to be unacceptable cross-border risks between the United States and China. The collapse of Lehman Brothers shocked China’s leaders. Not because they were overly concerned about contagion—they had fiscal and monetary tools to deal with the immediate economic problems. But because they saw that the United States was willing to let its major financial institutions fail. This made connections to the US system overly risky.

The Great Recession also forced the CCP to reassess the model it would structure its financial system around. The crisis revealed a more volatile and risky face of Western banking. Leading government-affiliated scholars became increasingly skeptical of a market approach to finance, which they saw as driving financial instability in the United States and Europe. 

China’s immediate response to the crisis was to rely on its state-owned banks. In conjunction with a massive fiscal stimulus program, Beijing instructed these institutions to substantially increase lending. Total domestic credit grew by more than one-third in 2009. It was through these state-owned banks and enterprises that China’s real economy—unlike Western economies—escaped relatively unscathed by the financial crisis and maintained employment despite a collapse of global trade. 

As China recovered from the recession, the dominant perception among policy makers and influential scholars became that insufficiently regulated financial markets caused the crisis. State-ownership, on the other hand, was fundamental to ensuring China could weather and then quickly exit it. 

These lessons laid the foundation for policy changes that have insulated the Chinese banking system from the collapse of SVB and Credit Suisse. 

Banking with Chinese characteristics

While 2008 forced Chinese policy makers to recognize these risks, other priorities delayed any action. They still wanted to integrate some parts of their economy into the global financial system such as including the Yuan in the IMF’s Special Drawing Right (SDR) basket. It was only in the later part of the decade, following its 2015 stock market crash that Beijing began implementing this policy pivot.

In 2015 the pop of a market bubble saw the Shanghai Stock Exchange lose more than 48 percent of its overall value. After the incident, financial regulation was named a top political priority at the 2017 National Financial Work Conference, a twice-a-decade event which set the scene for the country’s financial sector for the next five years. 

In the ensuing months, Beijing appointed a new top bank regulator who began implementing a “windstorm” of new regulations. In order to de-risk the sector, policymakers tightened controls on cross-border transactions, capital movement, and overall exposure to other markets. The following year Beijing also drew banks closer to the state. Regulators pushed banks to establish Communist Party Committees with a wide oversight purview. Most were formed with the stipulation that they would be consulted before corporate strategy was agreed upon. As our China Pathfinder project, a collaboration with Rhodium Group, shows, this—in conjunction with other measures—has led to a financial system with intense state supervision.

These reforms, as well as the banking structure that predated them, has generated major differences between China and Western approaches to banking. China has a high level of state ownership and control of its banking sector, and a government that more actively intervenes in banking decisions. 

As Premier Jiaboa promised, the result is a banking sector that is exceptionally focused on China’s domestic economy and adverse to cross-border risk, especially from Western economies. In 2021 cross-border lending of Chinese banks represented less than 5 percent of their total balance sheet. In the United States, cross-border lending constitutes more than 22 percent of its banks’ balance sheets. What little cross-border lending China does engage in is focused on emerging and developing economies. This lending can often be understood as a policy choice serving strategic goals, such as the Belt and Road Initiative. 

These policy choices have led to a financial system with more immunity to the problems facing the United States and Europe. While the collapse of Credit Suisse and SVB reverberated across all major Western financial capitals, China, with the world’s largest banking sector, was largely unimpacted. 

But that protection comes with its own costs.

First, Chinese finance is continually plagued with inefficient capital allocation. This is prominently playing out in the semiconductor industry with reports that senior officials are increasingly angry at the lack of development progress despite the tens of billions of dollars they have funneled into the industry over the past decade. Second, China’s lack of international and advanced economy banking connections mean it plays an undersized role in global banking standard setting such as the Basel Committee. For a country that has promised more international leadership in recent years, its lack of a large international financial presence often precludes it a seat at the rulemaking table (time will tell if China’s ambitions toward Hong Kong change this dynamic). Finally, its banking system is unable to offer Chinese savers attractive investment products, leading to other economic imbalances—including an asset price bubble in the country’s property sector. 

Similar to China’s zero-COVID policy, financial isolation comes with tradeoffs. While it may create a system that is relatively unphased by crises abroad, it also can generate and amplify endogenous issues within China’s own economy. 

Josh Lipsky is the senior director of the Atlantic Council’s GeoEconomics Center and a former adviser at the International Monetary Fund.

Niels Graham is an Assistant Director with the Atlantic Council GeoEconomics Center focusing on the Chinese economy.

The authors would like to thank GeoEconomics Center YGP Phillip Meng for his excellent research support.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The damage from China’s policy mistakes extends across several sectors of the economy. Zero-COVID lockdowns decimated the retail, restaurant, and tourism industries. A regulatory crackdown clipped the wings of high-flying e-conglomerates and destroyed online education companies that once boasted over four hundred million users. A real-estate collapse set in motion by tighter control over property lending has undermined the balance sheets of developers, local governments, and households. Unemployment among young people in cities has been in double digits for months, and 11.5 million college graduates are poised to enter the job market later this year. Even foreign institutional investors, who only a few years ago were gung-ho on Chinese stocks and bonds, have cut back on their exposure to China’s financial markets partly due to their concerns about government policies.

With COVID-19 controls finally lifted, the Chinese economy is showing signs of an unsteady rebound after posting only 3 percent growth in 2022. But uncertainty about the direction that Chinese leader Xi Jinping and his newly announced leadership team will take raises doubts about the viability of Beijing’s aspirations for economic superpower status.

Of particular concern is the inability—or unwillingness—of China’s private sector to play a needed role in driving the country’s productivity growth, capital investment, technological innovation, and hiring. In its most recent assessment of the Chinese economy, the International Monetary Fund (IMF) singled out the “persistent weakness” of private investment and private consumption as a key reason that China’s economic growth “remains under pressure.”

When China’s National People’s Congress met earlier this month to seal Xi’s unchecked power over the country, the problems besetting the economy—not to mention any solutions—were left largely unspoken. But amid the triumphal declarations, there was an undertone of concern that hinted at the worries coursing through Chinese society, especially among the beleaguered private sector.

Xi himself seemed to reflect on this uncertainty at a meeting with business executives during the National People’s Congress when he called for the Chinese Communist Party to encourage the “healthy growth” of the private sector “so that they can let go of misgivings, be unburdened and develop with courage.” Newly appointed Premier Li Qiang followed a few days later at his inaugural press conference by saying “last year there were some inappropriate discussions about private entrepreneurs, which made them feel concerned.”

Chinese entrepreneurs have every reason to worry. Beijing’s harsh regulation of leading conglomerates over the past two-and-a-half years under a policy of constraining the “disorderly expansion of capital”—Xi’s catch-all criticism of what he saw as unchecked capitalism—has hit some of the country’s largest and most profitable companies. Businesses have cut back investment despite repeated assurances that what officials call “rectification” has been “basically completed” and regulators will pursue “normalized supervision.”

Among the government’s many actions against private companies, the initial public offering (IPO) of Alibaba Group’s Ant subsidiary was blocked in 2020, and Ant Group was subsequently restructured; the ride-hailing giant Didi Chuxing was forced to delist from Wall Street in 2021 after proceeding with an IPO without Chinese regulators’ approval; and the online tutoring industry was hit with a ban on for-profit tutoring, leading to the wholesale destruction of companies. In addition, huge fines were levied against e-commerce conglomerates, after which many of the country’s most famous CEOs went into retirement or exile and over one trillion dollars of stock market capitalization were wiped out. The recent disappearance of one of China’s leading investment bankers—who was taken in to “assist” with a corruption investigation—has added to the uncertainty hanging over the business community.

Much of China’s crackdown on the private sector centered on activities that had been only lightly regulated in the past, such as practices now considered monopolistic; for example, major e-commerce company Alibaba was fined for preventing merchants from selling their products on competitors’ websites. Other business practices came under scrutiny and supervision as China’s political winds shifted. For example, data protection and cybersecurity—especially related to companies listing on Wall Street—became sensitive issues as tensions with the United States mounted. A multitude of new laws and regulations have been put in place, and approvals for new online products and services—especially video games—have languished in bureaucratic limbo. Moreover, the government’s acquisition of small stakes in several businesses—so-called “golden shares” that come with board seats—make it clear that control of the private sector will come from both without and within.

The end result for many companies has been sharply lower profits and plummeting stock market valuations. Mass layoffs have followed, with sixty thousand employees fired at one tutoring company and more than nineteen thousand let go at Alibaba, where 2022 revenue growth was the slowest on record. (On Tuesday, Alibaba announced a major reshuffle, splitting into six different business units.) That’s bad news for the coming wave of college graduates, most of whom won’t be equipped with the skills to find employment in “hard-tech” startups like semiconductor manufacturers and quantum computing firms that now are showered with subsidies and other support from Beijing. In February, the jobless rate among urban youth hit 18.1 percent, the highest level in six months.

Beijing’s campaign against such a vibrant part of the economy just adds to the scar tissue from the draconian zero-COVID policies that shut down cities and industries—and that were abandoned last year only after the unchecked spread of the Omicron variant and spontaneous street protests late last year that embarrassed the leadership. So it’s not surprising that as retail spending slowly recovers, Chinese consumers remain unsure about the future. It also doesn’t help that the property market remains in a deep downturn, affecting a sector that has contributed more than one-quarter of the country’s gross domestic product and directly hitting at least 70 percent of urban residents’ personal wealth.

Chinese leadership now offers soothing words to business, with Xi cooing at the National People’s Congress that “[w]e always regard private enterprises and private entrepreneurs as being in our ranks, giving them support when they are in difficulties and offering them guidance when they are uncertain about what to do.” But actions speak louder than words, and the “rectification” of the past few years represents one more self-inflicted economic wound. While the government’s program of supporting thousands of startups may one day bear fruit with new employment-generating high-tech enterprises, Beijing also has a track record of pouring capital into money-losing ventures plagued by corruption.

At a moment in which China faces mounting economic uncertainties—including looming recessions in important foreign markets—its most successful companies have been handcuffed by statist impulses. The end result could very well be slower growth and fewer opportunities for Chinese and foreign businesses—for example, a recent survey shows that one-half of US companies do not plan to make new investments in China. All this adds up to a bleaker outlook for continued improvement in the Chinese people’s standard of living. No wonder the celebration of Xi’s continued rule was largely confined to the halls of power.

Jeremy Mark is a senior fellow with the Atlantic Council’s Geoeconomics Center. He previously worked for the IMF and the Asian Wall Street Journal. Follow him on Twitter: @JedMark888.

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After the sale of Credit Suisse, the most poignant example of investor concerns is the market pressure on Deutsche Bank (DB).  DB shares have lost more than a fifth of their value this month—despite improving its financial performance in recent years. Following significant restructuring efforts since 2019, DB has posted ten consecutive quarters of profit, including a net income of €5 billion ($5.4 billion) in 2022, a 159 percent increase from 2021. At the end of 2022, its Core Equity Tier 1 capital ratio was at 13.4 percent, Liquidity Coverage Ratio at 142 percent and Net Stable Funding Ratio at 119 percent—all meeting Basel III regulatory requirements. 

The satisfactory regulatory ratios for most banks in the US and Europe have enabled financial authorities to insist that their banking system is basically safe and sound. Investors, however, have taken a different view. Since the 2008 global financial crisis, the ratio of market share price to net book value (assets minus liabilities) of European and US banks have traded at half of their pre-2008 averages. Specifically, European banks have traded at around a P/B ratio of 0.6–meaning investors value banks’ net assets at much less than what their financial statements show, reflecting lack of confidence in the profitability of those banks. By comparison, the P/B ratio of US banks has been around 1.4.

In short, the turmoil in the banking sector of global equity markets reflects the lack of confidence that banks can cope with the current and expected difficult business environment. Most worrisome is a likely recession that would cause losses in banks’ loan and credit portfolios. 

Besides interest rate risks, which have materialized due to quickly rising interest rates, credit risk is the second shoe to drop. Some economists have looked for this event to assess the severity of what increasingly appears to be a systemic financial crisis. Financial regulators have identified several areas of vulnerability that can crystallize into losses: commercial real estate, construction loans, and leveraged loans packaged into Collateral Loan Obligations. Those financial products have been distributed widely beyond the banking sector— to pension funds, insurance companies, and investment funds.  Some investment funds are vulnerable to redemption runs by their investors, thus bearing similar risks as SVB and Signature Bank of asset losses combined with unstable funding.

Unfortunately, under current unsettled financial conditions, monetary policy and financial stability policy as articulated by authorities have failed to reassure market participants. At times, they even seem to have the opposite effect.

Major central banks, most notably the Federal Reserve System and the European Central Bank, have continued to tighten.  However, the Fed has done so by less than it planned to, and the tightening has been accompanied by changes in rhetoric. The words “ongoing increase” became “some additional firming” in the recent Federal Open Market Committee statement. The banks have also indicated that they are prepared to raise rates further if inflation remains stubbornly high. The message sent to financial markets implies that, as a last resort, central banks are prepared to accept a recession to bring inflation under control. Consequently, market participants must price this possible outcome, focusing on the weak link—being banks and, eventually, other non-banking financial institutions.

Central banks have also emphasized that they will closely monitor financial market instability and stand ready to supply liquidity as needed. However, in the case of the United States, tension is revealed in the changes in Treasury Secretary Janet Yellen’s recent remarks. On March 22, 2023, she said she had not considered blanket insurance to all deposits (as requested by a group of mid-sized banks) without congressional approval. The following day, Yellen said she was prepared to stabilize banks and ensure the safety of their deposits. Amid growing political opposition to what is perceived to be bailouts of large depositors of the two failed banks, there is uncertainty about whether and to what extent the US Department of the Treasury and regulators can protect all bank deposits without congressional approval. This is especially difficult to predict given political divisiveness in the United States.

More importantly, supplying liquidity, while useful, may not be sufficient to quell the current market turmoil. This is despite the simplistic belief that authorities have a set of policy tools to deal with financial crises, separate from interest rate policy. Specifically, the problems facing banks are not necessarily liquidity or solvency weaknesses, but due to investor loss of confidence. Many banks—like DB—have maintained adequate capital and liquidity positions, but still came under market pressure when their investors lost confidence in their ability to navigate the difficult period ahead. Unfortunately, the authorities have amplified this fear by raising the risk of a recession and its attendant credit losses.

At this juncture, it is important for central banks to recognize that combating inflation is important in the medium term, while averting a full-blown global financial crisis is an acute problem which should be prioritized now. Central banks should do everything they can, including becoming more flexible in their interest rate decisions to calm down equity markets, especially for banks. At the same time, they should communicate their commitment to bring inflation under control over time.

This is a tall order for central banks and authorities to rise to in today’s politically polarized circumstances. But the stakes are much higher for everyone. There is a greater risk of losses of output, employment, and wealth in a recession accompanied by a banking crisis.

Hung Tran is a nonresident senior fellow at the Atlantic Council; a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The monetary-policy challenge cannot be overestimated.

Monetary policy basics

The Fed has a famous dual mandate that requires it to set interest rates that optimize price stability and full employment simultaneously over the medium term. In the most recent semi-annual monetary policy testimony to Congress on March 8, Federal Reserve Chairman Jerome Powell characterized the mandate as pursuing “our maximum-employment and price-stability goals.” 

But the Fed has two additional mandates that overlap with monetary policy at the margins: financial stability and managing payment-system access/operational integrity. During crisis situations, these additional mandates deliver the deciding factor for interest-rate policy.

The Fed is now in an unenviable position. Its monetary-policy and financial-stability mandates are at odds with each other. Raising interest rates would be justified—based on underlying economic theory pertaining to prevailing inflation rates and labor market strength—but doing so will generate additional stress on bank liquidity buffers. On the other hand, pausing or cutting rates will at least tacitly acknowledge that monetary policy intensified (if it did not cause) the current financial system stresses. 

The systemic stresses in play today are rooted in two specific details from the financial crisis in 2008.

The Global Financial Crisis and the high-quality liquid assets problem

One of the many Basel III reforms (enshrined into US law via the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act) involved creating a sensible requirement that banks hold more liquid assets. Banks were required to hold high-quality liquid assets (HQLA) so that they could meet liquidity needs by relying on capital markets rather than on possible government bailouts. The securities that most easily meet the definition of HQLA are US government bonds. 

Many policymakers solemnly vowed at the time that they would never again bail out a bank. Whether bailing out billionaire depositors (with deposits in excess of $250,000) is morally superior to bailing out bank shareholders should be debated separately. The bigger point is that this was not supposed to happen again.

There’s an HQLA problem—one that extends well past Silicon Valley Bank. The assets that banks hold may still be high quality, but the price and value of those assets have eroded significantly in the last year as interest rates increased. In addition, efforts to liquidate those securities at scale create other problems. Significant drops in price could potentially trigger risk limits at other banks, requiring them also to liquidate US Treasury bonds at fire sale rates.

A race to liquidate HQLA amid increasing interest rates while the Fed chases “maximum employment” would create much larger, undesirable financial system stresses. In other words, the run on Silicon Valley Bank at the start of March is actually the benign scenario. A sizable hole exists in bank balance sheets due to the erosion in value amid high and rising rates. The Federal Deposit Insurance Corporation’s data from the end of last year paints a somber picture:

The newly launched Bank Term Funding Program (BTFP) thus understandably tells banks not to sell their Treasury securities. Instead, the Fed promises to deliver to the banks liquidity support at par value (not the much-lower market value) against collateral in the form of… Treasury securities. The framework thus helps stabilize market prices for those instruments by suppressing sales.

Markets remain in a precarious position, as the coordinated central bank dollar-liquidity lines indicate. Many in finance will not be surprised. Within the first few days of operation last week, Reuters reports, banks utilized nearly half of the BTFP ($11.9 billion out of the available $25 billion)—and they had acquired additional liquidity support through the Fed’s discount window facility at a historic level. 

This is the first time this century that the discount window has been tapped at scale without a recession also being present. Treasury markets also came under stress last week.

The United States approaches this period of financial uncertainty with a booming economy and a booming labor market. However, data showing continued strength regarding inflation, the labor market, and gross-domestic-product growth all require a data-dependent Federal Reserve to continue hiking interest rates. More interest rate hikes will further erode the value of HQLA on bank balance sheets globally.

The Fed seems to have boxed itself into a corner, creating cross-border financial instability that tarnishes US leadership. From Europe to Japan, economies were emerging from the pandemic with a soft landing in their sights. If the HQLA situation triggers further instability and damages the global recovery, many policymakers may begin to question US economic leadership.

Barbara C. Matthews is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center. While in government, she served first as senior counsel to the House Financial Services Committee and then as the Treasury Department’s first attaché to the European Union. She is currently the founder and chief executive officer of BCMstrategy, Inc.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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As governments around the world weigh this crucial question, deciding whether to help failing banks first requires clarifying what exactly a bailout entails.

Take the most recent example. In the last week, US financial authorities moved promptly to guarantee all deposits of the two closed banks (SVB and Signature) thus trying to avoid turmoil in financial markets and the high-tech business sector in particular. In addition, the Federal Reserve (Fed) has launched a Bank Term Funding Program (BTFP) to lend to banks against high-quality bonds as collateral for up to one year, at face value instead of market value, which has been eroded due to rising interest rates. This has ignited a growing debate about whether protecting all depositors of the closed banks represents a bank bailout and whether it is justified.

Is it a bailout?

US President Joe Biden, the Federal Reserve, and US financial regulators have insisted that the measures adopted on March 12 do not constitute a bailout of the closed banks—since their shareholders and bondholders are exposed to losses potentially wiping out all their claims. Taxpayers’ money is not involved and, they argue, will not be lost as the deposit protection will be funded by selling the assets of the closed banks. However, this assertion is weakened somewhat by the fact that the Federal Deposit Insurance Corporation’s (FDIC) $125 billion insurance fund and $25 billion from the Treasury Departments’s Exchange Stabilization Fund will be available as a backup.

In turn, critics of these moves point out that protecting large depositors who are supposed to be at risk is bailing them out of the consequences of their actions, and in the process weakens market discipline and elevates moral hazard. After all, public resources are involved in the sense of allowing the Fed and the FDIC to use their balance sheets and buy time to go through the resolution process. If the FDIC’s fund is used, it will have to be replenished by assessments on all banks—so all the banks and their customers, meaning society at large, will have to pay.

Was the ‘bailout’ justified?

The answer to this question depends on distinguishing the short term from the long term. In the short term, the answer is “yes” simply because of the bleak consequences of the alternative. Not protecting all depositors of the failed banks would risk spreading the bank runs to other banks perceived to be in similar circumstances or weak in some ways, then to much of the banking system. This risks destabilizing the whole economy and inflicting tremendous costs on citizens.

The problem is that all crises require short-term responses, and repeated rescue operations, especially since 2008, have hard-wired these expectations and behaviors into financial market participants. When things go wrong, the government will come to the rescue without fail. As a result, moral hazard is no longer a theoretical concern. It is alive and well.

Another set of expectations has also become hard-wired in financial markets. A crisis usually triggers a kind of “New Year’s resolution” to implement financial regulatory reform to make the system healthier and more resilient in the future. That resolution may or may not go anywhere—most of the time not—but even when it does produce results, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the reform was later rolled back when things settled down.

In short, especially since 2008, the US financial system has morphed into one where any crises or stressful periods have been ‘competently’ pacified by the Fed—either by flooding the financial markets with ample liquidity or offering outright guarantees or protection to the market participants at risk. Naturally, when things go well, the owners of financial assets and senior managers of financial institutions—a small minority of the population—reap most of the benefits.

The long-term problem is that such a financial system is anti-capitalistic (Adam Smith would be turning over in his grave), inequitable, and unsustainable. The longer it persists, the more it undermines the legitimacy of the Fed and other financial regulators—and of the government as a whole.

Was there a better option?

According to SVB’s latest balance sheet, at the end of December the bank had assets of $211.8 billion, of which presumably high-quality bonds (US Treasury bonds, agencies, and mortgage-backed securities) amounted to $116.7 billion, net commercial loans made up $73.6 billion, and other assets making up the rest. The bank also had $173.1 billion of total deposits, of which $163.2 billion were uninsured and $132.8 billion were demand deposits. In addition, SVB has $19.3 billion of total debt and $16.3 billion of total equity.

Instead of offering a blanket guarantee to all large depositors, a much better approach would have been to protect large depositors up to the value of the closed banks’ high-quality bond portfolios, which are eligible as collateral to borrow from the newly launched BTFP. The limit could be the market value of the bonds (in which case there is no implicit public support involved); or their face value (in which case the BTFP provides a service by warehousing the bonds until maturity without realizing any losses). SVB’s bond portfolios at face value would have paid $116.7 billion out of the $163.2 billion uninsured deposits—leaving $46.5 billion uncovered. These “excess” deposit claims would have to wait to get paid from the sale of the remainder of the bank’s assets of $95.1 billion; either fully or partially depending on the outcome of the liquidation efforts. This is not a bad cushion as debtholders and shareholders will be the first to take losses.

This procedure would enable large depositors, presumably high-tech start-up companies in the case of SVB, to get money to carry on normal business without serious disruptions. But, critically, it would also subject them to some degree of market discipline. Hopefully, they would then be incentivized to shop around for banks with a healthy holding of high-quality bonds, in the process generating competitive pressure on the banks to do so to the benefit of their safety and soundness.

If more banks start to fail, regulators should use this approach with large depositors to help protect the economy without resorting to more bailouts.

Hung Tran is a nonresident senior fellow at the Atlantic Council, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

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At the same time, the Fed announced a new Bank Term Funding Program (BTFP) designed to lend to banks and other depository institutions for up to one year against high quality collateral such as US Treasuries, agencies, and mortgage backed securities, at their face values instead of market values. The BTFP will be backstopped by $25 billion from the Treasury’s Exchange Stabilization Fund (ESF)—in addition to the Federal Deposit Insurance Corporation (FDIC) fund of $125 billion, which has been paid in by banks as insurance premiums.

They also emphasized that all depositors at the two closed banks will have access to their deposits. Presumably, the closed banks have sufficient collateral to borrow from the new program to pay off all depositors. However, it is highly likely that share and bond holders will have to take haircuts in the resolution of the closed banks. Prompt actions by regulators enable startup companies to have access to their deposits at SVB to continue functioning. But they have failed to stabilize financial markets in the United States and globally.

The launch of the BTFP aims to help banks make full use of their US Treasury portfolios—without realizing mark-to-market losses—in order to payoff large depositors exceeding the $250,000 FDIC limit per account, per bank. The BTFP thus buys time for the Treasury collateral to regain par value at their maturity, allowing the authorities to claim that taxpayer money will not be involved in the resolution of the failed banks. Nevertheless, “buying time” represents rescuing banks from the marked-to-market losses on their high-quality bond holdings; and the public fund from the ESF is being used as a back-up. As a result, there will likely be criticism and protests from politicians opposed to bank bailouts following the 2008 financial crisis.

The announced emergency measures have failed to stabilize markets, with participants now looking for the Fed to ease off on its tightening regime, which is the root cause of the difficulties at the failed banks. Fed action remains to be seen, but events in the past week have already raised important questions which have to be addressed going forward.

Most immediately, what will happen if a bank under liquidity pressure does not have enough high-quality bonds to use as collateral—even at par value—to borrow money to pay off large depositors? Will the Fed relax the current rules and allow the BTFP to accept less than high-quality bonds (such as corporate bonds) as collateral. Will it require large depositors to accept less than their full amount? This uncertainty will keep depositors on edge and encourage at least some of them to move to strong banks in a flight to quality.

Secondly, the efforts to protect large depositors have put the US banking system on a slippery slope of socializing the deposit-taking business of banks, creating huge moral hazard. The risk is that, under the pressure of financial market turmoil and business disruptions, authorities will keep relaxing the conditions for lending to failing banks to help them pay off all depositors. It is important to realize that protecting all bank deposits would be hugely costly either in terms of necessary insurance premiums charged to banks or using public funds. Ideally, a clear limit for deposit insurance protection needs to be drawn. Above this limit, large depositors will need to be paid only from the liquidation proceeds of their failed banks. A precedent for this is the case of IndyMac, which failed in 2008. Its large depositors took a 50 percent haircut at that time, and were required to wait for potential residual payments later on.

Thirdly, authorities need to explore ways to minimize the detrimental effects of marked-to-market losses on the huge volume of bonds held by banks and other financial institutions during the long period of near-zero interest rates. The FDIC has estimated that unrealized losses on those bond holdings amounted to $620.4 billion at the end of 2022—more than doubling US banks’ net income of $263 billion in 2022. Presumably the unrealized losses would weigh more heavily on banks with inadequate risk management practices. However, while hedging can reduce interest rate risks—and losses—of individual banks, the risk and potential loss remain in the whole banking system.

Banks can put a portion of their bond holdings in “held to maturity” (HTM) accounts, in which case those positions don’t need to be marked to market. The theoretical marked-to-market losses on the HTM accounts amount to about $300 billion but will be protected by the BTFP. If banks put them in “available for sale” accounts, they must be marked-to-market and the resulting valuation losses charged against equity capital. As mentioned above, US banks—especially the systemically important ones—are better capitalized (with Tier 1 risk-based capital ratio of 13.65 percent at the end of 2022) compared to the 2008 situation. They can therefore absorb these valuation losses. Nevertheless, the unrealized losses would reduce banks’ propensity to extend credit—contributing to a tightening of financing conditions and slowing economic activity. In particular, the high-tech startups sector will experience growing funding difficulties in the foreseeable future. This sector is currently needed to sustain the US lead in its competition with China. The unrealized losses could also interact with deposit outflows to hobble segments of the banking system.

Fourthly, in the past year during which the Fed has raised rates, bank customers have moved about $500 billion of deposits from banks to money market mutual funds (MMMFs) offering higher yields. This shift is especially thanks to the fact that MMMFs can conduct reverse repo transactions with the Fed at 4.55 percent at no credit risk. Banks have had to compete by raising rates to attract deposits, including by issuing a growing volume of Certificates of Deposits. However, this has cut into their interest margins, reducing earnings going forward. More importantly, banks perceived to be weak would have suffered more deposit withdrawal. This “flight to quality” would accelerate now as clients scramble to diversify their deposits to stronger banks even with the recently announced measures—keeping segments of the banking system unstable.

Finally, most of the US banking system is not subject to the full force of the Dodd-Frank regulations. In 2018 President Trump signed into law deregulation legislation designed to exempt banks with assets less than $250 billion (the previous threshold was $50 billion) from the full application of the Dodd-Frank regulations—such as strict reporting requirements and stress tests. Consequently the full Dodd-Frank regulatory and supervisory regime only applies to the twelve largest US banks with assets more than $250 billion. The rest of the 4,706 strong banking system has been exempt. At present, it is not clear how rigorously most of the US banks have been supervised in the past few years, or how long it would take for supervisors to screen these banks to identify vulnerable ones and take precautionary measures. But the sooner they can do this, the better. More importantly, there should be an earnest debate to change the 2018 law to bring more banks back into the full Dodd-Frank regulatory and supervisory processes.

Besides interest rate risks which have crystalized into losses on bond portfolios, credit risks and losses threaten to move to the fore as the US economy slides toward recession. Of particular concerns are highly-leveraged loans packaged into collateralized loan obligations and commercial real estate loans—as identified in the Fed’s latest Financial Stability Report. These products have been distributed widely to banks and non-bank financial institutions such as pension funds, insurance companies, and investment funds. Similar to banks with weak funding bases, according to the Fed’s latest Monetary Policy Report, “prime and tax-exempt money market funds, as well as many bond and bank loan mutual funds continue to be susceptible to runs.” Consequently, these financial stability risks need to be dealt with as well.

In conclusion, even if the contagion effects of SVB, Silvergate Financial, and Signature Bank failures can be contained—still a big if—risks to the financial stability of the United States, and the world by extension, have increased significantly. The Fed no longer has the luxury to focus only on bringing down inflation. It must also avoid exacerbating financial stability risks. At the same time, the regulatory community should work with Congress to reform and strengthen the financial regulatory framework given the obvious weaknesses revealed over the past week. The current social and political polarization will undoubtedly make this exercise difficult—but it needs to be done.

Hung Tran is a nonresident senior fellow at the Atlantic Council; a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

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Table of contents

Executive summary

Rebranding Hong Kong
Welcome back
Objectives and methodology

Assessing risks to Hong Kong’s business conditions
Institutional changes in Hong Kong since 2019
One country, two currencies
Compliance: Sanctions and national security directives
The rule of law and judicial independence
Freedom of the press, transparency of information flows
Data security

Recommendations

About the author and acknowledgements

Executive summary

Hong Kong’s legal and institutional structure has changed fundamentally since the implementation of the National Security Law in 2020. When changes of this magnitude occur, it is difficult for anyone to know what shifts are transitory, and what adjustments will end up becoming permanent features of Hong Kong’s political and commercial environment.

Over the past three years in Hong Kong, a system based upon legal and institutional restrictions on government action founded on the Basic Law and British common law has shifted toward a system governed by political norms reinforced by the National Security Law. In that process, those dominant political norms have changed significantly from those that had governed the “one country, two systems” policy since the handover of sovereignty in 1997, and are increasingly driven by priorities in Beijing, rather than the previously dominant local leadership of Hong Kong. The National Security Law created a parallel system of authority operating both behind and above Hong Kong’s system of government established by the Basic Law and the Sino-British Joint Declaration of 1984. This new structure permits a broad interpretation of the definition of “national security,” leaving individuals and businesses with few options to challenge the law’s reach.

The National Security Law has been used to target multiple institutions seen as politically challenging to Beijing, including independent newspapers, media outlets, and pro-democracy politicians. It also has limited activities of the press, the publication and distribution of books and films, and the flow of information in other formats, including those essential to the operation of a modern commercial and financial system.

The bet for businesses operating in Hong Kong, and the financial industry in particular, is that they will continue to be viewed as essential for Hong Kong’s globally competitive position. Despite the widespread changes in the political and social landscape in Hong Kong, some argue that changes in the rest of Hong Kong’s operating environment will not influence their own businesses, because they will continue to enjoy some degree of special treatment.

This report attempts to provide an objective framework to assess the wager that business conditions for most firms operating in Hong Kong will remain unchanged, despite the dramatic changes that Hong Kong has seen within its legal and institutional infrastructure. The report analyzes in detail the risks to the commercial operating environment in Hong Kong that have emerged since the 2020 introduction of the National Security Law, including currency risks, compliance challenges, threats to judicial independence, access to accurate information, and data security.

While Western governments have already attempted to change their policies toward Hong Kong in the wake of the National Security Law, the business community needs a different set of strategies to maintain and protect its interests given these rising risks. While no strategy can completely eliminate these risks, lobbying collectively and maximizing the political relevance of Hong Kong’s self-declared status as an important international commercial and financial hub can be useful, and may have already generated some modest successes. Other recommendations include approaching outreach to Hong Kong authorities as a political campaign; communicating to Beijing the consequences of uncertainty over Hong Kong’s status; investing in compliance infrastructure and developing risk mitigation strategies; monitoring pro-Beijing media in Hong Kong and broader US-China political trends, as well as data concerning national security cases and outcomes, foreign participation, and outcomes within the legal system; and communicating the importance of independent media for Hong Kong’s future.

Rebranding Hong Kong

Under “one country, two systems” Hong Kong will continue to practice the capitalist system, and practice the common law system, an independent judiciary, a free flow of capital, no exchange control. Our dollar [the Hong Kong dollar] will continue to be pegged to the US dollar. So from investors’ perspective, indeed, Hong Kong will continue to function as a free international financial center with the best international regulatory regime and a trusted judicial system.

—Paul Chan, October 2022 remarks at Future Investment Initiative Forum

When conditions change rapidly, there is a natural tendency to seek certainty and stability. In that context, Hong Kong’s Financial Secretary Paul Chan knew his audience. Speaking at a financial forum in Saudi Arabia last October, he specified some of the exact fears that the global financial industry had developed concerning Hong Kong over the previous three years. Since the 2019 protests, the imposition of a sweeping National Security Law in July 2020, and the enforcement of strict COVID-19 restrictions and quarantine requirements in 2021 and early 2022, Hong Kong’s politics, media environment, legislative institutions, and business environment had changed fundamentally. But Chan’s audience in the financial industry was less concerned with what had already happened and more interested in what might come next. In very few words, he isolated some of the key components of Hong Kong’s attractiveness to international business, and argued forcefully that they would remain in place. The “capitalist system,” “common law,” an “independent judiciary,” the “free flow of capital,” and a credible peg of the Hong Kong dollar to the US dollar were exactly the pillars of Hong Kong’s operating environment that businesses valued.¹ The fact that Chan had to make this reassurance highlighted the rising perceptions that all were at risk. The financial industry in Hong Kong continues to operate on the assumption that the fundamental changes in Hong Kong’s political and legal institutional structures will not impact their business prospects specifically.

Chan’s mission was difficult. He was in the Middle East a week ahead of a summit of financial executives in Hong Kong meant to showcase that Hong Kong was reopening to the rest of the world and remained a viable place to do business. Even after the 2019 protests, Hong Kong had been largely closed off throughout the three years of the COVID-19 pandemic. With lengthy required quarantine periods for all travelers including Hong Kong residents, international travel was extremely unattractive and the volume of international flights declined sharply—on some days in 2022, fewer than one hundred people arrived at the Hong Kong international airport. The border between Hong Kong and the mainland remained similarly closed, with quarantines usually required to enter mainland China, even for those with permission. An exodus of both expatriates and Hong Kong residents also was underway, with the total population of Hong Kong declining by 216,300 people between June 2019 and June 2022, a drop of 2.9%.² Numerous media stories circulated about Singapore gaining new residents and investment at Hong Kong’s expense.³ Businesses in Hong Kong were facing problems retaining staff and recruiting new people to replace them.⁴

The aftermath of the 2019 protests created a far different and more expansive challenge for Hong Kong. The National Security Law enacted in July 2020 was Beijing’s response to the protests of the previous year. The measure was enacted through Annex III of Hong Kong’s Basic Law, which concerned security arrangements for Hong Kong and circumvented the usual legislative process of approval through Hong Kong’s Legislative Council. The new law established parallel systems of authority to Hong Kong’s traditional institutions, while permitting interventions into those jurisdictions on issues related to national security, and potentially conflicting with the provisions of the Basic Law. Early cases indicated that the National Security Law was being used against behavior in 2019 that Beijing sought to prohibit in the future, including the routine political activities of the opposition or pro-democratic politicians in Hong Kong. The concern for the business community and for financial institutions was whether the National Security Law meaningfully imposed restraints on government action under the law, the extent of those restraints, and the lines that were being redrawn between national security and commercial activity.

This report aims to clarify what has changed within the business environment in Hong Kong over the past three years, and the significance of those changes for businesses and financial institutions operating in Hong Kong now and in the future. The report aims to step back from politicized rhetoric to evaluate actual changes in institutions and outcomes.

Welcome back

Hong Kong’s “Global Financial Leaders Investment Summit,” a financial forum held in early November 2022, was designed by Hong Kong’s government to demonstrate that the global financial industry remained committed to Hong Kong—despite all of the changes in the territory—and implicitly, to China’s markets. Hong Kong has always played a role linking China with the international marketplace, and historically has highlighted the effectiveness of Western legal and judicial institutions operating under Chinese sovereignty. Chief Executive John Lee summarized the case as, “Hong Kong remains the only place in the world where the global advantage and the China advantage come together in a single city.”⁵

The events surrounding the financial conference presented several confounding facts to the attendees and the international media, raising numerous questions about Hong Kong’s continued convergence with international norms and practices. The event started with a tour of M+, Hong Kong’s newly completed international art museum. Between the project’s groundbreaking ceremony and its eventual opening in 2021, the legal environment surrounding the display of some pieces of contemporary art by Chinese artists had shifted within Hong Kong, and the museum shelved certain exhibitions in 2021 and then removed some paintings that were seen as politically charged from the walls in 2022 (although they were still visible on the museum’s website).⁶

On the same day of the financial forum, a trial was being conducted of an independent media organization, Stand News, with Hong Kong authorities accusing its publications of being seditious. The organization and the editors and journalists involved were not being charged under the National Security Law but an old colonial law created in 1938 targeting sedition.⁷ However, no journalist or publication had been charged under the law since the 1960s, until the National Security Law was in place.⁸

One of the most notable differences between Hong Kong and other global financial centers over the past three years was the territory’s restrictive measures to contain COVID-19, which mirrored the mainland’s approach. Hong Kong’s coronavirus response became a visible manifestation of the broader changes in governance underway and Beijing’s growing influence, with political mandates taking precedence over technocratic or scientific guidance.

The financial conference was designed to highlight Hong Kong’s return to normalcy after COVID-19 restrictions were eased, but mainland Chinese officials did not travel to the forum, and instead appeared virtually. One Chinese official, Fang Xinghai of the China Securities Regulatory Commission, argued, “I would advise international investors to find out what’s really going on in China and what’s the real intention of our government by themselves. Don’t read too much of the international media.”⁹ Chan, the financial secretary, had his own problems after suddenly testing positive for COVID-19 in Saudi Arabia the week before. Under Hong Kong’s rules at the time, testing positive upon arrival in Hong Kong would have forced Chan to isolate for seven days. Instead, despite testing positive to a PCR test at the airport, Chan was declared to have recovered in time to attend the forum, where he appeared in person without a mask, while outdoor mask mandates were still enforced outside the conference. At the event venue, the Four Seasons hotel, delegates at the summit were given different rules to allow them to socialize with one another without the benefit of masks or the required isolation, unlike normal travelers to Hong Kong at the time. Chan later responded to the criticism in a press conference, claiming that, “The treatment that I have been given was the same as anyone. There’s no particular privilege at all.”¹⁰

The changes in Hong Kong’s political system following the 2019 protests impacted the territory’s response to the COVID-19 pandemic as well, which revealed the growing influence of Beijing’s political priorities. Following the mainland’s “zero COVID” approach led to Hong Kong pursuing a draconian policy of isolating individual cases and close contacts of cases—even if they had no symptoms. After the Hong Kong leadership declared in late 2021 that the objective was to open the border with the mainland before international travel,¹¹ restrictions on businesses and individuals became far more common, with the apparent rationale of bringing Hong Kong’s practices in COVID-19 containment more in line with those of the mainland, to smooth the opening of the border. Whether or not Beijing officials ever communicated specific requirements to Hong Kong’s health authorities that were necessary for opening the mainland border, however, remained unclear throughout the three years of the pandemic.

Ultimately, even these highly restrictive measures were ineffective at containing the virus. The Omicron variant of COVID-19 eventually spread into the population in early 2022, with some cases ironically emerging from quarantine hotels themselves. The spread quickly overwhelmed the hospital system. Photos of elderly patients sitting on hospital beds outside, exposed to the elements, dominated the local media.¹² Hong Kong experienced the highest death rate in the world per capita during its Omicron wave from February to April 2022, with over 10,770 COVID-19 deaths, or around 0.15 percent of the population.¹³ Even though Hong Kong had already faced a devastating wave of cases that had impacted most of the territory, it was only after Beijing abandoned its own restrictions that Hong Kong’s COVID-19 controls were scrapped, with the border finally reopened to quarantine-free travel in January 2023.

The financial forum organized in early November 2022 was meant to show that Hong Kong had finally moved beyond its strict quarantine requirements and restrictions, and was ready to rejoin the rest of the world. But the industry participants were still receiving treatment that differed from what prevailed for the rest of the population.¹⁴The executives who had agreed to participate in the Hong Kong summit also reciprocated the hospitality of their hosts, and said favorable things about Hong Kong’s position in the international financial system. Mary Callaghan Erdoes, head of JP Morgan’s asset and wealth management division, commented, “There hasn’t been a city in the East that has emerged in the same way that Hong Kong has . . . Hong Kong never left. I mean, it shouldn’t be so hard on itself. It never disappeared.”¹⁵

The event was a microcosm of the implied assumptions about the financial industry’s position and importance in Hong Kong: that the sector would always be exempt in some way from the broader changes taking place in the rest of Hong Kong’s legal and political system. This was despite the growing risk that compliance obligations and international sanctions from both China and the United States could force financial institutions to operate between legal jurisdictions, or to choose between compliance with one system or the other. These assumptions about the financial industry’s position within Hong Kong will be tested more directly in the years ahead.

As Hong Kong’s political and legal structure changed and COVID-19 restrictions intensified over the past three years, many people chose to leave the territory. Ultimately, changes in population, particularly within a territory of Hong Kong’s size, can be viewed as an indicator of societal health and political support. Hong Kong’s demographic challenges are significant. Birth rates have declined sharply, from 95,500 births in 2011 to 53,700 in 2018, and only 37,000 in 2021; meanwhile, death rates have climbed in recent years. This is consistent with broader regional trends in East Asian countries including Korea and Japan, but the declines have been particularly sharp in Hong Kong itself. The median age as of 2021 is 46.3 years old—one of the world’s highest.¹⁶ The natural trajectory of Hong Kong’s population will be to decline in the absence of new immigration, which historically has flowed from the mainland via “one-way permits” allowing long-term migration.

The exodus that has taken place since the implementation of the National Security Law and coronavirus restrictions is unprecedented in Hong Kong’s history. The proximate cause of the wave of migration—politics or disease control—remains debatable, but the fact of the wave of emigration is indisputable, and distinct from other countries in the region facing declining populations. Since the summer of 2019, Hong Kong’s population has declined by 2.9%. The British government’s 2021 offer of a five-year path to citizenship for Hong Kong holders of British nationals overseas (BNO) passports, meaning those born in the territory before the 1997 handover, had been taken up by thousands.“¹⁷ While there was a wave of outbound travel immediately after the National Security Law’s implementation in 2020, the fastest period of emigration occurred in 2022, presumably in response to COVID-19 restrictions.

These statistics may be understating the true level of outbound migration, in part because many people may have simply traveled abroad quickly without formally changing residence. After significant legal and institutional changes, the decision to “vote with one’s feet” was the last form of meaningful popular franchise still available in Hong Kong.

Objectives and methodology

The most fundamental change in Hong Kong over the past three years has been a shift from legal and institutional constraints on government actions to political and normative constraints. Specifically, a legal system founded on the Basic Law and British common law has shifted toward a system governed by political norms reinforced by the National Security Law. In that process, those political norms have changed significantly, and are driven more by priorities in Beijing than the previous local leadership of Hong Kong.

The report will evaluate changes and risks in Hong Kong’s business environment in five critical areas. First, the changes in Hong Kong’s institutional structure create new risks for the future of Hong Kong’s independent currency, the Hong Kong dollar, and its peg to the US dollar via the linked exchange rate system (LERS). The credibility of the Hong Kong dollar’s currency peg is intrinsically linked to the credibility of the “one country, two systems” policy as it is practiced in Hong Kong. Questions about the currency peg were always going to be raised after “one country, two systems” was scheduled to sunset in 2047—now, those questions are surfacing much earlier. Central to the nature of Hong Kong’s currency arrangement is the prospect for maintaining open capital flows between Hong Kong and the rest of the world.

Second, Hong Kong-based financial institutions are confronting new compliance-related risks tied to sanctions activity, from both Washington and Beijing. There are reasonable concerns that both sides may intensify the use of sanctions-related controls in the future, and may seek to prevent the enforcement of conflicting directives in Hong Kong. Global financial institutions will plausibly be asked to devote increasing efforts to balancing business and compliance risks, with rising political risk associated with their decisions.

Third, the report will discuss the nature of the legal environment in Hong Kong and risks to the continued independence of the judiciary, which is essential for Hong Kong to maintain its reputation and attractiveness as a center of international commerce, and for adjudication of disputes in financial and commercial transactions.

Fourth, there are rising risks related to press freedom and the free exchange of ideas and information in Hong Kong. Business and finance depend upon reliable and credible information. Hong Kong’s media environment was very liberal by global standards before the National Security Law was imposed in July 2020. The environment has tightened considerably since that time, and there are considerable risks to the business environment should that trend continue.

Fifth, data security in Hong Kong is a new uncertainty after the passage of the National Security Law. The use of new legal sources of authority to seize data and control of company information creates new risks for businesses managing both internal and customer data. China’s own data security and protection laws may also create new risks if they are applied to Hong Kong in the future.

The direction of the accumulated changes is important as a signal of future actions. There are few effective measures determining when legal and institutional constraints no longer bind powerful actors. If norms and practices are changing in conflicting directions, with some pointing to a liberalization of the media environment and others to rising censorship, the implications may be unclear. But if the vast majority of institutional changes point to centralization of authority and reduced autonomy in the public sphere, it is more reasonable to draw conclusions about the steps that will follow.

Most critical for global business and the financial industry at present is to separate the changes that are resulting from a security-driven political campaign from the lasting shifts in the operating environment for businesses in Hong Kong. But measures that appear transitory and tied to security-related priorities can become permanent features of the business environment as well.

Assessing risks to Hong Kong’s business conditions

Institutional changes in Hong Kong since 2019

The fact that the legal and institutional environment has changed in Hong Kong is not in dispute: the leadership in Beijing and Hong Kong have been trumpeting those changes as essential in restoring “law and order” in Hong Kong after the protest movements of 2019.¹⁸ Other governments—notably the United States and the United Kingdom—have used those legal and institutional changes in Hong Kong to make the case that changes in their own policies toward the territory are warranted. The US Commerce Department’s Bureau of Industry and Security (BIS) stopped treating Hong Kong as a separate destination under its own export controls following a December 2020 executive order.¹⁹ The United Kingdom has declared that Hong Kong’s changes to the Legislative Council election system represent a “state of ongoing noncompliance with the Sino-British Joint Declaration.²⁰

This section very briefly summarizes the most significant and fundamental changes in Hong Kong’s legal and institutional environment since the 2019 protests.

National Security Law and the National Security Committee

The Law of the People’s Republic of China on Safeguarding National Security in the Hong Kong Special Administrative Region (aka, the National Security Law) was the most significant change in Hong Kong’s system of institutions following the 2019 protests. It was formally passed by Beijing’s National People’s Congress on June 30, 2020, and was applied to Hong Kong under Annex III of Hong Kong’s Basic Law, which consists of national laws in China that also apply in Hong Kong. The law did not enter the normal legislative process in Hong Kong, and most officials in the Hong Kong government were unaware of the contents of the law before it was implemented.²¹ The law formally designates four specific offenses related to national security, including secession, subversion, terrorism, and collusion with foreign organizations. The National Security Law also can be applied to alleged offenses that occur outside of Hong Kong.²²

The National Security Law is enforced in Hong Kong using a parallel system of policing and enforcement to Hong Kong’s conventional system, including a newly established Office for Safeguarding National Security. For cases deemed to involve national security or the crimes designated under the law, this office may involve mainland courts or other aspects of the mainland legal system. The structure of the National Security Law and its parallel system raise questions about where Hong Kong’s Basic Law still applies and where the National Security Law circumvents and overrides the authority under the Basic Law. For cases in which this is in dispute, the National People’s Congress Standing Committee in Beijing has the authority to interpret the law.

Judges presiding over cases under the National Security Law are to be selected by Hong Kong’s chief executive, rather than through the conventional process of selecting judges for criminal cases in Hong Kong, through the Judicial Officers Recommendation Commission. It remains unclear at this point whether or not lawyers involved in national security cases must also be approved or selected by the chief executive, as a recent interpretation of the law from Beijing suggests the chief executive may be able to overrule the courts concerning such questions.²³ Hong Kong’s secretary of justice can similarly specify that cases related to the National Security Law be conducted without a jury. So far, no criminal cases tried under the National Security Law have involved a jury. Very few cases have been tried so far since the passage of the National Security Law, and not all of those arrested have been formally charged with offenses, but the conviction rate for all such cases under the National Security Law remains at 100 percent.

Legislative Council structure and elections

Hong Kong’s Legislative Council, the de facto legislature for the city established under the Basic Law, had previously consisted of seventy seats, with thirty-five elected via popular vote through a system of proportional representation involving multimember districts, and thirty-five elected through “functional constituencies,” or representatives of different occupational groups, guilds, and unions. The next election to be held under this system was scheduled for September 2020, but was delayed by then-Chief Executive Carrie Lam, citing the COVID-19 pandemic.

In January 2021, fifty-three members of the pan-democratic alliance of political parties in Hong Kong were arrested under the National Security Law based on their participation in a primary election for the upcoming Legislative Council race.“²⁴ Hong Kong’s Legislative Council electoral system was then changed in March 2021 by legislation passed through China’s National People’s Congress.

The new system expanded the overall number of seats to ninety, and reduced the number of seats that could be directly elected via popular vote to twenty. The change reduced the functional constituencies to thirty seats, and then authorized forty seats for an Election Committee consisting of the people that also elect the chief executive in Hong Kong.²⁵ The 2020 Legislative Council elections were eventually held in December 2021, and voter participation for the seats elected via geographic constituencies declined from 58 percent in 2016 to 30.2 percent.“²⁶ The majority of pro-democratic politicians (the “pan-democrats”) who had not been arrested did not choose to stand in the December 2021 elections.

The election process for the chief executive of Hong Kong was changed as well. The previous system under Annex I of the Basic Law provided for 1,200 members of the Election Committee, with 117 seats selected by the District Councils. The last District Council elections, which were held in November 2019, were won overwhelmingly by pro-democratic candidates. The National People’s Congress decision changing Hong Kong’s electoral system removed the potential influence of these pan-democratic votes by expanding the Election Committee to 1,500 members and increasing the number of seats named by the Chinese People’s Political Consultative Conference (CPPCC) and other organizations controlled by Beijing. While Lam received 777 of the 1,194 votes in the 2017 chief executive election, Lee was the only candidate in the 2022 chief executive election, receiving 99.4 percent of the vote in the new system.

Along with changes in the structure of legal and political institutions in Hong Kong, the COVID-19 pandemic prompted new legal restrictions on the business environment in Hong Kong over the past three years. Hong Kong’s public health restrictions have been applied under a law passed in 2008 as the Prevention and Control of Disease Ordinance, and applied through administrative changes and amendments, rather than the normal legislative process. These restrictions imposed have similarly interfered with provisions of the Basic Law, such as Article 31, which permits free movement into and out of Hong Kong by Hong Kong residents. While most of these controls have since been dismantled, as the mainland moved quickly to remove COVID-19 restrictions, it remains unclear whether or not these authorities will remain a permanent feature of Hong Kong’s legal and regulatory structure, to be reimposed in the future.

One country, two currencies?

One of the most significant risks to the business environment in Hong Kong is the possibility that the Hong Kong dollar’s peg to the US dollar might change, and with it, free capital flows in and out of Hong Kong. The currency peg, through LERS, has been in place since 1983 and has significantly reduced the risks of operating in Hong Kong, particularly for companies engaged in international trade. The challenge to the currency peg is that fixed exchange rate regimes inherently depend upon the credibility of the institutions and leadership that maintain them. Hong Kong’s currency was always going to confront a “2047 problem,” in that the status of the currency would be uncertain after the fifty years of “one country, two systems” ended on June 30, 2047. Given the dramatic changes in Hong Kong over the past three years, however, and uncertainties about the degree of change between now and 2047, many of the future concerns about Hong Kong’s currency have advanced into the present day. It is highly unusual in global finance for any one sovereign country to issue two separate currencies, and to run two separate monetary policies.

The fundamental question is how long such a “one country, two currencies” system can persist. Credibility and confidence in Hong Kong’s fixed exchange rate regime depends upon confidence in the “one country, two systems” policy framework itself. There is no reason that the current arrangement, with the Hong Kong dollar trading in a range of 7.75 to 7.85 per US dollar, necessarily needs to change. As long as Hong Kong is willing to accept the consequences of US monetary policy within its domestic economy (primarily felt through its property market), it is still very unlikely that capital outflows from Hong Kong will overwhelm the system and force an exchange rate adjustment. The Hong Kong Monetary Authority (HKMA), the central bank that operates the LERS maintaining the peg, is expected to continue emphasizing publicly that the system will remain unchanged. Paul Chan’s October comments clearly indicate that Hong Kong authorities, including those outside the HKMA, agree that the peg is highly significant for Hong Kong.

The risk to the Hong Kong dollar’s stability comes not from Hong Kong but from Beijing, or more specifically from market uncertainty about Beijing’s intentions. Should Beijing at some point offer a public opinion about the future of the Hong Kong dollar, those words are likely to carry greater weight in global markets relative to statements from the HKMA. After all, throughout the legal and institutional changes from 2019 to 2022, Beijing’s will typically prevailed over the preferences of Hong Kong’s local authorities, such as the changes in the Legislative Council which reduced the roles of even the local pro-Beijing parties, and requirements for loyalty oaths to the government from career civil servants.²⁷

The reason Beijing may start to see risks attached to the Hong Kong dollar itself stems from the leaks in China’s capital controls. One of the primary benefits of Hong Kong’s position to Beijing is the fact that the territory permits capital flows to and from mainland China, in a legal and institutional system more appealing and understandable to foreign investors and financial institutions. The free flow of capital carries benefits as well as risks for Beijing: capital outflows from China via Hong Kong to the rest of the world have tightened financial conditions in China in the past, and could endanger financial stability in China itself if these outflows accelerated. China’s domestic savings of households and corporations are extremely high by global standards, and China has the largest money supply of any country in the world, measured in US dollars, at $37 trillion. Most of China’s household and corporate savings is still invested in renminbi-denominated assets, at around 98 percent. That pool of savings could generate trillions of dollars in capital outflows should China’s capital controls ease or if there were sudden changes in China’s economy that would drive capital flight.

If China were facing considerable capital flight, Hong Kong’s environment of free capital flows could appear as a greater vulnerability than benefit to Beijing, and to China’s central bank, the People’s Bank of China (PBOC). In early 2016 and January 2017, China’s central bank had already tried to shut down capital flight from China by intervening in Hong Kong’s market for the offshore renminbi (RMB) [labeled the CNH in currency trades to distinguish it from the onshore Chinese yuan or CNY], by tightening funding conditions for the offshore currency, making it more expensive to borrow and speculate on its depreciation. The actions supported the value of the offshore currency, but also introduced considerable new policy uncertainty, as the currency became far less attractive to hold as a result. Prior to this intervention, Hong Kong’s leadership was marketing the territory as a center for “RMB internationalization” and a market for offshore RMB-denominated financial instruments such as so-called “dim sum” bonds. The sudden squeeze in financing rates created significant obstacles to these financial markets developing within Hong Kong. But the priorities of Beijing in maintaining onshore financial stability clearly took precedence. If capital flight intensifies in the future, Beijing’s priorities could once again outweigh maintaining the conditions necessary to preserve Hong Kong’s currency peg and free capital flows.

The most likely alternative to the Hong Kong dollar’s peg to the US dollar is not a free float of the currency, allowing the market to set its price, but repegging the Hong Kong dollar to the renminbi. This would mean, in effect, that Hong Kong would be “importing” China’s own monetary policy rather than US monetary policy. The Hong Kong dollar would essentially transform into an offshore RMB. If there were any meaningful divergence between interest rates in Beijing and Hong Kong, capital would quickly flow toward the higher-yielding jurisdiction. As a result, such a change would place Beijing in a difficult position of needing to impose stricter capital controls between Beijing and Hong Kong or between Hong Kong and the rest of the world to prevent broader capital flight that would endanger the stability of China’s currency.

China’s own “managed float” against the US dollar would similarly face peril through broad-based capital flight and diversification of Chinese savings into foreign assets. China’s foreign exchange reserves are now only 8 percent of the money supply, down from 16 percent during the last period of aggressive capital flight, in 2015 and 2016.

Hong Kong needs free and open capital flows for its own survival as a global financial center, and for its benefits to Beijing. But any change to Hong Kong’s currency peg to the US dollar would create new questions about how long those capital flows would continue without new controls being imposed. Those fears alone could start to diminish Hong Kong’s attractiveness as a financial center.

China’s capital controls are porous, and Beijing is aware of that fact. If fundamental conditions point to China’s currency depreciating, the PBOC can only slow capital outflows to a limited extent. Often, these outflows show up under so-called “errors and omissions” in China’s balance of payments data. From 2015 to 2019, these cumulative outflows under errors and omissions were larger than China’s current account surplus, at $933 billion.²⁸As long as China’s current account for trade-related transactions remains open, capital flows are likely to take place, disguised as trade flows. This often occurs in China through overinvoicing or underinvoicing in trade transactions, to facilitate flows that would otherwise be permitted in developed financial systems. It also can occur through transactions designated as outbound tourism, in which individuals claim they need foreign exchange for travel, but may use it for any number of financial transactions instead. As a result of these porous controls, Beijing often experiments with tightening some of these channels when they see outflows intensify. The risk for Hong Kong is that those same incentives would start to apply in the territory itself.

One can easily argue that Beijing has no interest in changing the Hong Kong dollar’s peg to the US dollar, and that may be true. But most importantly, financial markets will start looking to Beijing to assess those preferences, rather than the words of the HKMA or other Hong Kong authorities. Regardless of how one assesses the probability of Beijing’s preferences changing, this is still a significant new risk that any company or financial institution operating in Hong Kong must consider and manage carefully.

Compliance: Sanctions and national security directives

One of the most significant new risks confronting businesses operating in Hong Kong, particularly for financial firms, is linked to compliance with international sanctions and the possibility of being caught between two different legal systems. Hong Kong represents China’s financial gateway to the rest of the world, which also means that the territory’s financial institutions must maintain access to US dollar financing channels, which involve transactions between banks that can be governed by the US legal system. Most of these transactions between banks involving US dollars use clearing accounts within the United States.

The risks arising from these compliance obligations are not theoretical. In July 2020, the US Congress passed the Hong Kong Autonomy Act,²⁹ and the Trump administration issued Exec. Order No. 13936, which included blocking sanctions for any individual involved in implementing the National Security Law in Hong Kong, as well as the use of the law for a number of other purposes, including censorship and “policies that undermine democratic processes or institutions in Hong Kong.”³⁰ The list of individuals sanctioned included several members of the Hong Kong government, including former Chief Executive Lam and the current Chief Executive Lee, who was then secretary for security.³¹

The Hong Kong Monetary Authority also issued a circular in August 2020 clarifying its own stance on foreign sanctions implemented in Hong Kong, arguing that “a distinction is made between targeted financial sanctions applicable under Hong Kong law and unilateral sanctions imposed by foreign governments.”³². The circular argued that these “unilateral sanctions” had “no legal status in Hong Kong.”³³

China has similarly retaliated against US sanctions by enacting its own Anti-Foreign Sanctions Law in June 2021, which permits Chinese institutions to freeze and seize assets of individuals and entities engaged in the creation or implementation of “discriminatory restrictive measures” against China’s interests.³⁴ As of now, the law has not been applied in Hong Kong, after an extensive lobbying campaign by the financial industry and Hong Kong authorities. However, China has administered its own sanctions against a list of US elected officials, private citizens, and organizations involved in government-related programs.“³⁵

Local security agencies in Hong Kong also are requesting that financial institutions make decisions which potentially conflict with their obligations to their clients and legal requirements in other countries. The request of the Hong Kong Police to freeze the accounts of Hong Kong activists, independent media, and civic groups put HSBC in the challenging position of suspending transactions in accounts of political figures in Hong Kong.³⁶

In addition, the National Security Law itself creates potential legal risks for financial institutions. Article 29 of the National Security Law specifies that if a person “engages in activities such as requesting, conspiring with, receiving instructions etc., from a foreign country” that they commit an offense under the law.³⁷ Simply by abiding by US sanctions policies, foreign financial institutions potentially invite legal risk within Hong Kong courts. No such cases have arisen so far, but the history of case law under the National Security Law remains a very short one. For the seventy-eight banks operating in Hong Kong, which are among the world’s top one hundred,³⁸ it will become increasingly difficult to thread the needle between obligations under US law and sanctions policies and Hong Kong’s changing governance.

Rising risks and compliance obligations

There is a growing risk that financial institutions operating in Hong Kong will be forced to make decisions related to sanctions compliance that invite regulatory scrutiny from either Beijing or Washington, and expose the institution to legal risks as well. Both Washington and Beijing are clearly attentive to the risks of sanctions compliance or noncompliance in Hong Kong, and as a result, financial institutions are at greater risk of potential secondary sanctions or additional compliance obligations in Hong Kong relative to other jurisdictions. On July 16, 2021, the US State, Treasury, Commerce, and Homeland Security Departments released a Hong Kong business advisory discussing several potential risks for businesses operating in Hong Kong under the National Security Law.“³⁹ The release of this advisory alongside updated lists of specially designated nationals (SDNs), including Chinese government officials in Hong Kong, highlighted the US government’s awareness and monitoring of Hong Kong-related sanctions efforts.

In November 2020, the United States government began to confront China’s use of dual-use technologies and firms by sanctioning the financing of specific companies contributing to the development and modernization of China’s military, intelligence, and security structures, and preventing US financial institutions from holding securities issued by those companies. Exec. Order No. 13959 provided a window between November 30, 2020, and January 11, 2021, for compliant firms to exit investments in the sanctioned entities.⁴⁰ The list of companies has continued to expand to include sixty-eight different entities. As these restrictions went into effect in January 2021, the shares of the affected firms sold off heavily in Hong Kong’s market, but were quickly purchased by mainland investors seeking bargains. The expanding list of restricted firms makes bundling assets and creating financial products less transparent, as selling the stock of restricted firms could also hypothetically be considered “receiving instructions from a foreign country” under the National Security Law. Navigating these limitations and exemptions increases compliance costs for financial institutions, particularly as these restrictions expand.

Hong Kong’s own position on enforcing foreign sanctions remains ambiguous as well. Most foreign financial institutions remain broadly in compliance with US blocking sanctions and those targeting specific individuals, in attempting to reduce their own legal exposure. However, in October 2022, Alexi Mordashov, a sanctioned Russian oligarch, was allowed to dock his yacht in Hong Kong, an act requiring approval from the Hong Kong Marine Department.⁴¹ In response, the Hong Kong government stated that it would only enforce sanctions imposed by the United Nations Security Council.

In response to the Russian sanctions after the invasion of Ukraine, China’s central bank and finance ministry convened a meeting of domestic and international banks to better understand the threat of the same types of sanctions being implemented against China.⁴² The consensus of that meeting, according to a Financial Times report citing people familiar with the discussion, was that China is highly exposed to the US dollar system and cannot effectively replace USD-denominated assets with other foreign exchange reserves.⁴³ The net result, if accurate, is that Hong Kong would remain in a critical position as a conduit of capital to China and the country’s critical link to the US dollar-denominated global financial system. It remains more likely that Beijing would attempt to tighten links between its own legal and political institutions and Hong Kong’s financial system, rather than allowing Hong Kong to strengthen legal and institutional ties to the rest of the world.

As strategic competition between the United States and China has intensified, Hong Kong’s location at the nexus of global finance and the Chinese political system has increased the risk of operating businesses within the territory. The continued escalation of financial restrictions from the United States and the enactment of the National Security Law in Hong Kong create additional compliance obligations and rising costs for firms.

These restrictions and requests can potentially create circumstances where abiding by one government’s laws places individual banks and financial institutions in violation of the other’s requirements. Navigating these dynamics presents a new set of challenges for banks offering a wide variety of services, as noncompliance by one branch of the bank could open the entire institution to restrictions.

While China serves as an attractive market for expanding financial services, the lack of clarity and broad reach of the National Security Law make future business operations in Hong Kong far more complex than in the recent past.

The rule of law and judicial independence

The National Security Law’s changes to Hong Kong’s legal and institutional framework have generated considerable uncertainty surrounding the continued operation of the rule of the law and the independence of Hong Kong’s judiciary, which have historically been cornerstones of the territory’s attractiveness to international business. The creation of a new system of authority under the National Security Committee leaves the jurisdiction of Hong Kong’s courts unclear in several matters that are relevant for commercial and financial transactions. Any loss of the transparency and predictability of the British common law system of jurisprudence creates significant problems for businesses and lawyers working within Hong Kong’s legal system.

Most significantly, under the National Security Law, Hong Kong courts cannot necessarily decide what falls within the definition of national security, even though they are granted jurisdiction over criminal national security-related cases.⁴⁴ This necessarily leaves the interpretation of national security to mainland law, which has historically interpreted the term expansively. Notably, Beijing’s conception of national security can include fields such as the economic interests of Chinese state-owned firms, food safety, and security of resources and energy, as well as “ideological security.”⁴⁵. In January 2023, Xia Baolong, the director of the mainland’s Hong Kong and Macau Affairs Office, commented that Hong Kong should amend its existing laws, given that the National People’s Congress had designated “overriding status to the national security law, which application should take priority [over other laws].”⁴⁶

In addition, while the National Security Law is clear in its treatment of criminal cases, it remains unclear how it could be applied in future civil cases, which are most relevant for business and financial institutions. In such civil proceedings, the boundary of where the Hong Kong courts’ jurisdiction ends and the authority of the National Security Committee begins is governed by political norms in Beijing, rather than legal restraints decided in Hong Kong. There are reasonable legal interpretations of the National Security Law that suggest Hong Kong courts lack any jurisdiction over civil cases involving national security-related matters, with the boundaries of “national security” decided by Beijing.⁴⁷

Since the 2019 protests and the passage of the National Security Law, public perceptions of the quality of Hong Kong’s legal system and its independence and fairness have plummeted, as the results of polling from the Hong Kong Public Opinion Research Institute reveal.⁴⁸

Judges under the National Security Law

Under Article 85 of Hong Kong’s Basic Law, judicial independence is guaranteed.⁴⁹ Hong Kong has historically featured a high degree of judicial independence, with credibility reinforced through nominations of judges via an independent Judicial Officers Recommendation Commission and subsequent approval by the chief executive. Prior to the enactment of the National Security Law, the Hong Kong government did not influence the selection of judges involved in trying particular cases. The Hong Kong Bar Association and the Law Society of Hong Kong (for solicitors in the Hong Kong legal system) had operated independently from the government as well, as professional bodies regulating the professional conduct of their members.

Foreign lawyers and judges have played a significant role in Hong Kong’s legal system, as it is based upon British common law. When trials are being adjudicated by Hong Kong’s Court of Final Appeal, one nonpermanent judge from another common law jurisdiction is chosen to sit with three permanent judges and the chief justice. Foreign lawyers’ and judges’ participation in Hong Kong’s legal system is not essential for judicial independence, but their presence does help to provide legitimacy to the independence of the judiciary similar to principles in other common law jurisdictions.

The passage of the National Security Law has changed the process through which judges are appointed to individual national security cases, with Article 44 of the law stipulating that the chief executive chooses these judges specifically for a term of one year.⁵⁰ However, the list of appointed judges is not made publicly available by the Hong Kong government.⁵¹ The one-year appointment potentially introduces political influence into the selection of judges for national security cases, since the chief executive can arguably replace any judge seen as less favorable to the government’s positions.

Similarly, the question of which lawyers can serve on national security cases in Hong Kong remains in question. The highly publicized trial of media tycoon Jimmy Lai has introduced new uncertainties, given that Lai has requested that he be represented by King’s Counsel Timothy Owen, a British barrister. Hong Kong’s Court of Final Appeal rejected the Hong Kong government’s attempt to prevent Owen from acting as defense counsel for Lai in the national security case.⁵² However, rather than accepting that outcome, the Hong Kong government instead requested that China’s National People’s Congress Standing Committee (NPCSC) issue a ruling clarifying whether or not it was the intention of the National Security Law that foreign lawyers could serve in Hong Kong’s national security cases. While waiting for the NPCSC to rule, Hong Kong’s Immigration Department withheld Owen’s visa, preventing him from acting in Lai’s defense, and the trial was delayed.⁵³ When Beijing formally interpreted the law in late December 2022, it appeared to give the chief executive—rather than Hong Kong courts—the authority to decide whether or not foreign lawyers could appear in a national security-related trial, or to make other decisions related to national security cases, even if those decisions conflicted with those of the courts.⁵⁴ It remains unclear if a ban on foreign lawyers might eventually be applied within national security cases or the Hong Kong judicial system as a whole, with more authority over this question now seemingly vested in the hands of the chief executive.⁵⁵

In March 2022, both Lord Robert Reed and Lord Patrick Hodge, the president and deputy president of the UK Supreme Court, respectively, resigned from Hong Kong’s Court of Final Appeal. Lord Reed said upon resigning, “The judges of the Supreme Court cannot continue to sit in Hong Kong without appearing to endorse an administration which has departed from values of political freedom, and freedom of expression.”⁵⁶ Their resignations marked the end of twenty-five years of British judges sitting on the Court of Final Appeal. There are still nonpermanent judges serving on the Court of Final Appeal in Hong Kong as well. Many released statements which stated their intention to remain in their roles.⁵⁷ Of the ten remaining foreign judges, six are from the United Kingdom, three are from Australia, and one is from Canada.

Over the past three years, there has been a notable decline in the number of foreign lawyers practicing law within Hong Kong’s legal system. Since 2019, the number of registered foreign lawyers in Hong Kong declined by 15 percent, from 1,688 in 2019 to 1,442 as of December 2022.⁵⁸ The former chairman of the Hong Kong Bar Association, Philip Dykes, noted in 2020 that “a career at the Bar may not be so attractive to fresh law graduates because of the change in the legal atmosphere.”⁵⁹ Dykes went on to say that the plans of many barristers to leave Hong Kong would negatively impact the legal system’s ability to operate effectively.

The Hong Kong Bar Association (HKBA) has been subjected to political criticism as well. Paul Harris, the chairman of the HKBA, publicly suggested in early 2021 that the Hong Kong government propose some modifications to the National Security Law given apparent conflicts with the Basic Law. China’s State Council Hong Kong and Taiwan Affairs Office accused Harris of using “his British nationality to collude with foreign forces in interfering with Hong Kong affairs.”⁶⁰ Harris left Hong Kong in March 2022 only hours after being interviewed by the national security police.⁶¹ Reuters has reported upon a broader pattern of seemingly state-directed intimidation against prominent lawyers in Hong Kong, particularly those within the Hong Kong Bar Association or those making statements concerning the National Security Law.⁶² Recent statements by the HKBA later in 2022 have tended to be more supportive of the Hong Kong government’s official positions, including in the case of Lai’s request for representation by Owen.⁶³

Disposition of cases

The National Security Law is relatively new, and there have been only a small number of cases tried under the law so far. However, no defendant has yet been acquitted under the law, and no case tried under the National Security Law has involved a jury trial. It remains unclear whether or not this trend will change. An estimated 213 people have been arrested under the National Security Law and other national security-related statutes between July 2020 and October 2022, with an estimated 125 facing formal charges.⁶⁴

In terms of national security cases involving businesses, the most prominent examples have included the prosecution of Next Digital, which is the parent company of Apple Daily, and the use of a colonial sedition law to target the independent media organization Stand News. Both have since ceased publication and broadcasting after the arrests of key executives. Next Digital and Apple Daily were charged with collusion with foreign governments under the National Security Law. With its assets frozen (along with those of its subsidiaries), Apple Daily was unable to publish after its issue of June 24, 2021. Stand News and its parent company and executives were charged with sedition, under a 1938 crimes ordinance from British colonial times. The Court of Final Appeal ruled in December 2021 that some of the investigative powers of the National Security Law could be used in other cases involving national security, including sedition.⁶⁵ Stand News ceased distributing news on December 28, 2021, and police seized HK$61 million of the company’s assets.⁶⁶

The broader risk to businesses operating in Hong Kong is the expansive power of the National Security Committee to interpret the scope of “national security” within the Hong Kong legal system. In the cases of Apple Daily and Stand News, different laws were applied by authorities to achieve the same objective—the closure of these enterprises and the silencing of their editorial voices. While these cases are identified closely with the pro-democracy movement within Hong Kong politics and the 2019 demonstrations, there were few legal avenues through which these companies were able to challenge the charges in order to stay in business. The broader risk is that Beijing’s conception of national security will continue to expand and encompass activities related to individual businesses or financial transactions. In this regard, the recent experiences of Western companies subject to mainland propaganda campaigns (H&M, Nike, and others) reveal potential concerns about business activities becoming suddenly politically salient.⁶⁷ In addition, continued reinterpretations of the National Security Law by the National People’s Congress Standing Committee are unlikely to provide for more autonomy or judicial independence in Hong Kong in the future.

Freedom of the press, transparency of information flows

Prior to 2020, Hong Kong’s media environment was one of the most open and free from censorship in Asia, and comparable to those in Western democratic and pluralist political systems. The situation has changed significantly over the past decade, but the fastest change in practices has occurred since the introduction of the National Security Law. Free flows of information and access to reliable data are essential for the operation of an economy and financial markets. A media that is free to report on both macroeconomic developments, governance, and corporate performance and decision-making is a similarly essential ingredient within those markets. Establishing trust in media institutions and the credibility of information they provide requires time and a competitive landscape in which reliable information is rewarded and less trustworthy outlets are gradually ignored. Decisions based on the fundamentals or relative value of certain assets or securities depend upon the information underlying the valuations and the reporting of corporate and macroeconomic data.

Financial analysts in Hong Kong are now reportedly engaging in clandestine forms of communications, including private WeChat groups or “burner” telephones, in order to share views on the economy or individual securities with their clients.⁶⁸ Bloomberg reported recently on a significant level of self-censorship among financial analysts, even for reports within firms, out of concern about the vague lines of the National Security Law.“⁶⁹ Individual analysts in China have seen their own social media accounts removed for reporting negatively on China’s economic prospects, and analysts in Hong Kong now fear similar treatment, which has reduced the flow of financial information.⁷⁰

Some of the earliest prosecutions under the National Security Law have been focused on journalists and media organizations, notably Apple Daily and its parent company Next Digital, as well as Stand News, as discussed previously. Citizen News, a small online publication, also closed its doors early in 2022. Radio Television Hong Kong (RTHK) has also removed some of its content concerning local politics, including the show “Headliner,” following the introduction of new management at the station.⁷¹

Immediately after the implementation of the National Security Law, some books authored by individuals identified with the pro-democracy movement were removed from Hong Kong libraries, based on the need to review them for compliance with the law.⁷² Hong Kong’s Leisure and Cultural Services Department assembled a list of titles removed from libraries in breach of the law, but then authorities refused to make that list public in April 2022.⁷³ The university library at the University of Hong Kong is now requiring users to register in order to access some books alleged to be politically sensitive.⁷⁴

Even Beijing agrees that the media environment in Hong Kong has changed fundamentally. After the arrests of the officers of Stand News, a People’s Daily editorial argued that Western critics were ignoring the criminal acts of the journalists, claiming, “Ignoring right and wrong, these people have willfully misrepresented the lawful actions taken by the Hong Kong Police Force, vainly attempting to use press freedom as a shield for criminal acts and hamper the rule of law in Hong Kong through the straw-man trick.⁷⁵ Similarly, Lee argued that press freedom required support for the police’s actions, claiming in a letter to the Wall Street Journal that, “If you are genuinely interested in press freedom, you should support actions against people who have unlawfully exploited the media as a tool to pursue their political or personal gains.⁷⁶

However, measuring the extent of the changes involved and their magnitude remains a difficult exercise. One of the most objective tools available are surveys conducted about the environment for journalists, with opinions from both journalists themselves and consumers of media. In addition, external organizations conducting cross-country surveys of press freedom conditions can help to place the overall change in Hong Kong’s media environment in context.

The Hong Kong Journalists Association (HKJA) has conducted its own annual poll of press conditions since 2013. The results in 2022 showed the steepest decline in perceptions of the media environment ever recorded within this survey, both from the perceptions of journalists themselves and from public consumers of media. In 2022, a full 97 percent of survey respondents indicated that conditions for press freedom had become “much worse” over the year, and 53.5 percent of the public respondents agreed.⁷⁷ In addition, the HKJA reported a significant nonresponse problem in the survey, as several respondents refused to provide data, believing that the HKJA was under political scrutiny. Only 169 journalists or media industry employees provided answers to the survey of 737 journalists, a response rate of 23 percent, down from 83 percent in the previous year.⁷⁸ The chairman of the HKJA, Ronson Chan, was arrested in September 2022 and charged with obstructing a police officer. He was granted bail, and was not restricted in his travel to the United Kingdom for a fellowship later that month.⁷⁹

Other surveys of media conditions in Hong Kong help to place the environment within a global context, including those conducted by Reporters Without Borders. Hong Kong’s ranking within that organization’s Press Freedom Index fell from 73 in 2019 to 148 in 2022, between the Philippines and Turkey in the rankings.⁸⁰ In 2002, Hong Kong was ranked 18th globally, the highest score awarded within Asia.

Similarly, actions of journalists themselves point to a significant change in their perceptions of the space for free and open reporting. The Hong Kong Foreign Correspondents Club did not offer its annual Human Rights Press Awards in 2022, with the club president, Keith Richburg, citing “significant areas of uncertainty and we do not wish unintentionally to violate the law.”⁸¹

Changes in corporate registry practices in Hong Kong have also been underway since investigative reports have emerged concerning the wealth of mainland officials and their families, with some of the first changes proposed in 2013.⁸² The net result of these changes implemented since 2021 have made it more difficult for independent researchers and investors to identify shareholders of companies registered in Hong Kong. Some exceptions have now been granted for law firms and accounting firms in conducting due diligence and complying with know-your-customer policies for compliance purposes.⁸³

The next immediate threat to free information flows in Hong Kong is the consideration of a “fake news” law, discussed publicly by then-Chief Executive Lam in 2021, which would give the government broad powers to limit the publication of information it finds objectionable, or “misinformation, hatred, and lies.⁸⁴ Hong Kong authorities had reportedly hired a consultancy in order to examine potential options for the law.⁸⁵

The risks to the business environment and to the financial industry can be defined both narrowly and expansively. Narrowly, censorship in media and a limited publication of competing views can easily expand from political topics to economic and business media. More broadly, without a media environment in which journalists are able to work effectively within institutions protecting their right to report freely, all forms of reporting and information flows will be threatened, including those necessary for the operation of financial markets. In mainland China, investigators engaged in due diligence concerning firms’ potentially fraudulent disclosures have occasionally faced arrest and prosecution under state secrets, corruption, or defamation laws.⁸⁶ In Hong Kong, the media environment is already tightening and the scope for quality journalism is narrowing. There are growing risks that the reporting necessary for transparency in business or financial markets will be undertaken by fewer outlets and fewer journalists in the future. And beyond journalism, there are growing risks to the transparency and accessibility of broader flows of information required for operating a modern economy and financial system, including basic reporting of economic data and corporate financial results.

Data security

The National Security Law introduces new concerns for international businesses operating in Hong Kong concerning corporate data and intellectual property, in addition to potential duties to clients and customers to maintain privacy. The law permits Hong Kong authorities to conduct surveillance and intercept communications in cases related to national security, in addition to searching electronic devices or data servers.⁸⁷ Hong Kong authorities also can compel service providers to divulge information concerning their customers and clients in cases related to national security. The Implementation Rules of the National Security Law issued on July 6, 2020, outlined the police’s ability to search National Security Law suspects’ phones and online speech as well as freeze their assets without a warrant.⁸⁸ National security authorities can potentially compel the deletion of data or customer information.

The decision-making authority driving the selection of these cases remains the Committee for Safeguarding National Security—without any oversight or judicial review of its decisions.⁸⁹ The trend in data security is similar to the changes throughout Hong Kong, as political norms have replaced legal and institutional constraints on government authority.

There are obvious practical implications for businesses operating in Hong Kong, including financial service providers. Intellectual property and trade secrets are potentially at risk of disclosure. It is arguable whether these types of corporate information were “safe” before the promulgation of the National Security Law in Hong Kong. But the law itself now provides the legal framework in which such information can be accessed by Hong Kong authorities, even without the knowledge of the companies involved. Firms have few legal remedies to shield data from authorities under national security investigations when it is requested or compelled, and this marks a notable change from the previous legal framework in Hong Kong.

For international firms prioritizing their clients’ privacy and protection of personal information, the change in Hong Kong’s operating environment likely requires different measures to segment data storage in order to maintain commitments to customers and users. The extraterritorial nature of the law creates additional risks in that a company’s employees in Hong Kong could face criminal liability if they refused to provide data concerning a client or customer of the company in another country, if the powers of the National Security Law were invoked. There are clear risks for any information service provider. Shortly after the National Security Law was imposed, the New York Times, for example, relocated significant proportions of its digital news operations in Asia to Seoul from Hong Kong.⁹⁰

Furthermore, if a state-owned firm in China competing with international firms saw an advantage in accessing data held by a multinational firm in Hong Kong, the National Security Law would provide the legal authority with which to obtain that data, with potential criminal penalties for the firms attempting to protect it. Merely segmenting data services between Hong Kong and the rest of the world does not entirely reduce these risks for firms. Before the National Security Law was in effect, firms often stored data concerning their mainland operations in Hong Kong, before using it in regional or global offices.⁹¹ This effectively meant that any controls on data sharing between Hong Kong and the rest of the world were the most important consideration for foreign firms, and historically, these were limited. The National Security Law creates new reasons for firms to limit that cross-border data transmission to reduce legal and reputational risks.

The data security risks become even more complex when considering cross-border data flows between Hong Kong and mainland China, and the overlap of legal restrictions on data transfers. Simply put, multiple legal frameworks appear to be in place in Hong Kong regarding data security, and firms cannot easily know if they are in compliance with the law or not. China also passed a new Data Security Law in 2021, detailing several different standards for protection of data and preventing cross-border export of data according to these classifications, related to how they affect China’s own national security. Initial public offerings in Hong Kong of Chinese firms are presumably still subject to those same controls and reviews by the Cyberspace Administration of China (CAC), before data concerning Chinese firms can be made public in the event of an initial public offering of equity.⁹² In addition, Beijing has passed a Personal Information Protection Law (PIPL) in 2021, which is more expansive than Hong Kong’s own Personal Data Privacy Ordinance, which was implemented only in 1996. The controls on cross-border data flows in China’s Data Security Law have not been imposed in Hong Kong at this point, or between Hong Kong and the rest of the world, but similar restrictions on data exports are possible in the future.

The risks to firms’ data security in Hong Kong remain difficult to define, but should be viewed in the context of the broader changes in the legal and institutional structures in Hong Kong, with greater authority vested in national security-related institutions. Managing data in Hong Kong after the passage of the National Security Law requires monitoring overlapping legal risks from multiple jurisdictions, as well as reputational risks associated with management of client or customer information.

Most of the risks now facing businesses operating in Hong Kong have risen significantly since the National Security Law was implemented in June 2020. Most are related to the vague definition of “national security” and the newfound inability to challenge Hong Kong or mainland authorities’ interpretations of whether or not a particular action involves security risks to the Chinese state. Institutions that could limit government authority through independent oversight, independent press coverage, or via legal channels are facing new obstacles in operating in Hong Kong. And as the harsh implementation and rapid reversal of COVID-19 restrictions in Hong Kong demonstrates, changes in the political climate in Beijing have become the primary motivating force behind critical governance decisions in Hong Kong.

All of these changes leave businesses with a different set of political variables to assess and risks to manage in operating in Hong Kong now and in the future. As political norms in Beijing are increasingly important in shaping outcomes in Hong Kong, particularly in the expanding universe of security-related matters, businesses must consider avenues beyond Hong Kong’s traditional legal and institutional channels to defend their interests.

Recommendations

While governments have already taken some actions to respond to the legal and institutional changes in Hong Kong, the business community also has some agency in mitigating their own risks. The recommendations outlined here are not designed to pursue a particular policy agenda, but are offered as suggestions for how firms can manage some of the risks associated with changes in Hong Kong’s legal and institutional structures.

The business community should speak collectively, and approach outreach to Hong Kong authorities as a political campaign, rather than a more traditional government relations effort. One of the most significant elements of leverage foreign businesses hold over Hong Kong authorities and Beijing is the fact that Hong Kong must protect its own public image as a major global financial center. This means that the perception that foreign businesses are comfortable and successful operating in Hong Kong is a key part of the government’s public messaging: it was exactly the reason for the financial forum organized in Hong Kong in early November. In turn, this requires Hong Kong authorities to acknowledge the importance of the norms underpinning Hong Kong’s competitiveness: faith in the rule of law, judicial independence, and free capital flows. It also increases the importance of the number of foreign employees working in Hong Kong, as a declining trend shows how some professionals are voting with their feet. The shift in regional headquarters out of Hong Kong, for example, provides an illustration of the changes in the business environment that ultimately will require a response from the Hong Kong government.

Engaging the Hong Kong government using collective lobbying on the basis of the norms that Hong Kong’s authorities value can help to slow the pace of change in the legal and institutional environment. Pushback from the business community was already effective at preventing the application of China’s anti-sanctions law in Hong Kong, and was similarly effective at delaying the implementation of separate national security legislation under Article 23 of the Basic Law.⁹³

With political norms now dictating the restraints on government action in Hong Kong, there are few institutional obstacles in Hong Kong’s current legal environment to the continued erosion of the rule of law and judicial independence. The obstacles to further changes in Hong Kong’s environment will be political, and collective lobbying and public relations by the business and financial community can shape the political calculus in Hong Kong and Beijing.

Collectively communicate to Beijing the consequences of uncertainty over Hong Kong’s status. Consistent with the logic of speaking collectively and approaching lobbying as a political campaign, the business community should use opportunities to communicate the consequences of uncertainty in Hong Kong’s status directly to Beijing officials, when possible. Businesses can link specific decisions about new investment or employment within the territory to the risks that have emerged since the imposition of the National Security Law. The financial community can collectively describe the potential consequences, for example, of changes in Hong Kong’s peg to the US dollar or new capital controls. Reinforcing rhetorical support for Hong Kong’s existing institutions can help to introduce some degree of caution or risk aversion in Beijing about continued changes in Hong Kong’s legal and institutional framework. Using alternative channels such as track-two or informal dialogues may be useful to communicate these messages, in combination with a more direct public campaign.

Invest in compliance infrastructure and develop risk mitigation strategies. Companies and financial institutions operating in Hong Kong are exposed to a growing number of compliance challenges. Lists of restricted individuals and corporations make constructing funds, managing portfolios, buying securities, and selling securities more cumbersome. Each of these activities requires operational oversight and concern with regulatory compliance. While constructing funds, portfolio managers must continuously monitor the growing list of restricted stocks to avoid holding assets of firms sanctioned by the US government. Wealth managers must develop a deeper understanding of their clients’ relationships to avoid facilitating transactions with sanctioned individuals. Intermediaries facilitating trading of individual securities must also avoid trading restricted stocks or acting on behalf of restricted individuals.

Companies continuing to operate in Hong Kong should develop internal assessments of the costs and trade-offs between rising compliance-related risks and continued business opportunities, particularly concerning potential cross-border transfers of data, from Hong Kong to the rest of the world or between Hong Kong and mainland China. Financial institutions should develop contingency plans associated with high-risk clients becoming subject to sanctions by the United States or China, or certain firms potentially being targeted for disinvestment.⁹⁴

Monitor pro-Beijing media in Hong Kong and broader US-China political trends. Monitoring the political dynamics and expectations from both China and the United States regarding Hong Kong is of critical importance. Within Hong Kong, many of the political “targets” of national security investigations first appeared in Beijing-aligned media within Hong Kong, or were criticized as part of the paper’s editorial voice. The People’s Daily, the Communist Party’s newspaper, seldom discusses Hong Kong political issues directly, so when the territory is mentioned, it should assume outsized importance in terms of monitoring potential risks to any companies or individuals directly named. In the United States, policy changes targeting particular companies or intermediaries active in Hong Kong may be more transparent in some areas, but lists of targeted companies have still caught financial institutions by surprise, such as those designated for disinvestment due to links to the Chinese military.

More generally, monitoring the broader ebb and flow of the high-level diplomacy within the US-China relationship can be fruitful to understand when compliance and business-related risks may intensify. The timeframes before a high-level summit or multilateral conference may create less risk for companies operating in Hong Kong, because both sides will want to mitigate disruptions to the meetings themselves. Periods of higher tension in the relationship would also suggest higher risks to firms operating in Hong Kong and greater regulatory attention to their actions. These risks are obviously more acute when compliance requirements place businesses and financial institutions in awkward positions between sanctions or regulations in multiple jurisdictions. A more comprehensive politically minded risk-monitoring strategy can help business to scale resources accordingly.

Monitor key data concerning national security cases and outcomes, Hong Kong’s foreign population and participation, and outcomes within the legal system. Foreign participation is certainly not essential for Hong Kong’s legal and institutional environment to function effectively. But trends in foreign participation—those who can choose to enter or exit the system—are a meaningful indicator of changes in the operations of Hong Kong institutions. Similarly, the functions of Hong Kong’s legal system can be monitored objectively, in terms of the outcomes of cases where the government’s positions do not prevail, as well as the participation of foreign lawyers and judges within the legal system. These are data series that are easy to monitor and will continue to be reported, either by Hong Kong’s own statistical agencies or other external data providers (such as moving firms or professional associations). Any attempts to censor or remove certain data series from regular reporting by Hong Kong’s statistical agencies should similarly indicate a growing risk of expanding government authority in the areas covered by the data.

Similarly, trends in the frequency and targets of national security investigations are important indicators concerning the overall focus of Hong Kong’s law enforcement institutions and political authorities. Monitoring those trends is therefore essential to interpret potential changes in political norms in Beijing and Hong Kong. Declining investigations in certain areas or for certain types of offenses will likely indicate a change in authorities’ foci, and may provide more confidence that the political environment is easing. Similarly, a continued trend of prosecutions of cases spotlighted in pro-Beijing media in Hong Kong may be an indicator of a new political campaign that would generate new risks for businesses.

Emphasize the importance of independent media for Hong Kong’s future. In the course of lobbying and pushing back against further changes within Hong Kong’s legal and institutional structures under the National Security Law, the fates of independent media outlets assume outsized significance. Companies should emphasize that “fake news” laws or further crackdowns on media outlets would endanger the flow of information necessary to conduct commercial and financial transactions, and would create new difficulties for companies to respond appropriately to libel, slander, and disinformation. More generally, continued growth of the business community in Hong Kong invites and requires a growing pool of journalists and press outlets to monitor commercial, financial, and political activity in the city. Conversely, a shrinking pool of local and international journalists covering the city’s affairs will reflect the declining international significance of Hong Kong as a commercial and financial center. A shrinking scope for independent reporting will likely produce a shrinking financial industry in short order. And a recovering Hong Kong is inconsistent with a contracting public sphere for discussion, publication, and information flows.

About the author

Logan Wright is a Partner at Rhodium Group and leads the firm’s China Markets Research work.

Logan is also a Senior Associate of the Trustee Chair in Chinese Business and Economics at the Center for Strategic and International Studies. Previously, Logan was head of China research for Medley Global Advisors and a China analyst with Stone & McCarthy Research Associates, both in Beijing.

Logan’s research focuses on China’s financial system and credit conditions in shaping outcomes within China’s economy, as well as the policies of China’s central bank. Logan and the China Markets Research team monitor China’s real economic conditions, financial market developments, and future policy directions to gauge the influence of China’s economy on global financial markets. He is also the author of two reports on China’s financial system and the country’s longer-term economic trajectory, Credit and Credibility (2018) and The China Economic Risk Matrix (2020).

Logan holds a Ph.D. from the George Washington University, where his dissertation concerned the political factors shaping the reform of China’s exchange rate regime. He graduated with a Master’s degree in Security Studies and a Bachelor’s degree in Foreign Service from Georgetown University. He is based in Washington DC after living and working in Hong Kong and Beijing for more than two decades.

Acknowledgements

This report is written and published in accordance with the Atlantic Council Policy on Intellectual Independence. The author is solely responsible solely responsible for its analysis and recommendations. The Atlantic Council and its donors do not determine, nor do they necessarily endorse or advocate for, any of this report’s conclusions.

The author wants to thank Rogan Quinn for valuable research assistance during this project as well as the the leadership and staff of the GeoEconomics Center and the Global China Hub including Josh Lipsky, David Shullman, Charles Lichfield, Colleen Cottle, Jeremy Mark, and Niels Graham for their guidance and support. This report was made possible in part by the support of the Committee for Freedom in Hong Kong.

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In part, the shock came because Banga hails from the private sector. He is the vice chairman of the private equity firm General Atlantic and a former chief executive officer of Mastercard. Names floated as potential nominees in recent weeks favored current and former government officials. 

Banga’s nomination comes after the current World Bank president, David Malpass, announced that he will step down in June, ahead of the end of this five-year term. It also comes as the nearly eighty-year-old organization faces an array of global crises, from the COVID-19 pandemic and food insecurity to climate change. In fiscal year 2022 alone, the World Bank provided more than $104 billion in loans, equity investments, grants, and guarantees to partner countries and private businesses. 

Below, experts from our GeoEconomics Center answer the burning questions around this announcement. 

Do you expect any pushback on Banga’s nomination?

Other countries can put forward their nominees, and then the World Bank’s executive board will consider the nominees. The board has signaled they will decide by the end of May. However, per an informal agreement at the creation of the Bretton Woods Institutions in 1944, the United States has always chosen the World Bank president and has always selected an American. The Europeans are informally granted the privilege of selecting the head of the IMF (currently Kristalina Georgieva, a Bulgarian economist who was actually a former acting president of the World Bank herself). It is possible that other countries from emerging markets may try to oppose this arrangement this time around, but it seems unlikely that they could prevent Banga from ultimately being selected.

—Josh Lipsky is the senior director of the GeoEconomics Center.

There has been explicit signaling from the World Bank’s executive board, as well as a push from the nongovernmental-organization community, including ONE, that it’s time for a woman to (finally) helm the World Bank. There has also been an increasing sense that emerging markets and developing economies should have a stronger role in governance. With this nomination of Banga, we could very well see an alternative candidate emerge. 

—Nicole Goldin is a nonresident senior fellow with the GeoEconomics Center and the global head of inclusive economic growth at Abt Associates.

What does Banga’s nomination reveal about how the Biden administration views the World Bank?

The US nomination of Banga as the next president of the World Bank seems to convey the priorities the Biden administration expects from the institution going forward. Besides sharing the administration’s concerns about mobilizing resources to combat the effects of climate change, Banga brings to the table his track record as a successful chief executive officer of Mastercard, skill in mobilizing public and private capital, and experience doing business in developing countries. These skills and knowledge are important in leading the World Bank in the period ahead. 

—Hung Tran is a nonresident senior fellow with the GeoEconomics Center and a former IMF official.

Selecting a former leader of a major international company (which is not the typical mold for a president) suggests that the United States is focused as much on internal reform of the bank as it is on changing World Bank lending policy on climate and China. Reforming the inner workings of the World Bank has been a perennial mission for the institution’s presidents, and it’s unclear if Banga will have more success than others. 

We have done work on this issue at the Atlantic Council through our Bretton Woods 2.0 project, and what we show is that the World Bank’s ability to lend effectively to countries around the world ties directly to how it is structured internally.

—Josh Lipsky

What is the most pressing issue the next World Bank president will face?

The next World Bank president will have to contend with compounding crises: COVID-19, climate change, and conflict. The fallout from them includes learning loss, the reversal of gains against poverty, inflation and food insecurity, widening inequality between and within countries, and debt.

—Nicole Goldin

While the White House announcement of Banga’s nomination highlighted climate change among “the most urgent challenges of our time” facing the World Bank, there are several other issues that will require his immediate attention, notably the debt crisis that has enveloped dozens of countries since the COVID-19 pandemic hit. An estimated 60 percent of low-income countries are in, or at high risk of, debt distress, and a solution to their plight has been elusive because of an impasse in getting private-sector lenders and China (the World Bank’s third-largest shareholder) to agree to debt-restructuring deals.

The US government and Malpass have repeatedly criticized China over the issue, and the White House likely will expect Banga to keep up the pressure. But as China cuts its lending to developing countries, the World Bank will face calls to increase its commitment of funds not just to climate change programs, but in traditional areas such as infrastructure and poverty reduction.

—Jeremy Mark is a nonresident senior fellow with the GeoEconomics Center. He previously worked for the IMF and the Asian Wall Street Journal.

The post The big questions (and answers) about Ajay Banga’s nomination to lead the World Bank appeared first on Atlantic Council.

The international community must apply pressure so that China and private-sector lenders join in facilitating a collective haircut that includes all lenders.

As this year’s G20 chair, India clearly wants to position itself as the voice of the Global South, and resolving developing-country debt distress will serve as validation of its approach. The International Monetary Fund (IMF) estimates that 60 percent of low-income countries are in, or at high risk of, debt distress—double the 2015 level. However, the international community has struggled to offer a cohesive solution to resolve the most urgent cases, as the damage from COVID-19 continues to deepen, global growth remains slow, and high inflation continues.

The debt issue will be front and center when G20 finance ministers meet in India this week, with the Indian chair clearly prepared to turn up the heat on recalcitrant creditors. But representatives of the bondholders and some bankers who are major lenders to developing countries were expected to be absent from the discussions as the governments seek to resolve their differences. The meeting, however, can be a hopeful, fresh start.

India’s tongue-lashing of China, coupled with pressure on Beijing from the United States, World Bank, and IMF, brings unprecedented pressure to bear on a single sovereign lender. It is the inevitable result of Beijing’s decision to move at a snail’s pace to resolve the debt crisis that is resulting from its extensive lending—more than eight hundred billion dollars to developing countries between 2000 and 2017. But Chinese flexibility alone will not be enough to resolve the crisis. Comprehensive debt solutions will only become possible when the arm-twisting turns to private-sector creditors (such as powerful asset managers BlackRock and Aberdeen Asset Management and Swiss commodities giant Glencore) whose lending represents a large proportion of several countries’ debt.

Baby steps  

To be sure, there have been small steps in that direction. Creditor committees have been established for some of the worst-off debtors—Zambia, Chad, and Ethiopia—with varied results. Committees for Ghana and Sri Lanka are likely to follow suit. But those talks have dragged, offering little hope to nations on the brink of default. The scale and depth of debt issues faced in particular by many African countries require a magnanimous, multilateral approach from all classes of creditors

By some estimates, China’s collection of official and quasi-official lenders accounts for around 13 percent of Africa’s stock of private- and public-sector external debt, much of it made at commercial rates. The private sector, by contrast, accounts for about 40 percent. Multilateral lenders such as the IMF and World Bank, which lend at zero or extremely low interest rates, account for an additional 32 percent. That has led Beijing to call for those institutions to take a haircut as well—a position that lacks support from the rest of the international community, including some borrowers. That’s because multilateral institutions need to retain their preferential status as creditors since they are often the only agencies willing to provide financial assistance during a crisis—when other lenders are unwilling to help. This impasse underlines that there can be no meaningful resolution to developing-country debt distress without the active participation of all lenders.

Of all the failures in global cooperation in recent years, the debt crisis stands out as a sad example of government lenders and private creditors working at cross purposes. At the outset of the pandemic, the G20 appeared to have found a response to the rising cases of debt distress by agreeing to a Common Framework for Debt Treatment (which governs the negotiations in Chad, Ethiopia, and Zambia). Multilateral agencies stepped in to provide emergency loans and some debt relief, and G20 lenders agreed to suspend interest payments until the end of 2021. These actions provided some breathing room for countries at the front line of debt distress and gave creditors the opportunity to organize and resolve the most urgent cases.

But debt resolution in the post-pandemic era has turned into a four-legged stool comprised of national governments, the Paris Club coalition of long-time government lenders and multilateral agencies, China, and private creditors—and if two legs break, the whole stool collapses. That appears to be the case in a world with shifting power dynamics as the Paris Club, led by the Organisation for Economic Co-operation and Development, has found itself out-flanked by more powerful creditors such as China and the private sector. To be sure, the latter two have sharply varying objectives when it comes to debt resolution, and there is no suggestion that they are colluding. While the private sector hopes to extract favorable terms by way of debt repayments or an outright haircut, China’s position is more ambivalent: Geopolitics plays a role, and Beijing prefers having leverage over countries in debt distress. The end result is an international community that cannot deliver.

A study in contrasts

This is starkly evident in the cases of Zambia and Sri Lanka. US Treasury Secretary Janet Yellen met with Chinese Vice Premier Liu He (who is expected to retire soon) in Zurich before she visited Lusaka, Zambia’s capital city, last month to, as she said, “press for all official bilateral and private-sector creditors to meaningfully participate in debt relief for Zambia, especially China.” IMF Managing Director Kristalina Georgieva followed with her own trip to Lusaka, urging a “swift resolution.” Yet there are few overt signs of Chinese flexibility on the six billion dollars it is owed by Zambia. Meanwhile, private holders of Zambian Eurobonds, who account for about 20 percent of Zambia’s external obligations, have largely sat on their hands while the governments try to work out their differences—a stance that hasn’t helped the restructuring process across Africa.

In the case of Sri Lanka, while some major official creditors (India and the Paris Club) have provided financing assurances that are critical to unlocking an IMF loan, China has merely agreed to a two-year moratorium on debt payments, with no indication of any future forbearance. Private-sector creditors—who represent about 40 percent of the country’s outstanding debt—have pursued a more constructive approach, with one group writing to the IMF earlier this month committing to “design and implement restructuring terms.”

Why is the private sector apparently being more cooperative with Sri Lanka than Zambia? In private conversations, bankers say that Sri Lanka has better credit credentials and should be judged as a middle-income country on its capacity and ability to repay in the future. The implied conclusion here is that low-income African countries in debt distress have neither the capacity nor the means to recover from the pandemic-induced shock. If these perceptions are widely held, it is a scathing indictment of the global financial architecture, which incentivized poor countries to reduce aid dependence and encouraged them to access international capital markets to finance their development needs.

What’s next in this never-ending saga of debt and distress? The G20 will try to work out some solutions this week. Two things need to happen to signal to the international community that this year’s G20 will not be business as usual.

First, the G20 has to decide if a new sovereign debt roundtable convened last week by the World Bank and the IMF, which includes China, is a more effective way of addressing debt restructuring cases compared with the Common Framework, which appears to be mired in bureaucratic reporting requirements that have little bite. The private sector’s enthusiasm to participate in the Sri Lanka debt negotiations offers a helpful model for addressing existing and future cases of debt distress, with a focus on a few large individual institutions driving the agenda rather than cumbersome industry associations.

Second, the G20 will have to delicately make a choice regarding China’s role. If the private sector and Paris Club creditors speak with one voice, Beijing may feel isolated enough to come to terms with aligning with the international community.

A new approach is needed, but the G20’s track record of stalemate on difficult issues over the past decade hardly offers confidence. In the absence of a breakthrough, it will be up to the individual governments, led by India, to maintain public pressure. That would likely prove less effective, but Beijing has already shown it will respond to pressure on some debt-related issues—for example, when it agreed to the Common Framework.

The international community needs to build momentum in 2023 for a comprehensive debt resolution. After initially facing the risk of a lost decade of development due to the pandemic, many low-income countries in Africa now face the prospect of several lost decades. To prevent this, the private sector and China need to be shamed into joining forces with the rest of the G20 and do what India has wisely suggested—get a haircut.

Vasuki Shastry, formerly with the IMF, Monetary Authority of Singapore, and Standard Chartered Bank, is the author of Has Asia Lost It? Dynamic Past, Turbulent Future. Follow him on Twitter: @vshastry.

Jeremy Mark is a senior fellow with the Atlantic Council’s Geoeconomics Center. He previously worked for the IMF and the Asian Wall Street Journal. Follow him on Twitter: @JedMark888.

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What are Sweden’s main policy priorities during its EU Council Presidency?  How will Sweden, as one of Europe’s more free trading nations, navigate the turn to industrial policy in Europe and lead the charge in boosting European competitiveness?  What ways is the European Union changing to adapt to an uncertain geopolitical and economic future? How influential is the EU Council Presidency and how will Sweden lead in Europe on issues, including Ukraine, the green transition, trade, security and democracy?

On this episode of the #AtlanticDebrief, Ben Judah sits down with Cecilia Malmström, Nonresident Senior Fellow at the Peterson Institute for International Economics, to discuss the main issues facing Europe as Sweden embarks on its EU Council Presidency. 

You can watch #AtlanticDebrief on YouTube and as a podcast.

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The post #AtlanticDebrief – What’s on the Swedish EU Council Presidency agenda? | A Debrief with Cecilia Malmström appeared first on Atlantic Council.

A joint report by the Atlantic Council’s Adrienne Arsht Latin America Center, the University of Texas at El Paso’s Hunt Institute for Global Competitiveness, and El Colegio de la Frontera Norte.

Executive summary

The announcements and commitments made at the North American Leaders Summit in January 2023 reiterated the importance of North American competitiveness, inclusive growth and prosperity, and the fight against drugs and arms trafficking.¹ To achieve the goals and deliverables established during the summit, it is critical that the US-Mexico border be managed and perceived as an essential contributor to national, binational, and regional security and economic development.

A more efficient US-Mexico border has the potential to reduce border crossing times for commercial and noncommercial vehicles, generating positive externalities for the United States and Mexico including enhanced security and economic growth.² This report – the second in a two-part series – outlines the economic impact of reduced wait times at the border, focusing on the costs and benefits for border states in both countries.³

This report shows that a mere 10-minute reduction in wait times – without any additional action – can create thousands of Mexican jobs, grow the gross domestic product (GDP) of several Mexican states, and generate hundreds of thousands of dollars in new spending in the United States. Ten minutes is then hopefully the starting point for even shorter wait times and even greater economic gains and job creation.

More precisely, increasing border efficiency by 10 minutes can result in more than 3,000 additional jobs across Mexico’s six border states while increasing their combined GDP by 1.34 percent.⁴ Additionally, this reduction would allow for an additional $25.9 million worth of goods to enter the United States every month and lead to $547,000 in extra spending across the United States’ four border states.⁵ A forthcoming standalone short report will evaluate the final destination of traded goods and the economic benefits for states beyond the border.

In terms of Mexico’s border states, Tamaulipas would see the greatest growth in GDP (1.9 percent), followed by Baja California (1.6 percent) and Chihuahua (1.5 percent). Overall, this would generate a $2.2 billion increase in GDP and a $167 million increase in intermediate demand and a $3.2 million increase in labor income across Mexico’s six border states.

A 10-minute reduction in wait times would also lead to an average of 388 new loaded containers entering the United States from Mexico monthly. This translates to $25.9 million worth of cargo crossing through the United States’ four border states (Arizona, California, New Mexico, and Texas), a figure identified in the part-one of this study.⁶ New research shows that approximately 222 (57.2 percent) of these containers would enter via Texas ports of entry, carrying $17 million in cargo every month.

Separately, the 10-minute reduction in wait times would lead to 5,020 additional noncommercial monthly crossings, resulting in $547,000 in extra monthly spending by families and individuals traveling from Mexico to the four US-border states every month. The model estimates that these individuals would spend an additional $256,000 in California alone, representing nearly 50 percent of the total increase in spending. The clothing retail industry would experience the greatest gains across the board, with $132,000 in additional annual revenue from streamlined noncommercial crossings.

Results were informed by engaging local and regional stakeholders in roundtables, focus groups, and one-on-one interviews to identify areas for practical improvement in border management. These include investing in technologies, infrastructure, management, staffing, and supply chains. For instance, deploying high-tech screening technologies further away from ports of entry would facilitate a greater and faster flow of cargo and passenger information. Similarly, a collaboration between the United States and Mexico to develop joint, decentralized tools for border management and processing could ensure a more efficient flow of legitimate cross-border traffic while detecting illegal activity. Improvements in infrastructure and an increase in personnel staffing ports of entry would prevent bottlenecks and decongest queues that regularly spill over onto interstate highways and local roads.

While this report outlines the potential economic impact of a more efficient US-Mexico border for the border region, it also identifies new spaces for growth and new questions to be asked, studied, and addressed. For example, a lack of data in non-border Mexican states makes it difficult to estimate what the impact of enhanced efficiency in non-border inspection points would be for overall binational commerce and within each individual state. Similarly, limited US data exists to determine the final beneficiaries of new economic activity. New, reliable data is essential to understand the greater implications of streamlined border processes and tools in the United States and Mexico.

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Issue Brief Dec 15, 2022

Road to the tenth North American Leaders’ Summit: Spotlight on competitiveness and supply chains

By María Fernanda Bozmoski, Jacob Kaufhold, and Isabel Chiriboga

North American competitiveness and supply chains are at an inflection point. The three leaders must take the momentum of the last meeting and continue to advance key priorities. In an increasingly complicated global context, close collaboration and partnership on all fronts is key.

Report Sep 27, 2022

The economic impact of a more efficient US-Mexico border: How reducing wait times at land ports of entry would promote commerce, resilience, and job creation

By Alejandro Brugués Rodríguez, John Byrd, Noé Arón Fuentes Flores, David Gaytan, John Gibson, Camila Hernández, Mayra Maldonado, Jason Marczak, Jorge Eduardo Mendoza Cota, Roberto Ransom, and Ignacia Ulloa

Improvements in border management and the adoption of new technologies at the US-Mexico border have the potential to enhance border security and generate economic benefits for the United States and Mexico through expedited flows of goods and people.

Economy & Business Latin America

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This was the fourth in a series of four events for the first cohort of the WIn (Women Innovators) Fellowship[SA1]  launched in Saudi Arabia led by the Atlantic Council’s empowerME Initiative in cooperation with Georgetown University’s McDonough School of Business with support from US Embassy Riyadh, PepsiCo, and UPS. The American Chamber of Commerce Saudi Arabia’s Women in Business Committee is the program’s in-person event partner. The yearlong program, which is taking place from March 2022 – March 2023, enables more than thirty Saudi women entrepreneurs to enhance their networks, gain practical knowledge, and develop US-Saudi people-to-people and business ties that will help them scale their business locally, regionally, and globally.

The key points from the discussion are summarized below.

Learning how to accept failure as part of the learning process:

• Dalal Almutlaq reflected on the times she has failed and how to move forward from them, saying: “if you just reflect and learn from those mistakes, that’s how you grow. That pain you get from failure is what helps you become more resilient, it teaches you to surpass difficult times. It’s always difficult times that teach us and helps us how to grow. I don’t like the word failure…it’s just lessons learned.”
• Helen Al Uzaizi talked about learning to accept that failure will be a constant: “I think the minute we recognize that life happens and things happen that are beyond our control, absolutely [we need] accountability, but [we need to] recognize that life happens. Sometimes it might just be that life happened, not necessarily a failure…once you’ve failed as many times as I have, and many of us have, you start to realize that it’s all just part of life and the process.”

How to find the balance between taking bold risks and being reckless:

• Hela Cheikhrouhou explained how to mitigate risk: “You don’t take reckless risk as such, but you have to be willing to lose for the greater impact that you’re hoping to achieve and of course, it has to be relatively well structured to increase the chance of success, because with success comes impact. However, if it is a failure like others today have said in an inspiring manner; we learn from those lessons.”
• Thereshini Peter talked about how sharing the responsibility of risk-taking makes it less intimidating: “The biggest part – depending on how big or small the risk is – the environment is different in how you tackle that. If there is a large risk and high reward, the level of assessment goes very deep. I think the big part in a larger organization is that the shared responsibility meets certain areas. But also, there is deep accountability to make sure that we grow and learn from that.”
• Al Uzaizi spoke on the importance of risk when pursuing an entrepreneurial path: “One of the key entrepreneurial mindset characteristics is risk-taking. And I think without being a risk-taker you really cannot be an entrepreneur. You can be someone that has a side hustle, and that’s a wonderful thing. But really entrepreneurship is about risk-taking.”

The kind of culture that incentivizes teams to be more creative and risk-taking:

• Almutlaq described her passion for creating a work culture that promotes risk:“You can make a mistake as long as you’re held accountable for it, if you know how to come ask for help if you need help. That safe environment for the team is what is core for pushing creativity because you need that safety net for creativity.”
• Kelly Blackaby noted that mangers should focus on inspiring their team through several key points: “I think in terms of focusing on that team, it really is about the freedom to be creative…your flexibility [offering hybrid or remote schedules]…and your reward policy; making sure that people are really motivated to keep trying.”

Steps that can encourage women to take risks while having an entrepreneurial mindset:

• Blackaby stressed the importance that mentors can have on your career: “I think a lot of women do suffer from imposter syndrome and sometimes it’s really hard to believe in yourself, but I think if you can access that encouragement either from peers, managers, or from outside organizations, [they] can really support you to believe that you can do this.”
• Cheikhrouhou stated that a key way to encourage more women to have an entrepreneurial spirit is to accept failure as an option: “I come from a conservative family; you’re supposed to be perfect…mistakes are not well tolerated, and that’s the opposite of entrepreneurial behavior…yes you do your best but sometimes [the timing and market] are wrong”.

The most important advice to give to an aspiring entrepreneur:

• Almutlaq spoke about how not taking the first step of starting is a failure in itself: “We were taught that an ‘F’ is wrong and ‘you cannot fail in university or at your job’…you’ll never know if you’re failing or not unless you take that first step.”
• Al Uzaizi talked about the importance of teaching youth to reframe their mindsets about traditional work culture: “We don’t teach [children] failure, and we don’t teach them how to fail because you cannot. But what we do is reflect: what worked, what didn’t and what risk did you take? When you do that, you’re automatically reflecting and building that resilience to failure and risk.”

How attitudes towards entrepreneurs have shifted in recent years:

• Al Uzaizi reflects on how differently society views entrepreneurship since she started her company in 2016: “Last week I got an email from the Ministry of Education in the UAE about entrepreneurship innovation and that went out to all schools and we concluded a program with the Ministry of Economy, which was entrepreneurship. This was never the case a few years ago. This is a testament to how much people believe in the development of these skills because it is the future.”

The importance of anti-fragility in the workplace:

• Blackaby spoke about the importance of adapting the mindset of anti-fragility: “The concept of anti-fragility is to think about how you grow and flex with stress…it’s a concern because organizations that cannot adapt to that are going to swept by organizations that can…having flexible policies and procedures in place that help you to adapt.”

How large organizations can promote effective risk taking and learning from their mistakes:

• Peter speaks from her personal experience working at multiple large organizations: “It is extremely important [for large companies] to be able to covet and to allow themselves to actually change and take risk…the difference with large corporations and the change that they are doing, is that they do see that they need to stop being so bureaucratic and start being more flexible.”

Amira Attia is a Program Assistant with the Atlantic Council’s empowerME Initiative at the Rafik Hariri Center for the Middle East.

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In the second half of 2022, China veered from one extreme to the other, with carefully choreographed control followed by sudden turmoil. In October, President Xi Jinping was elevated to an unprecedented third term, underscoring his iron grip on China’s Communist Party and the country. Two months later, the chaotic abandonment of zero-COVID measures, in place for nearly three years, triggered a nationwide health crisis. Throughout, the Chinese government has continued to claim that the path it has chosen for China’s economy and its people is the only right one.

Nevertheless, China’s economic weakness is pushing leadership to strike a more business-friendly tone. In recent months, Chinese officials have been reassuring a private sector hammered by regulatory crackdowns and rolling out the welcome mat for foreign investors who have been turned off by years of draconian COVID lockdowns. The defining question of 2023 will be whether the shift in policy and rhetoric is merely a short-term tactic by the Chinese government to shore up growth. So far, evidence of a more meaningful commitment to structural reform is hard to find.

The bottom-line assessment for H2 2022 shows that Chinese authorities were active in five of the six economic clusters that make up the China Pathfinder analytical framework: financial system development, competition policy, trade, direct investment, and portfolio investment. There were fewer developments in the innovation cluster, though we are watching to see if Beijing can muster a response to profound semiconductor controls imposed by the United States on China in October 2022. In assessing whether China’s economic system moved toward or away from market economy norms in H2, our analysis shows a mixed picture.

This issue of the China Pathfinder Update looks ahead to China’s post-COVID era and analyzes the “two confidences”—that of domestic consumers and businesses, and foreign investors—the Chinese government needs to rebuild in order to restart the economy. The end of zero-COVID restrictions and the resumption of travel and services sector activities for Lunar New Year will bring about an improvement in China’s economy—especially the consumer-facing segments—in the first half of 2023. However, an end to zero-COVID does nothing to remedy long-running structural problems. Distress in the property sector, lingering unemployment for new graduates, and weak growth in disposable income all stand in the way of a rebound. China’s charm offensive on the international front will also require follow-through, as foreign governments and investors await evidence of the country’s commitment to structural reforms.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The unitary globalized economy no longer exists. Driven in significant part by security considerations, a new and more diverse globalization is both required and being built. The transition is ongoing, and its final form is yet to be determined.

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Where is Europe headed on industrial policy? Could the loosening of state aid rules risk fragmentation of the EU’s single market? How can the European Union manage the risks associated with decoupling from China? What plans does the European Union have in place to diversify its chips industry?

On this episode of #AtlanticDebrief, Jörn Fleck sits down with Centre for European Reform Senior Research Fellow Zach Meyers to discuss the latest developments in the transatlantic industrial policy debate.

You can watch #AtlanticDebrief on YouTube and as a podcast.

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Jörn Fleck

Senior Director

Europe Center Transform Europe Initiative

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Providing expertise and building communities to promote transatlantic leadership and a strong Europe in turbulent times.

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Russia’s 2022 invasion of Ukraine, as well as G7 sanctions imposed in retribution, have expedited Moscow’s pivot to Beijing. While Russia’s economic reorientation has most prominently played out in its goods trade, particularly with hydrocarbons, Russia’s financial relationships have undergone a parallel shift. As a result, Russia’s economy is now heavily reliant on Chinese capital. Though this may be favorable for Russia now, overreliance on Chinese finance will reinforce Russia’s status as the junior partner in the two countries’ relationship.

Chinese authorities do not publicly report their banks’ consolidated positions, but alternative data sources suggest that Chinese lenders may have maintained or extended additional credit to Russian borrowers in the aftermath of Russia’s invasion of Ukraine. One notable example is syndicated lending—a type of loan provided by a group of lenders and preferred by international financiers, as it allows them to share risk. Syndicated lending data suggests loans originating from Chinese banks now account for nearly half the global total of syndicated loans to Russia. In the coming months, this overreliance will likely grow as financial institutions in other parts of the world, namely Europe, halt new lending to Russia and refuse to refinance or roll over existing loans, with many banks pulling out of the country altogether. 

Russia first identified China as a viable source of alternative financing in 2014 after Moscow found itself blocked or ostracized in the Western financial hubs of London and New York. Hoping to instead rely on Shanghai and Hong Kong, Russia began to more intentionally engage Beijing to foster a stronger economic and financial relationship. The Kremlin lifted political barriers such as a ban on asset purchases in the natural resource sector and investment in infrastructure contracts in sensitive industries like roads and railways. Beijing, in turn, encouraged its firms to invest or enter the Russian market. Borrowers and lenders followed, and the portion of Chinese lending in the Russian economy tripled from where it stood in 2014 to 2022. 

Although Moscow began to look elsewhere for its financing, not all European financial institutions saw the writing on the wall. While the UK, France, and Germany viewed Russia’s 2014 annexation of Crimea as an inflection point in their relationship with the Kremlin and began to reduce their exposure to Russia, Italy, and to a lesser extent Austria, did the opposite. Driven by a combination of high returns and a domestic political climate with more favorable views towards Russia, Italian banks increased their syndicated loan exposure to Russia from around 4.6 percent in the months following the seizure of Crimea to around 7.5 percent going into Q3 2022. Italy’s banking sector, led by the banking group UniCredit, is now forced to deleverage itself from Russia by writing off its cross border exposure, swapping loans with Russian banks, and identifying international buyers for its loans to Russian clients. 

Beware of financial overreliance 

While the Kremlin’s eastern pivot worked well in the aftermath of 2014 when the Chinese economy was booming, today Shanghai and Hong Kong may be less willing to fill the new gaps that are opening as Western lenders exit the Russian market. Chinese lending is typically shaped by the geopolitical and economic objectives of the Chinese Communist Party. In 2014, this benefited Russia. The Chinese economy was growing at upwards of 7 percent, its financial sector was flush with capital, and its government encouraged its firms to look internationally via a “going out” strategy. 

The opposite is now true. In 2022, China grew at a meager 3 percent—well below its target rate of 5.5 percent. Under Beijing’s direction, its financial sector is now focused on ensuring ample liquidity in domestic markets and low funding costs for businesses. Consequently, Chinese international lending has dropped by around 14 percent from the start of 2022 to July, when the latest data is available. In the short term, Beijing is far more likely to direct its banks to support its own ailing economy to meet its GDP target than to shore up any gaps opening in Russia. 

In the medium to long term, however, Chinese lenders will likely increase their exposure to the Russian economy. As western lenders shun the Russian market, Shanghai and Hong Kong will be able to extract new deals with more favorable terms for China. Russia could provide a friendly market for Beijing to test new financial policies it will eventually need to implement as it opens its own financial system to the rest of the world. 

While China remains Russia’s best option as a source of finance, Moscow is becoming overdependent. Even with a strong Chinese economy, the Chinese financial sector’s willingness to cover all gaps left by other lenders remains unclear. State-owned banks dominate the Chinese financial sector, and these banks are subservient to Beijing’s political interests. If they provide a foreign company access to credit, this implies that the project meets a strategic or economic interest for China. While this may be fine for a Russian firm hoping to raise capital to develop a new oil field for export to the Chinese market, if the final buyer resides in India or Turkey, Chinese banks may lose interest. Without a diverse lending base, otherwise viable projects will go unfunded. 

China’s dominance in Russian external financing will also amplify Beijing’s leverage in its relationships with Moscow. As the relationship becomes increasingly asymmetric, China will be able to force Russia to accept previously untenable concessions. China is already using this influence to its advantage in negotiations on a new pipeline to connect Siberian gas fields to China by asking for a price structure that benefits Chinese consumers, additional legal allowances that benefit Beijing, and, naturally, the use of the renminbi as the contract currency.

While Putin and Chinese President Xi Jinping present their countries’ partnership as a “no limits” friendship, Russia’s invasion of Ukraine has cemented Russia’s status as the junior partner of an increasingly one-sided relationship. As the West decouples itself from Russia, Moscow will increasingly rely on Beijing, not just for financing but a range of areas including trade, technology, and international diplomatic support.

Niels Graham is an Assistant Director with the Atlantic Council GeoEconomics Center focusing on the Chinese economy.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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Hearing on

“Examining Outbound Investment”

September 29, 2022

Thank you, Chairman Brown and Ranking Member Toomey as well as your hard-working staff for inviting me to testify on outbound investment, its implications for national security, and factors to consider if Congress decides to move forward with legislative proposals around screening or controlling such investments. It is an honor to speak with the committee today.

Let me clarify from the outset that the views expressed in my testimony today are my own, and do not necessarily reflect the view of my employer, Indiana University, or of the Atlantic Council, where I am a non-resident fellow.

I speak today as someone with both an academic and a government background. I am an associate professor of international studies at the Hamilton Lugar School at Indiana University. My research expertise includes the politics of investment liberalization, investment attraction, and the intersection of national security and investment policy, most notably inbound investment screening.

As a Council on Foreign Relations International Affairs Fellow, I worked as a policy advisor and Committee on Foreign Investment in the United States (CFIUS) staffer in the Office of Investment Affairs at the Department of State from August 2019 to August 2020.

And, in my capacity as a fellow at the Atlantic Council I have had the distinct pleasure of co-leading a policy working group on outbound investment controls with Emily Kilcrease of the Center for New American Security. Emily and I recently published a policy brief where we lay out our suggestions for how to design an outbound screening mechanism. Much of my comments today draw directly from that co-authored report.

The point of today’s hearing is to take a step back from tactical issues of policy design to instead:

1. lay out the potential national security risks that outbound investment may engender; 
2. identify existing gaps in US authorities to adequately address these risks;
3. develop overarching principles to guide the development of any additional authorities related to outbound investment controls that the USG, including Congress, may pursue.

The central guiding point of my testimony is this: While there are a set of national security risks that some kinds of outbound investments generate, there remains a great deal of uncertainty about the size of the problem and the cost of potential solutions.

Given that the openness of the US economy has been a major driver in our prominent position in the global innovation economy and therefore our national security, any attempt at addressing the risks of outbound investment must equally consider the potential unintended consequences of action. Smart policy will be narrowly scoped to national security, rooted in fact, tailored to the technologies of greatest concern, mindful of the limits of de facto enforcement power, non-duplicative of existing tools, and attuned to the need to act multilaterally. This is not to say that controls are not desirable or feasible, but that any action should be carefully measured.

I want to use the remainder of my time this morning to offer five observations that Congress should keep in mind while contemplating outbound investment controls:

First, there are gaps in the United States’ ability to address national security risks associated with some kinds of outbound investment. Export controls can stop the flow of US technology to these activities. But active forms of US investment—particularly foreign direct investment (FDI) and venture capital (VC) can provide intangible benefits to the Chinese firms and industries in which they invest. The United States can cut off all economic activity between US persons and problematic entities through list-based sanctions programs. However, there are reasonable arguments for why narrowly scoped expanded review authorities are necessary to protect national security.

Second, Congress should resist temptations to use outbound investment screening for purposes other than national security. The United States has national and economic security interests that intersect, and sometimes conflict, with the outbound investment activities of US multinationals and investors in several respects. To be consistent with a broader and long-standing commitment to market openness, the authority to intervene in an outbound transaction must be limited to a fact-based national security risk assessment, as is the case with inbound investment through the CFIUS process. It is my assessment that any outbound screen should focus on national security risks associated with indigenous technology development in countries of concern.

Third, Congress should recognize the uncertainty that pervades this issue. Crucially, current data collection on US investment flows to China is not detailed enough to be able to assess the national security implications of individual transactions. This is one reason why I advocate for a notification regime to help scope the size of the problem. An executive order related to outbound screening is likely a good first step because it allows for more experimentation before committing to a statutory requirement. This mirrors the experience of CFIUS, which was first established through executive order in 1975 and gradually became a statutory requirement through a series of amendments to the Defense Production Act, starting in 1988.

Fourth, Congress should not assume that a mirror image of CFIUS will work for outbound screening. The enforcement issues associated with regulating the movement of investment abroad is more challenging to address than regulating inbound flows. In the CFIUS case, a prohibition is enforced by preventing a foreign entity from buying a domestic asset, which is subject to US regulation. For outbound transactions, the United States can impose penalties on the US entity implicated in the transaction. But enforcement options become much less palatable if a multinational decides to channel the otherwise prohibited investment through a third country. It is also easier to compel a US target of a CFIUS review to provide the committee with the sensitive non-public technical information often required to complete a risk analysis. Compelling similar information revelation from a foreign target in the context of an outbound review will be much harder. The People’s Republic of China (PRC) might simply prohibit the transfer of such information.

Congress should be clear-eyed about the compliance and enforcement challenges likely to arise from outbound investment review that are less problematic in the context of inbound review. It should only move forward with a screening concept if it is reasonably sure that it has adequate monitoring and enforcement capabilities to give the regulation teeth.

Finally, Congress should think in network terms when contemplating what technologies to work hardest to protect. An administrable outbound investment review system will need to be relatively narrow in scope. We should avoid a “boiling the ocean” mentality. A broadly scoped review is likely to generate substantial negative consequences for US companies’ competitiveness and capacity to innovate. Congress can narrow its focus while remaining maximally effective by examining technology chokepoints in supply chain networks where US firms currently have the advantage and where process and know-how are central to the production of these technologies. A recent Center for Security and Emerging Technology report mapped China’s technology chokepoints. It found that the technologies for which China has the least domestic capacity tend to be in areas with very high quality control specifications. These kinds of technologies are likely of high national security value, require substantial know-how to perfect, and have outsized follow-on effects to other technologies relevant to US national security. They are good candidates for review.

At the same time, the United States’ ability to leverage its network position depends on China being integrated to some degree into the technology network. Congress should be mindful to not control technology and outward investment so much as to push China out of the network entirely. Take semiconductors as an example. The sanctions alliance against Russia’s invasion of Ukraine has been highly effective at cutting off Russia’s access to advanced semiconductors. As National Security Advisor Sullivan recently stated, this has substantially degraded the Russian military’s capabilities.¹ However, if Chinese entities could fabricate advanced semiconductors without access to US and other alliance members’ technology, we would lose this powerful tool. Right now, many Chinese companies seem to prefer to use US technology rather than invest the capital and time necessary to develop their own solutions. But, if we cut them off from this technology entirely, or if we develop policies that create enough uncertainty about future access, they will have no choice but to develop critical technologies domestically.

Prudent policy must balance the national security imperative to deny countries of concern indigenous capabilities in technology of high national security import, while also avoiding an overly restrictive regime that would inadvertently further push Chinese entities toward self-sufficiency.

US investment in China

To determine the size of the problem, we must first gather basic facts about how much US investors are active in China, through what vehicles, in what industries, and for what purposes. According to surveys of the Bureau of Economic Analysis’s surveys of US multinational corporations activities abroad, US companies have accumulated about $118 billion in foreign direct investment positions in China.² This equates to about 1.8 percent of all US FDI abroad. For comparison, 61.4 percent of all US FDI abroad is located in Europe. Measurement of US assets abroad, rather than FDI positions, suggest US multinationals have roughly $779 billion in assets in China.³ US venture capital, which is usually not included in FDI figures, has invested about $60 billion into Chinese start ups since 2010. To place this figure in context, venture capital activity in the United States over the same period was roughly $1.28 trillion.⁴

These numbers suggest that US investment in China remains relatively small compared to US investment activity at home and also compared to US investors’ activity overseas. Other argue, however, that evaluating the risks of such investment into China also requires attention to trends and to the specific activities to which US investors are contributing. On the first point, all measures of US investor activity suggest direct forms of US investment into China peaked between 2015- 2018 and have declined since then. The second point is harder to address given the data that are currently available. Data on sector specific investments provide some relevant information. US investments in theme parks, real estate, and consumer retail are not likely to have substantial deleterious effects on national security. Investments in some information communication technology businesses and activities—which was the sector that received the largest share of US FDI in recent years—could have security implications. But even sectors are too aggregated of a level of analysis to determine national security concerns. For example, investment in an enterprise software company serving the China market and investment in advanced semiconductor research and development likely have very different national security implications.

In other words, whether US investment in China poses national security concerns is best analyzed at the level of transaction, item, or activity rather than by aggregated investment values. And, currently available data do not provide enough insight to adequately judge the potential national security consequences of these investments because they do not provide detailed enough information about the activities of the investment target.

Defining policy objectives of a potential outbound screening mechanism

The United States has national and economic security interests that intersect, and sometimes conflict, with the outbound investment activities of US multinationals and investors in several respects. These include to prevent US capital from supporting firms implicated in China’s systemic abuse of human rights, to enhance the resiliency of critical US supply chains, and to address concerns arising from China’s indigenous development of technologies relevant to US national security.

At the same time, an open, market-based economy remains a key source of economic and technological strength of the United States. The fungibility of capital and the global mobility of firms limits the ability of unilateral US actions to prevent capital, knowledge, and technological flows to countries of concern. Policy action in this space needs to balance justifiable national security restrictions with a broad commitment to an open, market-based economy that seeds and sustains technological innovation. Bureaucratically complex and resource-intensive authorities are likely to have negative effects on competitiveness and could encourage the most innovative and productive businesses to relocate to less restrictive jurisdictions. Authorities that are too broad or ambiguous may have the same effect. Additionally, rules that do not have clear enforcement mechanisms for non-compliance will be of limited value.

The United States should limit any outbound control measures to national security—rather than broader economic competition—policy objectives. Furthermore, it should focus attention at the nexus of the most pressing national security concerns and the areas where interventions are most likely to successfully impede the most problematic policy objectives of countries of concern. This entails strengthening existing authorities before creating new ones and finding opportunities to pursue multilateral coordination or action with allies and partners wherever possible. National concerns related to China’s indigenous technology development are those that can be most directly addressed through an outbound investment mechanism and represent a genuine gap in existing authorities. Human rights concerns and issues of supply chain resiliency are best addressed through other measures.

Human rights

The United States has several existing tools that can be used to address concerns related to the use of US capital or technology in facilitating human rights abuses. First, it can use the Non-Specially Designated Nationals Chinese Military-Industrial Complex Companies List (SN-CMIC) sanctions program to prevent US capital from contributing to Chinese companies operating in the surveillance technology or defense and related material sectors. Second, export controls—via the Entity List or other means—can effectively stop the flow of US technology to these activities, especially if the Export Control Reform Act of 2018 (ECRA) is amended to expand a prohibition on US persons from providing support to a “foreign military, security, or intelligence services.”⁵ The Uyghur Forced Labor Prevention Act is another example of authorities Congress and the executive branch can use to address similar concerns. 

Supply chains

Recent legislative efforts have coalesced around supply chain resiliency issues, which is not surprising in the context of Covid-19 and related supply chain disruptions. However, outbound investment screening is a poor tool for addressing supply chain restructuring. Because so much of the US supply chain is already offshore, policies addressing supply chain security must focus on how to move operations already in countries of concern back to the United States or onward to partners and allies. Blocking a proposed outbound investment on reshoring grounds would not provide the company attempting to offshore with the capability to succeed in the United States on commercially viable terms. In other words, screening would only address a symptom rather than the cause of offshoring.

Moreover, using outbound screening to address supply chain resiliency is likely to generate problematic legal issues as well as complicate economic and security cooperation with our partners and allies. Blocking a proposed outbound investment on issues of supply chain resiliency would require either: a) an outbound review mechanism to provide the president with the authority to block a transaction for reasons beyond national security, or b) a further expansion of the concept of national security in ways that would damage the United States’ reputation as an excellent place to start and grow innovative companies.

Expanding blocking rationale beyond national security would likely invite increased litigation from US firms subject to an investment prohibition. CFIUS largely avoids such litigation because courts provide the president with substantial deference in the area of national security. Prohibitions on other grounds will likely be easier to challenge in court, and could create lengthy and costly legal battles that would increase regulatory uncertainty, thereby reducing the United States’ status as one of the most desirable places to do business.

Further expanding the concept of national security also has important negative consequences. The first has to do with perceived legitimacy of US government action. While the public and industry mostly recognize the right of the US government to intervene in market activity that generates clear risks to national security, this support rests on common understandings of what is a reasonable claim to national security. Overuse of national security rationales to justify government intervention into private sector transactions decreases the public’s trust in the reasonableness of these claims. Eroding trust could lead to reduced voluntary compliance with the law, more creative work-around solutions, and a US public that is increasingly skeptical of US actions in the area of national security and economic policy.

Whatever the United States does with respect to outbound screening, we should be prepared for other countries to develop similar authorities. Outbound mechanisms focused on supply chain structures as an essential security issue and/or an economic resiliency issue that warrants prohibitory intervention could be used among our European allies and others in ways that would create substantial harm to US interests, including by making it harder to develop more redundancy and multiple suppliers in critical supply chains through increased ties with allies’ economies.

Establishing more resilient supply chains requires an affirmative industrial policy that addresses the root economic causes of offshoring of critical capabilities long before a company enters an offshoring transaction and that makes reshoring production commercially viable. In this regard, the incentives and other “run faster” provisions of the CHIPS and Science Act of 2022 are an excellent start. Attempts to reshape supply chains must also consider how to do so without creating additional negative supply shocks. These considerations are particularly important in the current context of high inflation that has been largely driven by supply-side shocks.

Impeding Chinese indigenous technology development

Concerns over how US technology and investment can support indigenous technology development in China was central to the policy discussion surrounding the 2018 reforms of CFIUS and export control authorities, through the Foreign Investment Risk Review Modernization Act (FIRRMA) and ECRA. The initial draft of FIRRMA provided CFIUS with review authority over outbound investments. Some lawmakers were especially worried that the PRC was benefitting from critical technology transfer from US firms to Chinese counterparts through joint ventures. After substantial debate, Congress found a compromise in which CFIUS would remain focused on inbound—though it does have jurisdiction over some forms of outbound joint ventures—while national security concerns related to outbound investment would be regulated through expanded export control authorities.

The gap in this approach is that there are ways in which the participation of US multinationals and investors in China’s innovation economy can harm US interests through channels other than technology transfer. Decades of research on the role of foreign direct investment in development has shown that inward FDI, particularly when paired with active host country regulatory strategies, can help FDI-receiving countries expand domestic markets and move up the value chain.⁶ Multinational corporations and their affiliates make up 36 percent of global output and are responsible for two-thirds of exports and one-half of imports.⁷ Domestic firms participate in global supply chains largely through incorporation into MNCs supply chain. For instance, MNCs operating in the United States source 25 percent of their inputs domestically. MNCs in Japan source over 50 percent of inputs domestically. The more domestic firms interact with MNCs, the more they learn from those MNCs, including how to increase their production capabilities. By interacting with MNCs, domestic firms gain foreign market knowledge to directly compete in international markets. Domestic firms that integrate into MNCs’ supply chains are statistically significantly more likely to become exporters, increase their ability to supply the domestic market, and produce higher quality and more complex products. Normally, we view all of these spillover effects of FDI as beneficial to economic development. However, in narrow cases related to specific critical technologies relevant to national security, the linkages literature provides insight into how US MNCs can help develop Chinese critical industries. The issue goes beyond technology transfer. MNCs help foster indigenous industries by incorporating local firms into their supply chains and by importing knowledge about international markets, connections to MNCs’ broader supplier and buyer networks, and other managerial practices that increase efficiency and quality control. These, less tangible, contributions to the domestic market are not able to be controlled through export controls.

In the realm of US venture capital (VC), there are also potential concerns that are not addressable through export controls. As the National Venture Capital Association (NVCA) lays out in their 2022 Yearbook, venture is distinct from other types of investing because it typically entails relatively small equity stakes in a company, but the general partner in the investment is much more involved in strategic management decisions of the target than passive investors are.⁸ VCs provide more than an infusion of capital; they mentor and advise founders who often need substantial strategic and logistical help to scale up their business. They often play prominent roles on corporate boards. Moreover, they provide founders and their teams with access to the investors’ financial, commercial, professional, and political networks. By investing in a company, VCs are putting their seal of approval on the enterprise, signaling that the company was able to pass a thorough vetting process. And, when VCs invest in a company, they are tying their financial future to the company. It is in a VC’s interest to crowd in more investors into future funding rounds so that the companies in which they invested increase in value in each funding round, which ultimately leads to an acquisition or initial public offering through which the VC can exit the investment, hopefully at great profit.

Venture capital plays a critical role in the continued dynamism of the US innovation economy. From 1974-2015, 42 percent of US companies that went public were venture backed.⁹ These 556 companies accounted for 63 percent of the market capitalization of the 1,339 US companies that went public over the period and 85 percent of all the research and development expenditures associated with those companies. The flip side, however, is that these same features that have been so central to the journey from start up to commercial viability in the United States could generate national security risks if US VC contributes to critical technology start-ups in countries of concern. Similarly, to the intangible benefits of FDI described above, export controls do not provide an adequate remedy to these kinds of national security concerns. 

Approaching outbound controls

As the Congress moves forward with an outbound screening concept tailored to issues of the national security risk of indigenous technology development in countries of concern, it should: 1) be mindful of dynamics that make outbound investment screening harder to enforce than inbound review; 2) measure potential tools against five principles of good design; and 3) follow a strategy that leverages the United States’ privileged position in many technology supply chain networks.

Enforcing outbound screening

The conversation around outbound screening is colored by the United States experience with inbound review. CFIUS is widely seen as well-designed and effective and Congress should be careful to not overlearn from the CFIUS example. It much easier from an enforcement perspective to control market access than to limit outflows. In the CFIUS case, a prohibition is enforced by preventing a foreign entity from buying a domestic asset, which is subject to US regulation. For outbound transactions, the United States can impose penalties on the domestic entity implicated in the transaction. But enforcement options become much less palatable if a multinational decides to channel the otherwise prohibited investment through a third country. Enforcing a prohibition in that case would likely require substantial extraterritorial reach that the US government will likely wish to avoid due to issues of proportionality and allies’ and partners’ sensitivities.

Other aspects of administration and enforcement are much easier for inbound investment than for outbound. For instance, it is easier to compel a US target of a CFIUS review to provide the committee with the sensitive non-public technical information often required to complete their review than it would be to compel the same information from a foreign target in the context of an outbound review. Indeed, other country government may simply prevent the foreign target from providing such information. Additionally, in the case of mitigation agreements, it is reasonable to assume it is much easier for the US Government to monitor behavior of firms in its own jurisdiction than firms overseas.

For these reasons, Congress should be clear-eyed about the compliance and enforcement challenges likely to arise from outbound investment review that are less problematic in the context of inbound review. Congress should only move forward with a screening concept if it is reasonably sure that it has adequate monitoring and enforcement capabilities to give the regulation teeth.

Design principles

Along with having enforcement capabilities strong enough to deter, Congress should consider the following principles when designing a screening tool

1. Review should be targeted to transactions that present the highest national security threat and any governmental action should be subject to a national security risk assessment. As with CFIUS, an outbound mechanism should be narrowly tailored to national security risks rather than a tool to bolster broader economic competitiveness objectives. Congress should instead pursue issues of competitiveness and social standards through affirmative industrial policy such as the CHIPS and Science Act and through trade and investment frameworks such as the Indo Pacific Economic Framework (IPEF).
2.  A review mechanism along with any additional outbound controls should be clearly defined and understandable to private-sector participants. This includes clear definitions of what types of investors and economic activities are covered. The private sector will be responsible for the first line of compliance, so they must understand to what they are obligated. For the regulation to be seen as a legitimate use of the government’s regulatory authority, its purpose and necessity must be explainable to the American public. Without public support, firms will not face substantial reputational costs for evading the spirit or the letter of the regulation. A supportive public is key to regulatory compliance.
3. Any review should be non-duplicative of existing tools such as export controls. In the context of inbound transactions, CFIUS is designed as a tool of last resort. Any outbound investment screen should be thought of similarly and any use of outbound authorities should occur only when other authorities are insufficient to address the national security risk that arises from the transaction in question.
4. Any review mechanism must be scoped proportionately to the government’s institutional capacity to effectively administer a new mechanism. We should not take lightly the administrative burden that a well-functioning outbound review process would place on the executive branch. For example, CFIUS requires hundreds of staff and attention across its nine member agencies plus ex officio and support agencies. FIRRMA appropriated $20 million a year for five years to help build up CFIUS agencies to support the expansion of its authorities.
5. Finally, any Congressional action on outbound screening should be paired with meaningful multilateral engagement with allies and partners so that US investors are not disadvantaged and so the goal of impeding national security relevant indigenous technology development in countries of concern is more likely to be met. Similar to export controls and inbound screening, outbound investment controls are more likely to be effective if large portions of the global economy implement similar measures. This is especially important in the context of outbound investment where there is justifiable concern that a US outbound mechanism without coordination with other advanced economies could just lead to MNCs from other OECD countries occupying the investments that US firms otherwise would have participated in. Similarly, multilateral engagement is important in the context of critical technologies, as the United States is not the only relevant member of these supply chains.

Leveraging the US network position

As a final conceptual point, I encourage Congress to think in network terms as much as possible when contemplating any outbound investment control mechanisms. Even before the Covid-19 pandemic, scholars of international relations started to borrow from complexity science to understand on the structure of different kinds of global networks generate power and vulnerabilities. The United States has effectively leveraged its central position in currency and finance networks to extend its power in important ways. Even now, we see how this centrality has imbued the United States with regulatory power over companies that wish to list on US-based exchanges.

As the Congress shifts from conceptual issues to more tactical and technical concerns related to coverage and definitions, I encourage it to use insights from complexity science to design its mechanism. This entails focusing attention on chokepoint technologies as much as possible. Rather than trying to “boil the ocean” and cover all technologies possible, it will likely be more effective for the US to evaluate what specific technologies are especially critical to a host of other technologies. For instance, it may be particularly challenging to cover all manner of artificial intelligence technologies. However, limiting investment in specific extreme ultraviolet lithography tools and technology as well as most likely candidates for the next next-generation lithography may be more feasible. To the extent that advanced AI relies on advanced semiconductors, controls on NGL will have spillover implications for AI as well.

As another example, the Center for Security and Emerging Technology recently published a report evaluating “China’s Self-Identified Strategic Technology Import Dependencies.”¹⁰ It found that China’s chokepoints tend to be in technologies with very high-quality control specifications including precision requirements, consistency requirements, and the ability to perform under stress. Focusing attention on these areas—or more broadly, areas that the Chinese self-identify as chokepoints—would likely be particularly because these chokepoints relate to production process issues rather than the underlying technologies. Additionally, research on information problems in authoritarian contexts suggest that achieving high levels of quality control will likely remain a challenge for Chinese companies so long as delivering bad news is politically dangerous. This suggests not only that the PRC currently faces disadvantages in these chokepoint technologies, but also that the United States’ open, democratic system provides us with a clear competitive edge in these areas. This is an important reminder that the United States’ leadership position in advanced technology and economic dynamism is a function of our open, non-arbitrary, rules-based system. To best protect our national security, we should confidently embrace those core principles that have fueled our economic prosperity rather than erect overly complicated bureaucratic structures that emulate competitors’ systems.

Conclusion

I close my testimony where I began. Outbound investment creates a range of policy issues that Congress may want to address. The issue is which issues warrant a policy response and, of those, what policy response, or combination of policy responses, is most likely to produce outcomes that strengthen US national security.

I recommend that Congress consider five issues while contemplating the path forward:

First, the gaps that currently exist in the government’s authorities relate to the ability to control the intangible benefits associated with outbound FDI and VC flows. Export controls already provide authority over technology transfer. Policy solutions will need to address the components of investment that generate risks through managerial expertise, transfer of know-how, connection with supplier and buyer networks, and the legitimation effects of partnering with a US investor.

Second, any outbound investment review mechanisms should be narrowly focused on national security rather than broader policy objectives. Issues of economic competitiveness are best addressed through other tools.

Third, outbound investment screening would be a new authority and represent a substantial break from central tenets of decades of US economic policy. There is a great deal of uncertainty about the size of the problem and the potential negative unintended consequences of outbound review. An approach that is designed to gather more information as well as allow for experimentation is likely to work better than enacting a broad statutory screening requirement all at once.

Fourth, Congress should not assume that a mirror image of CFIUS will work for outbound screening. The enforcement issues associated with regulating the movement of investment abroad is in many ways more challenging to address than regulating inbound flows. Congress should make sure that any mechanism be narrowly scoped to national security, clearly defined and seen as a legitimate use of government authorities, non-duplicative of existing tools, administrable, and paired with meaningful multilateral engagement on the issue with allies and partners.

Finally, smart policy will take cues from networks and complexity science. Clamping down on all outbound investment to countries of concern is not a viable option. By focusing on chokepoint technologies, the United States can scope coverage in a way that is most impactful with the least amount of negative economic consequences.

Fellow

Sarah Bauerle Danzman

Nonresident Senior Fellow

Economic Statecraft Initiative GeoEconomics Center

Economy & Business Financial Regulation

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Transcript Jan 19, 2022

Outbound investments may spell trouble for US national security. Can screening reduce the risk?

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The US government is aware of the ways that outbound investment flows to countries like China can harm national security. Can screening those investments help the United States boost its own protection?

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Is the US going to screen outbound investment?

By Sarah Bauerle Danzman

There is a growing consensus in Washington that the U.S. government needs more tools to prevent the People’s Republic of China (PRC) from using U.S. capital markets to amass military capabilities and control supply chain chokepoints.

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At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The post Bauerle Danzman testifies to the Senate Banking Committee on examining outbound investment appeared first on Atlantic Council.

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1. Central banks part ways

Based on the past few years, you could be fooled into thinking that central banks all operate together with some unified theory of inflation and interest rates. But see the new forecast below to understand why all that is about to change:

Since the pandemic began, the world’s largest central banks largely moved in unison. They cut rates together, they raised rates together, and they even kept similar patterns in terms of basis points increased per meeting.  

This year is going to look a lot different. We’ll see a wider spread of decisions as the idiosyncratic problems of individual economies outweigh global forces. So when Federal Reserve Chairman Jay Powell finally starts to pivot in the coming months, remember the new pattern and don’t expect the rest of the world to automatically follow suit.

2. New pressure on unlikely Russian oil buyers

It’s no surprise that Russia has been looking for different buyers of its oil after being hit with sanctions. But we’re not sure most people appreciate how rapidly the change has happened or understand precisely which countries have stepped up: 

The chart above only reflects seaborne imports, meaning it likely undercounts how Beijing is helping Moscow. But even so, India, Kazakhstan, and Egypt jump out from this chart. Egypt alone has a 9,983 percent increase year over year. Yes, you read that right. 

What’s happening in Cairo? It looks like Egypt is becoming a major international hub of Russian seaborne oil. The ships are coming into Egypt, and then the cheap Russian oil is flowing out to Saudi Arabia and around the world. In 2023, we think the United States steps up pressure on the blue countries—especially places such as Israel and Turkey.

3. Asia sees the return of Chinese tourists

In 2019, the Asia-Pacific saw over 260 million tourists, which created nearly 190 million jobs across the region. Then the pandemic struck, China shut down, and international travel has yet to recover:

China’s lockdown has created a gaping hole in the international tourism business. The ripple effects go beyond hotels and restaurants. When Chinese citizens traveled abroad, the money they spent built up other countries’ foreign currency reserves.  

Now, these Asian nations are intervening in their currency markets and have dwindling reserves at their disposal. If a wave of defaults hit or the global recession lands hard in the Asia-Pacific, these governments would be especially vulnerable.

Some reprieve could be on the way. Following China’s stunning reversal of its domestic COVID controls, Beijing has also announced that it will be ending its international travel restrictions later this week. However, don’t expect Chinese citizens to suddenly all head overseas. China’s surging case numbers have prompted some usual tourist destinations such as Japan and South Korea to impose new testing requirements for travelers coming from China. Low consumer confidence as well as jobs and savings losses from the pandemic will also make for a slower travel recovery. But the move is a clear sign that Chinese leader Xi Jinping is eager to remind the region how much they rely on China.

4. The real economy (not crypto) leads the way

Cryptocurrency suffered two trillion dollars in losses over the course of 2022, and we can’t say the outlook in 2023 is any better. But it’s how interest—and media interest—in crypto compares to other economic issues that really has us worried: 

Of course, two trillion dollars is a lot of money. But global gross domestic product (GDP) is around one hundred trillion dollars. The semiconductor market is worth trillions globally and supports the economic engine of nearly every country in the world. But those topics get a fraction of the interest of crypto.

We get it. Crypto is relatively new, it has characters like Sam Bankman-Fried, and just like a car crash, it can be hard to look away. But expect 2023 to be the year the real economy gets its revenge. Central banks are going to push forward on their own digital currencies, a global recession will impact many more people than FTX ever could, and China’s manufacturing ability, or lack thereof, will decide the economic fate of millions. 

5. G20 voters have few chances to express discontent

As our new analysis shows, 2023 is shaping up to be a strangely quiet year in terms of elections in large economies: 

In fact, only once in the last fifteen years has the global economy grown under 2 percent (a good benchmark for a global recession) and also seen so few elections in the Group of Twenty (G20) nations. In 2023, only Argentina and Turkey are scheduled to hold national elections (Turkey is the seventeenth largest economy in the world and Argentina has long since dropped out of the top twenty. Both countries have major inflation problems, though only one has a new World Cup title.) 

So, barring another snap election in a parliamentary democracy, nowhere in the Group of Seven (G7) will citizens have a chance to register their discontent during a difficult year for jobs and GDP. Does that translate into unrest or just a bigger build-up for 2024? We think it’s the latter, but it’s something we’ll keep a close eye on.  

Sophia Busch, Niels Graham, and Mrugank Bhusari contributed to this article.

Josh Lipsky is the senior director of the GeoEconomics Center and a former International Monetary Fund advisor. This post is adapted from the GeoEconomics Center’s weekly Guide to the Global Economy newsletter. If you are interested in getting the newsletter, email geoeconomics@atlanticcouncil.org.

The post Five trends to watch in 2023 as the global economy tries a dangerous reboot appeared first on Atlantic Council.

While many countries are still on the rebound from the COVID-19 pandemic, new crises—and their effects—are emerging, and are expected to continue into the next year. From global inflation to a costly energy crisis, and from food insecurity to new political shifts, how can the region meet changing dynamics head-on? And how might risks turn into opportunities as we enter a highly consequential 2023?

Join the Adrienne Arsht Latin America Center as we look at some of the key questions that may shape the year ahead for Latin America and the Caribbean, then take our signature annual poll to see how your opinions shape up against our predictions.

How might new regional collaboration take shape across Latin America and the Caribbean with a wave of new leaders? What decision points might shape government policy? Will Bitcoin continue to see the light of day in El Salvador? Are the harmful economic effects of Russia’s war in Ukraine in the rearview mirror for the region, or is the worse yet to come? Will China’s new foreign policy ambition translate to closer relations with LAC?

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As this year began, many experts predicted inflation would be transitory, Europe’s recovery would be stronger than the United States’, and China would return to strong growth. Then inflation soared and Russian President Vladimir Putin invaded Ukraine—fueling an energy crisis in Europe and food price shocks around the world. Meanwhile, China’s zero-COVID policy chained its economy. To make sense of a shocking year for the global economy, our GeoEconomics Center experts take you inside the numbers that mattered—including many you may have missed—in 2022.

Over the past year, the market value of cryptocurrency assets has collapsed from $3 trillion to about $850 billion as Bitcoin—the original and best-known cryptocurrency—plunged from $68,000 to $17,700, stablecoins such as TerraUSD broke the advertised one-to-one peg to the US dollar, and the crypto-exchange FTX sank from a $32 billion valuation to bankruptcy within a week. Those losses and market turmoil have laid bare the volatility of crypto-assets and the pressing need for consumer protections. 

Going forward, crypto-assets may not recover their full value, and it’s clear that regulation needs to be tightened to deal with the financial instability and lack of consumer protections exhibited by this year’s market upheaval. In our latest tracker, the GeoEconomics Center explored regulatory developments in twenty-five jurisdictions, which include Group of Twenty (G20) member countries and six countries with the highest crypto adoption rates. Among the countries we studied, cryptocurrency is legal in thirteen, partially banned in nine, and generally banned in three. We found that in 88 percent of the countries we studied, crypto regulations were under consideration, and the next frontier of regulatory developments will be on stablecoins. The United States has a number of legislative proposals under consideration currently, with a larger debate on which regulatory authority must have jurisdiction over crypto-assets. Watch for 2023 to be a marquee year on crypto regulation, especially as Europe and the United Kingdom clarify their regulatory structures.

—Ananya Kumar is the associate director for digital currency at the GeoEconomics Center. 

A striking ten of the G20 countries (including Russia of course) do not participate at all in the financial sanctions triggered by the invasion of Ukraine.

Admittedly this division did not prevent the issuance of a G20 Bali Leaders’ Declaration on November 16 stating: “Most members strongly condemned the war in Ukraine and stressed it is causing immense human suffering and exacerbating existing fragilities in the global economy—constraining growth, increasing inflation, disrupting supply chains, heightening energy and food insecurity, and elevating financial stability risks.”

Yet only advanced economies have joined the sanctioning process, even if to a varying extent, whereas emerging economies (except for South Korea) are not involved. This illustrates how fragmented the world has become and contrasts with the G20 momentum created by the global financial crisis—during which the entire group was largely on the same page in crafting a robust response.

—Marc-Olivier Strauss-Kahn is a nonresident senior fellow at the GeoEconomics Center and a former director general and chief economist for the Banque de France.

In October, a US government report found that the Russian military lost six thousand pieces of equipment since invading Ukraine in February. The imposition of Western sanctions has made it difficult for Russia to acquire the supplies and foreign parts it needs to repair or maintain this lost equipment, which includes items such as tanks, armored personnel carriers, and infantry fighting vehicles. This six thousand figure is important because it offers a tangible example of how sanctions can undermine a country’s war machine and make it difficult to pursue its aggression. Now, because of sanctions, the Russian regime must find other costly and more complicated means of acquiring hard-to-find parts, which was a deliberate goal of the sanctions, as reported by the New York Times. Often, when analysts, the press, or even governments discuss the impact of Russia sanctions, they first look at the state of the Russian economy or currency. But those figures are not entirely affected by sanctions and can change for numerous reasons; whereas, this six thousand figure is proof that sanctions are working to achieve their stated goal—to undermine Russia’s aggression against Ukraine.

—Hagar Chemali is a nonresident senior fellow at the GeoEconomics Center and a former spokesperson for terrorism and financial intelligence at the US Treasury Department.

This is the amount of Central Bank of Russia (CBR) reserves that Group of Seven (G7) nations and the European Union (EU) have immobilized since Russia’s invasion of Ukraine. In response, CBR Governor Elvira Nabiullina pledged to file legal claims in order to recover the reserves, but she has yet to set a timeframe to do so. Meanwhile, experts and policymakers on both sides of the Atlantic have discussed seizing frozen Russian reserves and using them for Ukraine’s reconstruction. However, this effort is hindered by laws in the EU and other sanctions-wielding countries. Confiscating frozen assets is allowed only in case of criminal conviction, and even then, getting each case through the court could take years.

But even before it could seize the frozen assets, the West still has to identify where the blocked assets are. Sanctioning jurisdictions are publishing reports at their own pace on how much Russian reserves they have immobilized, but a multilateral effort is essential to identify the rest. We are hearing that the US government is certain about the location of only a third of the three hundred billion dollars, and it is working to find the rest.

Sanctioning the CBR and blocking its assets held in Western central banks took Moscow by surprise. However, the policy hasn’t delivered the punch to the gut that it might have. At least not yet. The West has options now to make it truly hurt.

—Maia Nikoladze is a program assistant at the Economic Statecraft Initiative within the GeoEconomics Center.

On December 5, the G7-led price cap on Russian oil exports came into force. The decision to place the initial cap at sixty US dollars per barrel was reached only a few short days beforehand. EU member states that had pushed for a much lower cap managed to secure a last-minute drop from sixty-five.

Wary of adding more complexity to an already tense market, the policy’s original backers in the US Treasury are reasonably happy with a cap that is close to the average price Russia has been selling at over the past six months. In their view, this locks in a discounted price, which has already cost Moscow billions in lost revenue and which new buyers of Russian oil such as India will unashamedly use as they negotiate contracts.

Implementation relies on Western providers of insurance and shipping services, which must ask buyers of Russian oil for attestations that they have paid at or below the cap. So far, energy markets seem to understand the guidance that has been issued and we haven’t seen any major price swings. This doesn’t rule out snags that could fuel fears over supply, such as the recent situation where Turkish authorities started demanding proof of insurance from all tankers flowing through the Bosphorus.

—Charles Lichfield is the deputy director of the GeoEconomics Center.

This year produced one of the most significant sanctions programs ever devised, both in terms of the scale of the economy where sanctions were imposed, as well as the speed and comprehensiveness of the tactics used. Despite the fact that Western sanctions programs expanded by 42 percent in 2022, there are still substantial sectors where Russia trade continues and has grown in some instances. The one absent element of an effective sanctions program has been enforcement—which has been severely lacking in the United States, United Kingdom, and EU against violators of the Russia sanctions. There has yet to ever be an EU sanctions enforcement action, and some nations don’t even have the legal authority to levy sanctions. Enforcement in the United States, which historically has led the world in monetary fines, has dropped substantially in each of the past three years. While cases typically take time to build, early moves to highlight and penalize sanctions violators could serve the objective of continuing to put on notice those that would try to still carry out certain business with Russia.

—Daniel Tannebaum is a nonresident senior fellow in the GeoEconomic Center’s Economic Statecraft Initiative and a partner in Oliver Wyman’s Risk and Public Policy Practice, where he leads the firm’s Global Anti-Financial Crime Practice.

Sixty countries globally have reached an advanced stage of central bank digital currency (CBDC) development. As of November, the United States is one of them. 

Eighteen of the G20 countries have CBDCs under development, piloted, or fully launched, as reported in our Central Bank Digital Currency tracker. Motivations differ globally for CBDC exploration, from concerns about international standards setting to efforts at improving financial inclusion. The logistical difficulties of sending physical COVID-19 stimulus checks called attention to inefficiencies in US payment systems. By harnessing technology, including the blockchain, central banks may be able to develop payment systems that are quicker, cheaper, and safer. In November, the New York Federal Reserve released a white paper explaining that it was starting to test a wholesale (bank-to-bank) CBDC in cooperation with the Monetary Authority of Singapore. In doing so, it joined the European Central Bank, which is already in the development stages for a retail digital euro. A pilot program for China’s digital currency, the e-CNY, began in 2020 and has now expanded to over two hundred million users.

With the risks of cryptocurrencies and stablecoins front and center in the news, attention may turn more and more to central banks. CBDC development, and what the United States does next, will play a major role in the future of payments in 2023.

—Sophia Busch is a program assistant at the GeoEconomics Center.

The Biden administration has declared US dependence on advanced semiconductors produced in Taiwan as “untenable and unsafe” (in the words of Commerce Secretary Gina Raimondo) because of the threat to the country from neighboring China. As a result, the administration in 2022 prioritized the passage of the CHIPS and Science Act, which was signed into law in August. The law provides fifty-two billion dollars of subsidies and tax incentives to promote the development of cutting-edge semiconductor factories on US soil. One of the projects taking advantage of that funding is being undertaken by Taiwan Semiconductor Manufacturing Corporation (TSMC), which currently produces over 90 percent of the most sophisticated chips in the world in Taiwan. When TSMC’s Phoenix plant reaches full capacity in the next two years, it will produce about twenty thousand wafers of semiconductors each month. That will only represent less than 1.6 percent of the company’s current monthly output of 1.3 million wafers. Reducing dependence on Taiwan will remain a long way off.

—Jeremy Mark is a nonresident senior fellow at the GeoEconomics Center and former official at the International Monetary Fund (IMF) and reporter for the Wall Street Journal.

Investment screening regulations continued to proliferate, strengthen, and expand in 2022. Seven EU member states drafted, introduced, or started consultation processes for new investment screening authorities this year (Belgium, Croatia, Estonia, Greece, Ireland, Luxembourg, and Sweden). In the United States, the Biden administration issued the first executive order designed to provide clarity over the process by which the Committee on Foreign Investment in the United States (CFIUS) evaluates the national-security implications of foreign acquisitions of US businesses. And this fall saw two congressional hearings on the prospects of creating a CFIUS-like process for outbound investment. Look out for increased regulation over both inbound and outbound investment among major economies in 2023.

—Sarah Bauerle-Danzman is a nonresident senior fellow with the GeoEconomic Center’s Economic Statecraft Initiative and associate professor of international studies at Indiana University.

North America is still the commercial dynamo for the United States, with over three million dollars per minute in goods traded between the United States and its two neighbors through September of this year.

Canada and Mexico are the top two US trade partners, together accounting for more than twice what the United States trades with China. North American trade is growing at double digits within the framework of the US-Mexico-Canada agreement (USMCA), which came into effect in 2020.

In the most recent study available, North American trade was estimated to support more than twelve million US jobs in 2019 and millions more in Mexico and Canada.

North America is demonstrating the clear potential to emerge more competitive globally vis-a-vis China and other commercial powerhouses, as the world transforms following the pandemic, the war in Ukraine, and other disruptions. The question will be how well the United States, Canada, and Mexico can work through differences and seize the opportunities to maintain the impressive commercial growth that can boost the continent’s prosperity and well-being.

—Earl Anthony Wayne is a nonresident senior fellow at the GeoEconomics Center and a former US ambassador to Mexico.

A staggering and concerning 60 percent of low-income countries are currently at risk of debt distress or debt default, according to the IMF. If a series of low-income countries were set to default, it is possible the IMF would not have enough resources to to disburse the loans these countries would need to keep afloat. The G20 had a plan to deal with the problem called “the common framework.” It was supposed to be a way to help countries restructure their debt and involve the world’s largest bilateral creditor, China. But only a handful of countries have used the system—largely because it’s slow and private creditors haven’t fully signed on. This number is a flashing red light for the global economy headed into 2023. 

—Josh Lipsky is the senior director of the GeoEconomics Center.

Forty-five million people are expected to face starvation by the end of 2022. A series of economic shocks sent global food prices to an all-time high in 2022 and curbed households’ ability to pay for sustenance. Extreme global uncertainty and the prospect of sudden unemployment resulted in food hoarding in 2020 during the pandemic. The supply-chain constraints of 2021 then dramatically increased transport costs for those items. And Russia’s invasion of Ukraine at the beginning of 2022 unexpectedly eliminated large volumes of food items from the global market overnight. In the past year, food insecurity was exacerbated by export bans by other major grain producers, weakening currencies, and accelerating inflation around the world. The threat of a global recession next year now looms large over hundreds of millions of people who are struggling to fulfill basic human needs.

—Mrugank Bhusari is a program assistant at the GeoEconomics Center.

In November, the world’s population surpassed eight billion and is expected to continue to rise as life expectancy increases around the world and fertility rates remain high in several regions, primarily sub-Saharan Africa and South Asia. The geoeconomic and development implications are stark and are compounded by the lingering effects of COVID-19 as well as climate change and conflict. The world’s people and resources are not distributed equally, and inequality within and among countries is rising. Ever-expanding cities seek to capitalize on the benefits of agglomeration while managing the resulting stress on infrastructure and services. At the same time, in lower- and middle-income countries—which tend to be the most populous—food, health, and education systems struggle to meet expanding and evolving needs. 

Younger and older people tend to bear the brunt of the challenges associated with population growth, especially in terms of economic opportunity as job creation fails to keep pace with the number of labor market entrants, and digitization, automation, and the changing nature of work put worker longevity and job security at risk. However, history and emerging evidence show that strategic economic and environmental policies combined with investments in human capital, lifelong learning and wellbeing, and technologies that increase innovation and productivity are what enable the accumulation of earnings and intergenerational wealth. That catalyzes consumption and can harness larger populations toward demographic dividends and sustainable, inclusive growth.

—Nicole Goldin is a nonresident senior fellow at the GeoEconomics Center and global head of inclusive economic growth at Abt Associates.

To combat inflation, central banks representing nearly three-quarters of the global economy, measured by gross domestic product (GDP) weight, increased their benchmark interest rates in 2022. Most noticeably, this was done by the US Federal Reserve (the Fed), European Central Bank (ECB), and Bank of England, together accounting for 42 percent of global GDP. The Bank of Japan, People’s Bank of China, and Central Bank of the Republic of Turkey were among the few central banks cutting their benchmark interest rates in 2022. When it comes to central bank rate hikes, it is important to note that forty-one countries have their currencies pegged to the US dollar and/or euro. To protect the peg while also allowing for the free flow of capital, these economies have no choice but to increase their domestic interest rates on par with the Fed and ECB—even if domestic inflation is not a concern for their economies—therefore reducing their growth potentials. Oil and gas exporting countries of the Persian Gulf are among these economies.

—Amin Mohseni-Cheraghlou is the macroeconomist at the GeoEconomics Center and an economics professor at American University.

On September 28, 2022, the US dollar, euro, and British pound were closer to a triple parity than ever before. The dollar had appreciated against most currencies throughout the year, reflecting the relative strength of the US economy, the Federal Reserve’s determination to bring inflation down by sharply raising overnight interest rates, and a flight to safety after the start of the Ukraine war. European inflation has been more strongly tied to energy, and the ECB was therefore slower to embark on a tightening cycle, helping the dollar breach parity to the euro in August for the first time in twenty years. And in late September, the pound fell to the lowest ever value against the dollar after the short-lived government of Prime Minister Liz Truss presented its inflationary tax-cut proposals and the Bank of England had to prevent a collapse in the UK government bond market. Both the euro and pound have rebounded since, but for a short moment the three currencies were only a few basis points away from being valued equally.

—Martin Mühleisen is a nonresident senior fellow and former chief of staff and strategy director of the IMF.

The share of global environmental, social, and governance (ESG) investments as a proportion of total assets under management is projected to increase from 14.4 percent in 2021 to 21.5 percent in 2026.

ESG funds, which evaluate how well companies are managing risks and opportunities related to environmental, social, and governance issues, are growing rapidly to become the new default choice for investors. As investors refocus their long-term investment strategies, the demand for ESG funds is out-stripping the existing supply. Asset managers looking to deliver investor success and survive turbulent investment markets are embracing ESG funds as the best way to differentiate their products in the future. These emerging global trends in the asset and wealth management industry—led by the United States—provide a critical reality check on swiftly evolving investor priorities and an important counterweight to concerns that recent anti-ESG rhetoric and legislation were taking some of the steam out of enthusiasm for impact investing. ESG funds are the next big thing.

—John Forrer is a contributor to the GeoEconomics Center and director of the Institute of Corporate Responsibility at George Washington University

For most of the world, 2022 was the year the pandemic became endemic. While COVID-19 case numbers continue to soar, with year-over-year cases increasing by nearly 75 percent in 2022, deaths have sharply declined by some 67 percent when compared to 2021. At the same time, the pandemic remains one of the foundational trends shaping the global policy landscape—complicating a range of issues from Russia’s invasion of Ukraine to a potential global recession. In the United States, COVID continues to moderate economic productivity with a recent National Burea of Economic Research working paper estimating that people’s unwillingness to be in close proximity with others reduced labor force participation by 2.5 percent in the first half of 2022. This translates to roughly a $250 billion drop in potential output—or around 1 percent of GDP. COVID’s sweeping impact is most prominently playing out in China, which in recent weeks has been rocked by the most widespread protests in decades following nearly three years of periodic lockdowns and dampening economic prospects. 

—Niels Graham is an assistant director at the GeoEconomics Center.

The US Federal Reserve has reduced the size of its balance sheet in 2022 by $381 billion, draining liquidity from the financial system. This quantitative tightening (QT) policy aims to support the contractionary impact of the Fed’s interest-rate hikes to rein in inflation. At the current pace, the Fed will shed $1.6 trillion in assets by the end of 2023, reducing its overall balance sheet by roughly 18 percent. While it remains difficult to measure QT’s impact, a reduction of that size could tighten financial conditions significantly. This matters because it might allow the Fed to forego a rate hike in 2023 and/or start decreasing interest rates earlier. QT targets long-dated assets that have an outsized influence on equity and bond markets. A severe recession or the Fed’s desire to ease financial conditions could all spell an early end to QT. This is a space to watch in 2023.

—Ole Moehr is a senior fellow and consultant with the GeoEconomics Center.

That’s how many manufacturing jobs have been created in the United States since April 2020 (when manufacturing employment was at a record low) to reach a total of 12.9 million manufacturing jobs as of November 2022. US manufacturing employment started out at nine million in 1940 and rose steadily to a peak of 19.5 million in July 1979. The US then lost 8.1 million manufacturing jobs in the following four decades, a result of the hollowing out of the US manufacturing base due to the offshoring of manufacturing to other countries, in particular China. Since early 2020, pro-manufacturing policies in the US seem to have reversed the declining trend. It remains to be seen if this nascent recovery will be strengthened in the future as a result of efforts to attract high-tech manufacturing activity back to the United States with incentives provided to companies in the US CHIPS and Science Act and the Inflation Reduction Act.

—Hung Tran is a nonresident senior fellow at the GeoEconomics Center and a former IMF official.

Year to date, the US Commerce Department has designated 390 parties to the Entity List, a 260 percent increase over the designations made in 2021. Along with various other export-control mechanisms, Entity List designations are increasingly used to promote US national security and foreign-policy interests by restricting the target parties from receiving certain, or in some cases all, items subject to US regulation. Because US export controls are primarily property-based, these restrictions can be effective in covering gaps left by trade and economic sanctions, which may not apply to certain foreign parties whose dealings in US-regulated products, technologies, or software could benefit US adversaries. 

Unsurprisingly, the vast majority of Commerce’s Entity List designations in 2022 involved parties in Russia. Notably, parties elsewhere, including in certain US ally countries such as the United Kingdom and Spain, were listed for having acquired or attempted to acquire US-regulated products in support of Russia’s military, defense industrial base, or strategic ambitions. China was also heavily targeted by designations that took aim at parties involved in certain semiconductor manufacturing activities. Whether the swell in designations continues over time remains to be seen, but it seems likely that Commerce will continue to use the Entity List in furtherance of efforts to limit Russia’s and China’s military and advanced manufacturing capabilities. In addition, Commerce has the authority to designate parties whose host governments fail to facilitate US security-driven end-use verifications, as well as those involved in human rights, cybersecurity, and spyware-related threats. Regardless of the final numbers, the Entity List is a score worth tracking in 2023.

—Annie Froehlich is a nonresident senior fellow at the GeoEconomics Center’s Economic Statecraft Initiative and special counsel at Cooley LLP.

The post By the numbers: The global economy in 2022 appeared first on Atlantic Council.

Latin America and the Caribbean is in the midst of a delicate economic transition, with five of the LAC6 countries attempting a tax reform before their GDPs recovered to pre-pandemic levels.¹ As the region confronts rising inflation, the economic spillovers of the war in Ukraine, and budgetary pressures left behind by the pandemic, governments should improve their taxation systems to rebuild fiscal stability, stimulate growth, and enhance equity – a delicate balancing act among overlapping policy priorities.

Regional taxes are a heavy administrative burden, requiring nearly twice the time to complete in LAC as in the OECD.² At the same time, the region struggles with average tax evasion of 5.6 percent of GDP³ and a continued overreliance on corporate income taxes.⁴ With still-high public debts and fiscal deficits, governments must respond by implementing policies to streamline and modernize revenue collection and management.

What are the pros and cons and trade-offs involved in increasing or decreasing the region’s three main taxes (VAT, PIT, and CIT)? How can governments optimize enforcement and collection without resorting to rate changes? What policies outside the tax authority are needed to support tax reforms? How can policymakers better navigate the thorny politics of tax reforms?

The following pages provide new analysis and concrete recommendations to address these questions. Drawing on the powerful expertise of its authors in addition to valuable commentary and insight from private, nonpartisan strategy sessions, legal experts, and regional governments, this report is a strong addition to the Adrienne Arsht Latin America Center’s #ProactiveLAC Series, which aims to provide insight and foresight to LAC countries on how to advance economic reactivation and long-term prosperity.

Read the full report below

The Adrienne Arsht Latin America Center broadens understanding of regional transformations and delivers constructive, results-oriented solutions to inform how the public and private sectors can advance hemispheric prosperity.

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The post Improving tax policy in Latin America and the Caribbean: A balancing act appeared first on Atlantic Council.

The TTC is only eighteen months old, but so far it has not met its high expectations in coordinating US-EU trade and technology policy. The TTC’s role in developing a robust sanctions and export-control response to Russia’s invasion of Ukraine cannot be denied. However, it has yielded little else of significant value. The TTC has not led to joint policy action on China, it has not made any discernible progress on Biden administration priorities such as climate change, and it has not prevented new disputes or subsidy wars.

Monday’s TTC ministerial meeting outside Washington may signal incremental progress on a few of its objectives, but it is highly unlikely to herald significant progress on resolving US and EU concerns about the other side’s discrimination on critical climate and digital issues. The joint statement released after the meeting offered only platitudes on the most contentious issue—new electric vehicle (EV) tax credits in the US Inflation Reduction Act—without presenting a specific path forward. Indeed, according to reports, the TTC devoted just forty-five minutes of its Monday agenda to the EV dispute and it does not appear to have touched on the EU’s digital discrimination at all.

To help set up the next edition of the TTC for success, the United States and EU should immediately agree that the TTC needs to evolve and make addressing today’s transatlantic irritants one of its principal aims. Tackling these issues ahead and successfully resolving them is the key to opening up a new era in US and EU trade relationships, something necessary to confront tomorrow’s most substantial problems, whether they be climate, digital policy, or the threat posed by China.

At the moment, US-EU trade relations appear to be on a downward spiral with the TTC’s failure to prevent the adoption of policies that blatantly discriminate against the other side. The United States’ ill-advised EV tax credits, which only provide benefits to vehicles assembled in North America, is the most recent example. But the United States is far from the only offender. The TTC has not even placed a speed bump in the EU’s mission to discriminate against US technology leaders through one-sided digital taxes, imbalanced data disclosure elements in the Digital Marketing Act and Data Act, and the exclusion of US cloud companies from EU and French cloud-security certifications, to name a few. Given the priority that the United States and EU place on joint leadership on climate and digital policies, the fact that both sides are discriminating instead of coordinating with each other is all the more tragic.

But perhaps the latest crisis in the relationship actually points to a more promising path forward. In particular, what this spat helps illustrate is the need for a permanent body through which the United States and EU can raise, discuss, and try to resolve major irritants in real time at the ministerial level. The EU’s outrage over the EV tax credit has led to the creation of an ad hoc task force to try to address the measure’s discriminatory elements, but it is not as high-level as the TTC, does not address broader green subsidy issues, and will not necessarily head off subsequent misguided policies. It is also hard to understand why such an effort is one-sided—only focusing on EU complaints about a recent policy while ignoring US ones.

Regardless of the mechanism utilized, fixing these policies will not be easy. In order to address EU concerns about the EV tax credit, the US Congress will likely need to modify the legislation. Likewise, addressing US concerns about the EU’s digital sovereignty agenda will require policymakers across the EU to significantly modify their approach to regulating such that it applies equally to companies from the US and the rest of the world. This points to another needed change to the TTC: the Biden administration and European Commission must take steps to better secure buy-in from the US Congress, the EU Parliament, and important EU member states including France to work in good faith to resolve trade disputes. Complete political buy-in is a necessary ingredient for real change in the relationship’s trajectory in any case.

These ideas should not supplant the rest of the TTC’s agenda. Long-term standard setting—especially as a counterweight to Chinese efforts—is a laudable and important goal. But as the events of the past few years illustrate, efforts to coordinate are unlikely to yield success if the United States and EU continually get caught up in short-term disputes that are more politically pressing for their leaders.

Clete Willems is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center and former deputy director of the National Economic Council in the White House.

The post The US and EU need a sturdier structure to resolve their trade squabbles appeared first on Atlantic Council.

When we first looked at the debate in June, Secretary Janet Yellen’s Treasury was a strong proponent, but the EU was skeptical. By October, the EU had become a strong advocate and included in its eighth package of sanctions a promise to implement the cap before the EU ban on seaborne imports of Russian oil comes into effect on December 5.

A senior US team was in Brussels two weeks ago to iron things out. The fact that details as fundamental as the level of the cap are being agreed so close to the deadline betrays the extent to which conversations have been heated. Contracts on shipments that will arrive after December 5 have already been signed, and we hear the cap will only apply to shipments which are “loaded” after the date.

As implementation of the price caps finally gets under way, we will get answers to three critical questions:

1. How will the price cap work? And will it work?

The cap prevents firms in participating countries from providing shipping, insurance, and other services including trading and brokering to shipments of Russian crude oil that are sold above a certain per-barrel price, in this case sixty dollars. In practice, the onus will be on these providers to ask their clients for proof that they have bought at a cap-compliant price.

OFAC’s guidance shows some regard for the fact that shipping and insurance firms may not have complete information about how much their clients pay for each shipment. It calls upon them to request attestations that the cap has been respected via simple, and already standard, contract provisions. Firms that are requesting these (and have no reason to believe they are false) aren’t likely to face enforcement actions. This approach does give OFAC and its counterparts the authority to pursue whoever may have lied in an attestation, for instance by making a separate transaction above the cap.

For now, the cap isn’t as low as some would wish. Russian oil is already trading at a discount: about sixty-nine dollars per barrel compared to eighty-six dollars for Brent crude.

Some EU member states were pushing for a much lower cap—one which would remove Russia’s ability to turn a profit. They obtained a slight drop from a proposed sixty-five-to-seventy dollars to a (reportedly) final level of sixty. Even this was enough to generate concerns over implementation from the US Treasury. 

At sixty dollars Russia would still turn a strong profit. The much-discussed Chinese and Indian buyers the measure is designed to affect would simply use the cap in their negotiating tactics. When the stakes are low, it isn’t worth circumventing Western (especially European) firms’ hold on the shipping and insurance markets. If it were, Iran and Venezuela would have had an easier time exporting their oil in recent years.

We also think there will be opportunities for cheating, especially if the price difference between Russian-made Urals crude and Brent crude increases.

History has shown that it is possible for the shipping industry to misrepresent or obscure the origin of its cargo. Meanwhile, exemptions for certain pieces of the Russian production complex (notably the Sakhalin-2 project, which was heavily funded by Japan) suggests that there will be “un-capped” Russian barrels still floating into the market. The cap doesn’t fully address blends that include Russian crudes (perhaps intentionally), suggesting that there may be additional opportunities to maneuver Russian barrels through refined or partially refined products. Finally, it will be difficult for countries enforcing the cap to truly track the price paid, given the market’s opacity.    

The primary onus for compliance is placed on the unregulated brokers and traders of Russian oil products. The crucial test of this policy’s viability will lie in enforcement of the cap when breaches inevitably happen. OFAC has threatened cheaters with consequences, but taking action against them may well chill participation by other participants in the scheme and further undermine the dual policy goals of keeping Russian product on the market but cutting revenues for Moscow. 

2. What kind of global impact can we expect?

Washington, Brussels, and other capitals will be judged on whether we see Russia’s export revenue decline without prices at the pump at home increasing too much. As long as these two conditions are fulfilled, it doesn’t matter whether the cap is the decisive factor.

For now, the cap is not significantly below the price of Russian crude, so it’s not clear how Moscow will respond. Indeed, Russian President Vladimir Putin has just approved an increase in production. Assuming most of Russia’s supply remains on the market, the effect on prices will be small.

Should global prices increase and the cap force Russia to accept an even higher discount, we do expect Moscow to respond by selling less. The question is whether this is a little less or whether most of Russia’s supply becomes temporarily unavailable. Prices are well down from their July peak. This is mainly due to the risk of a G7 recession, but it is also true that engagement from the governments behind the price cap has reassured market participants. We had initially feared that additional layers of complexity would add tension to the market and result in higher prices.

However, the cap also becomes harder to enforce if prices increase and stay high. Between a sixty-dollar cap and an eighty-six-dollar Brent price, it may not be worth taking the risk of being fined and Russian revenues will be down compared to 2022 anyway. But the temptation will grow with the market price.

While G7 governments decided that a floating cap was too complicated, participating countries can always decide to move the fixed cap by committee. The cap could be moved down if G7 governments believe that enforcement is working. It could also be moved up.

3. What kind of impact can we expect on the Russian economy?

Russia’s export revenues have fallen since the record-breaking second quarter of 2022, due to lower oil prices and lower volumes of gas sold. The second factor—lower volumes—is partly due to Russia’s decision to reduce gas flows into Europe.

Consequently, the Russian government is already struggling to finance the increasing costs of its war in Ukraine and day-to-day spending (some of which is indexed to inflation). The latest budget foresees deficit spending in 2022 and for the three years to come. Initially, the gap was meant to be filled by transfers from the National Welfare Fund, which receives some of the oil and gas export income every year. But the government has now turned to borrowing on domestic markets.

The outlook is certainly bleak. Perhaps bleak enough to argue that Russia needs its oil revenue and will therefore continue to sell, even if the cap becomes more of a constraint than it will be to start with.

Reed Blakemore is the deputy director of the Atlantic Council’s Global Energy Center.

Charles Lichfield is the deputy director of the Council’s GeoEconomics Center.

Brian O’Toole is a nonresident senior fellow at the GeoEconomics Center and a former senior adviser to the director of the Office of Foreign Assets Control at the US Department of the Treasury.

The post What to expect from the new Russian oil price cap appeared first on Atlantic Council.

In the same way, institutional capital has remained concentrated in developed markets. Investors have sought to optimize for near-term returns rather than sustainable returns through diversification. The situation has resulted in unprecedented levels of liquidity: Global assets under management (AUM) have grown by more than 40 percent since 2015 and are expected to grow from over $110 trillion today to $145 trillion by 2025.

Investors looking for returns need to look to new markets. Africa—the most demographically dynamic region of the world—has been making headlines for the massive investment potential it offers, and yet has been stubbornly ignored. The continent’s average growth over the past two decades has oscillated between 4.5 percent and 5 percent, with five countries averaging over 6 percent. While the recession induced by COVID-19 hit wealthy countries of the Organisation for Economic Co-operation and Development hard with a 5.5 percent contraction in 2020, African countries were more resilient, only shrinking by 2 percent.

Despite the compelling economic data, the African growth story has not resulted in the concomitant boost in investment from global players. Investment into the region is made by the same long-time investors, including development finance institutions. Meanwhile, mainstream institutional investors remain on the sidelines.

Surveys have long documented the difference in risk perception between investors with established operations on the continent and those that are considering opportunities from afar. Those already invested in the region see Africa as the most attractive investment destination, while those that don’t have operations in African markets view it as the second-least attractive region. For funds and firms that have yet to enter African markets, a stubborn dichotomous view of African risk—one that oscillates between seeing the continent through a lens of foreign aid and another that embraces the high risk/high return view—creates confusion and causes hesitation. Furthermore, the mainstream investment strategy used by investors in developed markets—one that is data dependent and push-oriented—is ill-suited to the opportunities in African markets.

From data dependence to trend analysis

Developed markets are data rich. In North American or European economies, investing is governed by subsector experts who focus on niche industries and specialized asset classes. The accelerating financial complexity and sophistication of highly public markets in developed countries progressively made specialists critical to finding opportunities and delivering returns. The internet economy of the 2000s and the growing importance of real-time data has accelerated the specialization. Now, large data sets and artificial intelligence-powered analysis have become quantitative assets to specialist investors.

This was not always the case. Prior to the 1980s, top-level generalists who deeply understood political economy dynamics were successful investors. In the post-war era, international investors navigated domestic social change, reconstruction, decolonization, and oil shocks to build the continent’s first private equity firms and iconic multinational companies. Over the same period, the emerging computer revolution transformed economics from the study of human behavior in an environment of scarcity to a series of equations and advanced mathematical modelling. Economics as a science grew up alongside Masters of Business Administration (MBA) programs, resulting in a disconnect between economic and geopolitical analysis and an elevation of data in business decision-making.

In contrast to developed economies, African markets are defined by a lack of real-time, reliable data and strong interaction between political and economic realities, thus developed market analytical approaches will fall short. Cutting and pasting the data-dependent, specialist model in African markets leaves managers unable to understand and mitigate the operational, on-the-ground market risks. Country risk assessments, developed by economists at international financial institutions, tend to position geopolitical risk as a matter of insurance instead of being central to investment decision-making in projects and deals with medium-to-long-term returns horizons.

Taking a more intersectional perspective bringing together economic and geopolitical analysis requires an understanding of the trends currently reshaping the continent.

Most investors still operate on dated perceptions of African markets driven by oft-repeated factoids and the news cycle, failing to recognize the mutually reinforcing trends that have over the past twenty years restructured many African economies and enhanced their resilience. Coups grab headlines but day-to-day political stability makes for boring news. Despite the recent coups in Mali and Burkina Faso, the map of Africa is no longer a swath of autocratic regimes as it was in the 1980s but rather a mosaic with standout democracies such as Ghana and Senegal, which have—for the most part—been fortifying their institutions.

Regional powers such as Kenya and Nigeria, despite setbacks, have been on a trajectory of democratic progress. After the 2007 post-election violence in Kenya, the country reformed its electoral process and promulgated a new constitution in 2010 which devolved power. In Nigeria, the 2015 elections marked a turning point: the first time since the return of civilian rule in 1999 that an opposition party, the All Progressives Congress, won against the People’s Democratic Party that had ruled until then. In the 1990s, the Economist Intelligence Unit (EIU) only identified three democratic countries in Africa. In 2020, the EIU ranked twenty African countries as hybrid or higher on a democratic scale, despite democratic backsliding globally (including in the United States).

Accompanying the increasing political stabilization, economic diversification has also shored up African economic resilience. The continent’s sustained growth cannot only be attributed to high commodity prices but also is the result of a progressive shift away from raw material export models toward services and middle-class-based consumption.

The “oil curse” that colors the conversation of African economic growth is proving to be less powerful even in major oil exporters such as Nigeria. The oil price collapses of 2008 and 2014-16 revealed a previously unrecognized level of resilience on the continent. When oil hit a low of twenty-six dollars a barrel in 2016, regional gross domestic product fell to 2.2 percent from 3.4 percent the previous year, but the continent did not become mired in stagnation as it did in the “lost decades” of the 1980s and 1990s. Instead, growth recovered in 2017, revealing structural improvements (particularly in Nigeria).

Diversification has been supported by increased investments made in infrastructure, deepening regional integration culminating in the creation of the African Continental Free Trade Area in 2019, and greater amounts of disposable income that have supported domestic markets for consumption. African countries have had greater choice in international partners. Over the past two decades, China has become Africa’s most significant trading partner and the largest financier of infrastructure in the region to the tune of twenty-three billion dollars between 2007 and 2020. Over seven billion dollars of that financing went to telecom infrastructure. Increasing mobile penetration and digitization accelerated by COVID-19 are undergirding an exponential growth in venture capital into African markets. In 2016, total venture capital flowing into the region was just above $350 million. Five years later, it crested four billion dollars, with the lion’s share going to Nigeria, Egypt, South Africa, and Kenya, and with over 60 percent of the capital coming from US-tied entities.

The interaction of political stabilization, better macroeconomic management, technological change, and young demographics will support the continent in returning to growth after the COVID-19 crisis. Just like in the case of the 2016 oil shock, African growth bounced back to 3.7 percent in 2021, showing unanticipated resilience after the continent’s economy contracted by 1.7 in 2020. By analyzing the trends and accepting that rapid growth is neither linear nor smooth, investors can find success in African markets.

Pull over push strategies

Understanding transformative macro trends is sine qua non, but not enough to guarantee successful ventures. It is also critical to employ a pull strategy rather than a push approach. The latter focuses on creating new consumer needs and desires and then pushing relevant products into the market. The former instead rests on identifying unserved market needs and then creating products to meet that latent demand. Push strategies work well in consumption-based economies supported by efficient capital markets such as the United States or Europe in which affluent consumers can be convinced that their want of the newest mobile phone is actually a need. African markets are best-suited for pull strategies.

Most large European and US investors have a self-referential bias whereby they consider African opportunities through the lens of their own market operating environments. Many of them are looking to simply add a high-risk premium to compensate for investing in African markets on top of their familiar underlying asset structures. Some seek short-term, liquid, and safe assets such as treasury bonds while others pursue high internal rates of return (IRRs) in a seven-year fund lifecycle. Some are looking for real assets with developed secondary markets to ensure liquidity, while others want to deploy billions of dollars through thematic strategies such as infrastructure or climate.

Each “push” strategy will be exposed to difficulties that can create Goldilocks-type scenarios: not enough market depth, too few “bankable” projects, too much volatility, not enough liquidity, too much risk, inadequate profitability, and other such conditions. The list of reasons not to invest therefore becomes overwhelming and results in the accumulation of dry powder.

Fundamentally, African market realities are different—liquidity more often than not comes with volatility due to systemic local currency risk on the continent. The days of making 20 percent IRR in relatively safe private equity (PE) environments are also long gone: The first and second vintage in the early 2000s of African PE funds invested in banks, telecoms, and other low-hanging fruit, leaving only difficult operational, consumer-facing firms for today’s investors to build. Reports from both the International Finance Corporation and the African Private Equity and Venture Capital Association—better known as AVCA—show returns of less than 10 percent in African PE due to currency fluctuations. High returns can be found in the African early-stage venture space, but those opportunities are often too small for institutional investors.

To gain access to the tremendous opportunities that African markets offer at scale, emerging market investing must be built on pull strategies based on intersectional approaches, incorporating an understanding of existing demand and working to find overlaps between the realities of African markets and the requirements of investors. For example, the billions flowing into climate and environmental, social, and corporate governance (ESG) funds can deliver good returns, strong developmental impact, and advancement of United Nations sustainable development goals if investors think beyond immediate climate resilience within today’s economic context and recognize that African countries have a dual imperative–stimulating rapid green growth and alleviating poverty.

On a continent where six hundred million people lack reliable access to electricity, additional generation capacity is a critical priority on which the green or digital revolutions depend. While climate investors rightfully eschew investments in coal, natural gas generation opportunities may prove a good opportunity as they can create the base power necessary for broad-based solar. Likewise, attractive carbon reduction opportunities can be found in agribusiness, so having the flexibility to invest outside the energy sector increases the potential for success.

A flexible and intersectional approach can also help asset managers wanting to deploy billions of dollars in the short term. By recognizing that market absorption capacities will limit their deployment, they can invest smaller amounts in the nascent private debt industry, which will grow rapidly in the next three to five years given the continuously growing financing gap in African markets.

If large asset managers want the diversification and returns that these markets can offer, they must accept the intrinsic trade-offs found in emerging markets. If liquidity is the priority, an investor can buy bonds in Cairo, Lagos, or Johannesburg but must accept the concomitant volatility and depreciation risk resulting from the underlying assets being valued in local currencies.

If predictability and stability are desired, then an investor must prepare for illiquidity. While investing in illiquid assets in the real economy offers opportunities ranging from infrastructure to agribusiness to renewable energy, exits are difficult to time. The classic high risk, high return investment profile does exist but is now concentrated in the emerging tech and creative industries.

With recession looming on the horizon in the United States and Europe, investors who want to participate in the next wave of growth and create wealth from—and in—fast-growing emerging and frontier markets in Africa and beyond need to adjust their approaches to invest along transformational trends, navigate political economy concerns, and tap latent demand.

Twenty years ago, the Economist dubbed Africa “the Hopeless Continent.” Today, the associated risks with investing in Africa are very different. Risk perception must be updated to reflect the increasing resilience, digitization, and integration that now are taking hold in African markets. Investors will succeed if they work to understand market realities instead of coming with pre-defined investment strategies, if they find the overlap between their internal requirements and market needs, and if they embrace flexibility and intersectional approaches. The geopolitical and economic dynamics of this post-COVID-19 world make looking at African markets not a niche option but rather a mainstream necessity.

Guillaume Arditti is founder of Belvedere Africa Partners and a lecturer in international relations at the Political Sciences Institute of Paris (Sciences Po).

Aubrey Hruby is a co-founder of Tofino Capital, a senior fellow at the Atlantic Council’s Africa Center, and an adjunct professor at Georgetown University.

An abbreviated version of this article also appears on LSE Business Review.

The post The Africa investment imperative: Diversification and resilience amid economic downturns appeared first on Atlantic Council.

The December 5 gathering in the Washington area of US cabinet officials and European commissioners—the third semi-annual meeting of the Trade and Technology Council (TTC)—should be a perfect opportunity for high-level grappling with these disputes. However, neither is on the agenda, causing European Commissioner for the Internal Market Thierry Breton to decide the trip wasn’t worth his time. The reasons for that illustrate the limits of this new kind of transatlantic trade diplomacy.

The EU originally proposed the TTC, and it has been designed as the antidote to the lengthy, failed negotiations between the United States and Europe on a comprehensive trade agreement, the Transatlantic Trade and Investment Partnership (TTIP). The TTIP crashed at the end of the Obama administration, a victim of over-ambitious scope and deep-seated opposition in major EU member states to some of its planned measures to open up European markets to US competitors.

The TTC, by contrast, aims more modestly to “coordinate approaches to key global technology, economic, and trade issues; and to deepen transatlantic trade and economic relations, basing policies on shared democratic values,” according to its inaugural joint statement. The shelved quest for a grand transatlantic trade bargain would be replaced by political alignment on global economic challenges such as China and Russia, and by shared, concrete technology projects.

The December 5 meeting should deliver on some of this promise. Washington and Brussels are expected to announce coordinated transatlantic funding for digital infrastructure projects in the developing world, common definitions and methodologies for assessing artificial intelligence risks, a early-warning system for gaps in the global semiconductor supply chain, and efforts toward joint standards for charging electric vehicles, among other achievements.

But these “deliverables” pale in comparison to some of the bigger challenges that the TTC could be tackling. Both the United States and the EU are confronted by China’s robust state mercantilism and its efforts to shape global technology standards, for example, but these concerns figure only indirectly in the upcoming meeting. Washington and Brussels do discuss China in other international fora, of course. Yet without a shared appreciation of China’s economic threats, practical work on it in the TTC remains very limited.

Major trade irritants related to climate technologies are also missing from the TTC’s agenda, notwithstanding the group’s original announced objective to “fight the climate crisis [and] protect the environment.” Notably, European trade ministers have pronounced themselves “very concerned” by new US incentives for consumers purchasing electric vehicles containing locally sourced battery elements. These measures are contained in the Inflation Reduction Act (IRA), the recently enacted centerpiece of US climate strategy. The EU fears that the subsidies, which likely violate US obligations in World Trade Organization agreements, could incentivize European car manufacturers and producers of climate-mitigating technologies to relocate their production facilities to the United States.

The public response of the US Trade Representative (USTR) has been not to engage on the trade law questions, but rather to stress that the IRA represents “meaningful action to combat the climate crisis by investing in clean energy technologies and addressing supply chain vulnerabilities.” At the same time, the USTR and the European Commission have set up a high-level task force, chaired by officials from the US National Security Council and the office of European Commission President Ursula von der Leyen, to address the EU’s IRA concerns. The group operates independently of the TTC structure, however, and in any case no result from its discussions is expected by the December 5 meeting.

The uproar in Europe over US electric vehicle subsidies has drowned out US concerns regarding whether the EU’s Carbon Border Adjustment Mechanism—a proposed tax on importing into Europe products manufactured in countries not meeting the bloc’s strict emissions standards—conforms with international trade law. A joint EU-US technical working group has been charged with “developing a common methodology for assessing the embedded emissions of traded steel and aluminum,” but it too has been organized outside the TTC structure.

The other glaring absence from the TTC’s work-plan is collaboration on the regulatory challenges of information technology. Over the past three years, the von der Leyen-led European Commission has racked up an impressive set of legislative achievements in this area, adopting measures aimed at platform companies’ competitive advantages and at their role in spreading information damaging to democracy. Next on the EU horizon is passage of a comprehensive Artificial Intelligence Act and a law structuring the commercialization and international transfer of industrial data. Alarm bells also have gone off in Washington recently about a proposal from the EU’s network security regulator to impose foreign ownership limits and data localization requirements on cloud service companies. These cybersecurity certification requirements could exclude non-compliant foreign companies from the booming market in selling cloud services to EU governments.

The Biden administration periodically has registered its concerns in Brussels about these EU measures through the usual diplomatic channels. But the EU has rebuffed US entreaties to utilize the TTC structure to examine them, instead pushing ahead with its legislative agenda. The TTC also was not utilized as a negotiating venue for the new EU-US Data Privacy Framework, an accord intended to solve a decade-long dispute over US national security agencies’ access to personal data located in the EU.

Compartmentalizing the big issues in transatlantic trade and technology policy in this fashion has led to a palpable sense of frustration and disappointment in Washington that the TTC is not fulfilling its admirable goals. Diminished expectations were perhaps inevitable: There never was any realistic prospect that Washington or Brussels would slow their respective legislative agendas to accommodate a technocratic coordination process. Nor is the TTC’s elaborate format necessarily the panacea for resolving thorny policy problems.

Nonetheless, the TTC’s patent exclusion of the issues of greatest import in transatlantic economic affairs from its deliberations does not inspire confidence that it will prove to be a lasting institution. Despite their ritual invocations of unity and renewal, Washington and Brussels increasingly are returning to business as usual in their ever-prickly trade relations. Rebuilding a relationship of trust in transatlantic relations remains a work in progress.

Kenneth Propp is a nonresident senior fellow at the Atlantic Council Europe Center, teaches EU law at Georgetown University Law Center, and is a former legal counselor to the US Mission to the EU in Brussels.

The post The big problems you won’t hear about at the EU-US Trade and Technology Council appeared first on Atlantic Council.

Table of contents

Introduction
I. Trade and the strong ruble
Strong ruble and sanctions skepticism
II. Budgets and long-term savings
III. Reserves and the CBR’s shrinking room for maneuver
Where’s the money?
Less income, more stress
Conclusion

Introduction

Russia’s economy has demonstrated impressive resilience in the face of Western sanctions, so far. Forecasts of gross domestic product (GDP) downturn have been consistently revised on the upside, and inflation, though high, is lower than in Italy and in line with global trends.

This resilience stands in stark contrast to the consensus in the immediate aftermath of Russia’s invasion of Ukraine that unprecedented Western sanctions would at least give the Kremlin pause. While observers knew the export controls on key technologies and inputs would take time to bite, it was hoped that the financial sanctions and the blocking of the Central Bank’s reserves would be so disruptive that Russia just might reconsider. Many, including this author, fell for this kind of reasoning.¹

However, the factors that have spared Russia an immediate financial crisis and allowed it to finance the war are relatively few, and not guaranteed to remain in place. Many good recent reports delve deeper into production and how export controls are running down inventories and damaging entire sectors. This report takes a different tack by looking at the Russian government and the Central Bank’s management of oil and gas income, and how they’re preparing for the years to come. Difficulties are likely to compound as income falls and spending increases.

Official databases now feature obvious and deliberate gaps. The Central Bank of Russia (CBR) stopped publishing important time series relating to reserves at the onset of the war, while the customs authorities stopped updating the detail of trade volumes. Yet, there is still enough available in terms of raw data—and via official reports—to get a reasonable idea of what is going on.

Why? Russia may be waging a senseless war in Ukraine, but it also wants to be taken seriously by financial stakeholders, both internal and external. The lost access to Western finance has affected banks’ profitability, so it is vital that they convince Chinese and other banks that the Russian financial system remains robust enough.²  There are now fewer independent data available, as Western financial institutions and ratings agencies are leaving Russia. This forces the institutions to provide just enough transparency, while depriving sanctions-wielding countries of the information they want to test the effectiveness of their own policies.

So, it is up to us to use the data we can access, but use them with a critical eye.

I. Trade and the strong ruble

On a visit to Poland one month after Russia launched its invasion, President Joe Biden bragged that the unprecedented package of sanctions had reduced the ruble “to rubble.” While sell-offs had indeed caused the ruble to depreciate strongly in late February and early March, the picture was already quite different by the time Biden made his speech on March 26.

The story behind the ruble’s rapid recovery is one of good crisis management and good luck, in equal measure.

The Central Bank’s initial firewall response forced financial actors inside Russia to wait it out. In her February 28 press conference, dressed entirely in black, Governor Elvira Nabiullina announced a series of measures that went against her long-standing principles of free-flowing capital and a reasonably transparent lending system, all to serve the immediate priority of compensating for lost hard-currency reserves and keeping banks’ balance sheets in the black.

The key interest rate was slammed up to 20 percent, providing an immediate incentive against runs on banks. Eighty percent of export income would be forcibly converted into rubles. Now reduced to 50 percent, this measure still grants the Central Bank access to dollars and euros, which it can then lend to banks to meet their liabilities or to firms to import goods. It also stemmed the flow of foreign exchange leaving the country by limiting nonresident investors’ ability to withdraw capital and Russians’ ability to take cash across the border. Finally, the bank loosened auditing requirements for private banks, allowing them not to update or publish asset valuations.³ This measure was finally phased out on October 1, but some capital controls will remain in place until the end of 2023 at the earliest.⁴ 

These highly unorthodox measures, of which observers were skeptical at the time, succeeded in keeping the Russian financial system in suspended animation for long enough before the dominant factor behind the ruble’s recovery came into play: a bumper current-account surplus powered by high oil and gas prices and lower imports.⁵

Russia’s current account reached a record high of $76.7 billion in the second quarter of 2022. It remained well above historical trends in the following period, between July and September, at $51.9 billion. Figure 2 shows clearly just what kind of an outlier this year has been.

While still high, the current account surplus has fallen as Western oil importers have sought to diversify away from Russia, and as Russia has reduced the volume of its gas deliveries to Europe on its own initiative. There is also a secondary, but underappreciated, dynamic at play in net investments and net transfers, which are falling. In other words, Russians leaving the country are taking their savings with them, and Western firms are slowly beginning to divest despite the remaining constraints on capital flows.

The relationship between a positive current account and currency appreciation is easy to grasp. Higher commodity prices have meant that more US dollars and euros have flown into Russia and pushed up demand for domestic currency. For the money market to clear, either the interest rate or the exchange rate must increase. But the interest rate has been dropping step by step since the Central Bank’s initial hike to 20 percent just after the invasion. The exchange rate alone is able to reflect higher demand for rubles.

In late March, much was made of the Russian government’s decision to demand that “unfriendly”—meaning sanctions-wielding—countries pay for energy imports in rubles. This announcement is remembered as a turning point for the ruble, and it is true that the market anticipation of more demand for the currency was an early spark to its recovery.⁶ However, the policy has little to no impact on balance-of-payments dynamics. About twenty European gas-buying firms have opened ruble accounts with Gazprombank, and swap their dollars and euros for rubles there. Russia’s energy exports are the reason it has been able to access sufficient hard currency for its immediate needs since the beginning of the war, in spite of the much-publicized blocking of Central Bank foreign-exchange (FX) reserves.

Strong ruble and sanctions skepticism

The ruble’s strength and Russia’s bumper export income have caught the public’s attention in countries that decided to wield sanctions against Russia. Their own governments initially presented the ruble’s initial tumble as evidence of the sanctions’ effectiveness, so it is only natural that voters should be puzzled by the current situation.

The governments concerned should have seen this coming. Uncertainties over supply due to the war were going to raise prices. And energy exports are so important to the Russian economy and government income that oil and gas prices impact the relative prices of Russian goods, the business cycle and trade balance, and even interest rates. Gas and, especially, oil prices influence all the determinants of the ruble exchange rate, in the short, medium, and long runs.

This author argued in May that, while the ruble exchange rate is not a good indicator of the health of the Russian economy, it shouldn’t be ignored by Western policymakers either.⁷ It is, first and foremost, a symptom of oil and gas exports being Russia’s economic lifeline. To a limited, but not insignificant, degree, a strong ruble also allows firms and consumers who can afford them to secure embargoed goods and technology, at a significant premium. New iPhones are available in Moscow for just under 175,000 rubles ($2,900). The same model is available for $1,599 in the United States.

It is true that ruble trade volumes are much smaller than they were before the war, so the exchange rate is no longer an accurate or insightful indicator of value.⁸ The Urals index has fallen from peaks above $100 to below $70 without much of a depreciating effect on the ruble. Measures introduced in late February, like the forcible conversion of export income and capital controls, even temporarily increased demand for black-market exchanges, with rubles being sold at a lesser rate to the dollar.⁹

A strong ruble exacerbates the risk of “Dutch disease,” especially when combined with Western embargos on new technologies. The Russian economy has little incentive to diversify, and will not be competitive in doing so anyway.

Sanctions-wielding countries are struggling to communicate this complexity to the public effectively. This is understandable. Other familiar economic indicators have also outperformed expectations since the beginning of the war. GDP is only expected to slide a few percent year on year, instead of the 15 to 20 percent initially forecast. Year-on-year inflation is high, but lower than in Italy. Prices have actually been falling month on month since the initial spike in the second quarter (Q2).

So, it’s important to dig deeper and look into what the Russians are still able to do with their export income, and why the domestic economic outlook for 2023 is bleak.

II. Budgets and long-term savings

It is hard to imagine a more mixed policymaking picture than record export income combined with a twenty-percent decline in domestic economic activity. Watching the interactions between stakeholders in the federal budget process offers remarkable insights into their priorities and concerns related to short- and long-term income. This section will look at how income and spending have shifted this year before considering why President Vladimir Putin has just signed off on a change to the “Fiscal Rule,” which has dictated the volume of transactions to the National Welfare Fund (NWF) since 2017.

The ruble’s appreciation means that this year’s record export income has converted less favorably into rubles. This is a regular feature of Russian fiscal planning. A (more or less) free-floating exchange rate keeps the ruble value of export income more stable than it may seem from outside Russia. When oil prices are low, a weaker exchange rate can also ensure that export income doesn’t fall as sharply in ruble terms.

The main reason why oil and gas income has provided a remarkable lifeline is the government’s decision to suspend its own fiscal rule. This redirected into this year’s budget 4.8 trillion rubles ($79 billion) that would have been deposited into the NWF early next year. The comparison in Table 1 between the original 2022 budget (signed off in late 2021) and the current outlook for this year shows a 66-percent boost to oil and gas income. Even so, the collapse in non-oil and gas income due to the domestic economic downturn, combined with higher security and defense spending, means that the government will not avoid deficit spending this year.

It became clear that annual spending would overtake income much earlier in the war, during Q2, when classified spending started growing to fund the war effort as well as a domestic security crackdown. Finance Minister Anton Siluanov acknowledged Russia was heading for a deficit measuring 2 percent of GDP as early as June.¹⁰ There have since been pockets of “good” news in terms of income. Finance Ministry data suggest that income was still ahead of spending by 128.4 billion rubles ($2 billion) by the end of October. This was partly enabled by a special 416-billion-ruble ($6.9 billion) tax on the record profits made by Gazprom, which is 50 percent state-owned.¹¹ And yet, a deficit is still being planned. Twenty percent or more of Russian annual expenditures accrue in December, a month in which economic activity and state income tend to slow down.

The government’s strategy for covering the deficit has kept changing. In late October, Prime Minister Aleksandr Mishustin confirmed that a deficit would be covered this year with funds from the NWF. Meanwhile, the Finance Ministry has gradually reintroduced borrowing on domestic markets. This started slowly in October but, on November 16, the ministry announced its largest-ever issuance of Federal Loan Obligations (OFZ), measuring about 0.5 percent of GDP.¹² The new bonds have proven popular with Russian banks. These are demanding a rate of return seventy basis points above the 7.5-percent key interest rate for the shortest maturities, to account for inflation and uncertainty.

Resorting to domestic borrowing in addition to raiding the NWF isn’t simply the result of a growing deficit. The NWF is being pulled in several directions at once. We already know expected deposits from oil and gas income were suspended this year to fund day-to-day spending. Moreover, assets held in sanctions-wielding countries have been blocked and some of the fund’s sparser resources have already been committed to emergencies in the private sector, like the recapitalization of Aeroflot.¹³

Discussions around the NWF’s long-term fate are also revealing of all the challenges Russian policymakers face, from sanctions to the gloomy economic outlook.

From a Russian perspective, the NWF is separate from the Central Bank reserves. In 2008, the original rainy-day fund set up in the early 2000s, the Stabilization Fund, was split into the NWF and a Reserve Fund, which was meant to manage oil and gas income. But the Reserve Fund was run down in the aftermath of the annexation of Crimea and the first batch of Western sanctions, both in 2014. From January 2018, a single NWF has accumulated excess oil and gas income, following a fiscal rule whereby income above a cutoff price per barrel of oil ($45 was planned for 2022) was deposited into the NWF for it to invest in foreign currency and other less liquid assets.

The Finance Ministry oversaw a de-dollarization strategy ahead of 2022, as can clearly be seen from the last publicly available distribution of NWF assets, published on February 1, in which US dollars do not feature in liquid holdings.¹⁴

Unfortunately for the Federal Ministry of Finance, the United States was not alone in blocking the NWF’s assets alongside the Central Bank’s reserves. Some of the NWF’s Western currency assets are held by the CBR on its behalf, and should therefore still be accessible. But this may not cover the entirety of the $112.7 billion in liquid holdings declared on February 1. The NWF’s vulnerability to Western sanctions has been an important factor in the discussion about what should happen to the fiscal rule from 2023 onward, after its temporary suspension this year to support day-to-day spending.

At the beginning of this unusual budget season—Siluanov and the head of the Duma Budget committee Andrei Makarov agreed it was “the most difficult ever”¹⁵—the Finance Ministry was arguing that the price cutoff should be raised to $60 to raise more immediate revenue. The CBR and the Audit Court—presided over by former Finance Minister Aleksei Kudrin, who will soon switch to running the holding company of Yandex—both objected to this policy.¹⁶ The two institutions also argued that the original budget was based on growth projections which, while gloomy, were still too optimistic. So why object to more immediate revenue for the federal budget? Probably because they believe conditions will worsen, and the NWF needs everything it can get now to plug deficits in the difficult years to come.

Moscow hasn’t quite reached the end of the budget season, but a compromise on the new fiscal rule has already been found, and President Putin has signed off on it.¹⁷  From January 1, 2023, there will be no official cutoff price. Instead, the government projects a base of oil and gas income of eight trillion rubles per year for 2023–2025, which it believes is possible if the Urals index stays between $60 and $75 and production stays between nine and ten million barrels per day. Income above the base is to be made available to the NWF, which will invest the money into “friendly currencies.”

The new rule comes with a lot of leeway: the amount to be kept for NWF deposits will be decided on a monthly basis. This isn’t only the result of anticipated budgetary issues; it is also very clear that the Ministry of Finance does not know whether it will be able to find friendly currencies without any risk of blocks or confiscation. Investing in renminbi on the magnitude needed by the NWF cannot happen without Beijing’s approval. It should be a goal of Western policy to dissuade China from helping Russia invest its energy income.

However, with the NWF on the hook to at least partly cover the deficits of the next three years and only meager fresh funding planned under the new fiscal rule, it is clear that the Ministry of Finance plans on running down nearly all the NWF’s accessible and liquid assets over the next three years.

Looking at the federal budget in greater detail has shown that, even with this year’s purported windfall oil and gas income, the Ministry of Finance is struggling to keep up with current spending, let alone invest. But as the situation worsens, couldn’t the institution that has played a pivotal role in withstanding the initial shock ensure Russia continues to muddle through? What will the Central Bank do over the coming years?

III. Reserves and the CBR’s shrinking room for maneuver

Without the Central Bank’s drastic policies, Russia may have faced a financial crisis early in the war. The fact that the banking system withstood the shock to confidence—especially when the lender of last resort had just been deprived of more than half of its FX reserves—is no mean feat. However, the CBR is not all-powerful. This section will look at how the CBR has managed hard currency since the invasion before looking at its room to maneuver next year, when export income is expected to be considerably lower.

Where’s the money?

The oft-cited figure of $300 billion in “frozen” assets is derived from the last time the CBR made the composition of its FX reserves public, in January 2022. The report has since been removed from the CBR’s website, but can still be downloaded via the Wayback Machine.¹⁸ What the Group of Seven (G7) and a few more likeminded countries decided to do in the weekend after February 24 was, in fact, to block the CBR and NWF’s access to their holdings. The use of the word “freezing” is not accurate. It also suggests the sanctions-wielding capitals know exactly what assets they are freezing, when this is not the case.

The Atlantic Council’s private conversations with authorities in the United States and abroad suggest that the total of known, identified assets is less than one-third of the $300-billion figure, and intense work is being done in consultation to identify where the rest is, and which Russian institution owns what.

The CBR, predictably, is not making the job any easier. In addition to stopping its regular publication of FX composition, it has also cut off its regular reporting on FX reserve totals, so observers can now only see total reserves, including FX and gold. This indicator has been on a slight downward path since the beginning of the war, falling from $630 billion in February to $540 billion in October. Buried in a report on regional inflation, the bank argues that the dip in dollar value is because of the relatively low share of dollars in the overall mix.¹⁹ The dollar has appreciated against other currencies this year, so Russia’s total reserves have shrunk in dollar terms.

It is doubtful that this is the only factor at play. The CBR is still forcibly converting 50 percent of export income. It is clearly swapping this back to banks and firms that need FX. But with lower imports and no servicing of foreign debt, these liabilities are lower in practice than they were pre-invasion. The euros and dollars may well be accumulating off the Central Bank’s FX balance sheet—for instance, with the private banks that the European Union has refrained from sanctioning (Gazprombank, Credit Bank of Moscow, and Rosselkhozbank)—but, in this case, it should be a priority for Western policymakers to inject the maximum amount of uncertainty and complexity into these banks’ ability to move the money fast to serve CBR priorities. Sanctions policymakers also need to remain alert to unusual, large transactions to “nonaligned” central banks and sovereign wealth funds.

Less income, more stress

The CBR’s job is made easier when high commodity prices increase export income. Until 2008, the bank’s main role was to build up FX reserves and flood the market with rubles to prevent over-appreciation. Every time Russia has seen a sharp decline in its oil revenue (2008, 2014–2015, and 2020), the CBR has merely been able to smooth the transition to a lower exchange rate, not arrest it. Realizing a fixed-exchange-rate policy was unsustainable was the main reason the bank shifted to a policy of inflation targeting with independent rate setting in November 2014. But Russia’s dependence on goods imports means the bank still cares about the exchange rate, as it remains a key determinant of inflation.

With or without an effective G7-led oil price cap, the central scenario for 2023 is that Russia will sell lower volumes of oil and gas, at lower prices. The third-quarter data show this trend, yet the ruble hasn’t depreciated (see Figure 1). This does not mean that the special measures introduced at the beginning of the war—including capital controls—have succeeded where reserves and rates policies failed until 2014. The Central Bank will be forced to allow the ruble to depreciate before long, simply to ensure that the lower export income converts more favorably into rubles.

While it can be prudent in how it lifts capital controls, the CBR will struggle to smooth this transition to a weaker ruble. The two main tools at its disposal—reserves and interest rates—are blunter than they were before the invasion.

Before the war, the CBR could use its colossal reserves (the fourth largest ) to buy rubles, and thereby smooth depreciations. This was a reasonably effective tool, though no match for the effect oil price fluctuations had on the ruble exchange rate.

The two countervailing forces can be compared using a simple vector autoregression (VAR) model tracking the monthly interactions of the Urals price index, domestic production and prices, the ratio of Central Bank loans to FX reserves, nominal exchange rates, and interest rates between 2007 and 2021. On average, a 15-percent negative shock to oil prices causes the ruble to depreciate 5 percent against a basket of dollars and euros. The average CBR response through selling reserves arrests less than a third of this effect, and the depreciation tends to happen anyway after the policy’s effect wears off. This was before sanctions-wielding governments blocked the CBR’s access to reserves held within their institutions.

Unfettered access to these reserves also made the CBR an extremely credible lender of last resort for the domestic banking system. Nothing prevents the CBR from lending more rubles than it can access in foreign exchange but, in a high-inflation environment, it will want to avoid giving the impression it is just printing rubles. In the two decades before 2022, the bank never lent out more (at any given time; in rubles, euros, and dollars combined) then it had stored in FX reserves. It arguably broke this unwritten rule in February and March, when its lending reached 75 percent of pre-invasion FX reserves—above the amount to which it really had access following the sanctions. In 2023, domestic banks’ balance sheets will come under stress as they finally update their asset valuations after months of suspended animation.

Deputy Governor Alexei Zubotkin has acknowledged that the blocked reserves place additional pressure on the second instrument at the bank’s disposal: interest rates.²⁰ Over the past decade, the bank has acquired a dominant role in dictating the cost of lending through its key interest rate, which was introduced in September 2013. February 2022 showed just how helpful this can be for keeping faith in the banking system. But interest rates have proven a much less effective instrument for smoothing depreciations over the years. The same VAR model shows interest rates becoming more effective in controlling inflation after the CBR switched to an inflation-targeting mandate in 2014, but no significant improvement in its ability to smooth depreciations.

The CBR can expect challenges to compound in the near future. It lacks sharp enough instruments to smooth the transition to a weaker ruble. Expansionary budgets tend to increase inflation expectations. The bank may also need to lend to struggling banks more than it has in accessible FX reserves, which will further fuel expectations. Like the National Welfare Fund, the CBR is also coming under pressure to fulfil ever more varied and esoteric duties, from issuing guidance on which licensed financial professions should be exempt from the military draft²¹ to cracking down on Telegram channels suspected of promoting “pump and dump” buying frenzies.²² Overall, we expect the CBR to face a much more challenging year in 2023.

Conclusion

Though largely enabled by one dominant factor – oil and gas export income – Russia’s response to sanctions and the exodus of Western firms has been competent.

In retrospect, it is easier to see how effective some planks of the “Fortress Russia” strategy have proven, at least in withstanding the initial shock of Western sanctions. A Central Bank with a clear mandate and an influential rates policy can concentrate on shoring up confidence in the domestic banking system. A “de-dollarized” National Welfare Fund provides an extra cushion when deficit spending becomes inevitable. And, as we might have expected, exporting crucial commodities at a time of heightened uncertainty will provide an income boost, however temporary.

But risks for Russia remain, largely on the downside.

As Atlantic Council Senior Fellow Carla Norloff writes in the Guardian,²³ sanctions may have individual weaknesses, but they work through force multiplication. Export controls are beginning to bite. Despite the record income of Q2, sanctions and embargos have already cost Russia billions in revenue this year by lowering Western demand and putting Moscow in a difficult bargaining position with new buyers. Lower income will require a weaker ruble to sustain public spending. But the Central Bank is now deprived of the monetary policy tools which could have helped it ensure this transition was a smooth one.

The anticipation of lower income already means that the Russian government is planning on running down the liquid part of its National Welfare Fund. Western policymakers should remain vigilant to long-term investments being made in “friendly” denominations, like Renminbi. They should also continue to work on filling knowledge gaps, especially regarding which Russian assets Western central banks currently hold. Progress on this front is a precondition for any kind of negotiation on Russia’s withdrawal of Ukraine and its payment of reparations.

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The post Windfall: How Russia managed oil and gas income after invading Ukraine, and how it will have to make do with less appeared first on Atlantic Council.

Everyone is still trying to figure out precisely what went wrong and why. But the revelations thus far are stunning. For starters, FTX was not only the world’s third-largest crypto exchange—which is a website where customers deposit, buy, and sell various sorts of tokens and derivative products—but it also had close ties to an affiliated trading firm run by FTX’s CEO called Alameda Research. To make matters more complicated, FTX had also minted a token of its own called FTT.

That overlap is where the trouble began. At some point this year, FTX CEO Sam Bankman-Fried allegedly transferred ten billion dollars in customer funds to Alameda Research to make up for trading losses incurred there. On November 6, FTX’s major competitor, another exchange called Binance, announced that it owned a large amount of FTT tokens and was going to sell them all, which could crash the price and imperil the balance sheet of FTX. Customers became spooked and began withdrawing their funds from FTX by the billions. Binance briefly floated a plan to swoop in and acquire FTX, but promptly abandoned that. Things went downhill from there: FTX froze withdrawals and most of FTX’s legal and compliance teams quit. Other serious allegations came to light, including that there may be a secret backdoor in FTX software that eluded auditors and led to some $1.7 billion going missing. The drama was heightened by the persona at the heart of it, Bankman-Fried, who was once considered a wunderkind of crypto, testified before Congress, and was an active political donor. He has been live-tweeting the entire episode (sometimes enigmatically) and continues giving detailed and disconcerting interviews. All told, thousands of FTX customers have billions in funds that they cannot withdraw, and the crisis has spread to other companies.

The fallout has been swift. In a single day, FTX filed for bankruptcy, Bankman-Fried formally resigned, and someone (potentially a hacker) absconded with over three hundred million dollars in assets. Federal officials at the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, and Manhattan US Attorney’s Office are all reportedly investigating the matter. Congressional hearings are planned, and US Senator Elizabeth Warren, a leading Democrat on the banking committee, called for “stronger rules and stronger enforcement.” Commentators are suggesting that this is a death knell for crypto generally. Cryptocurrency proponents are reeling, and some partly blame regulators for failing to catch wind of irregularities earlier.

All of this litigation, investigation, and regulation will take several years to unfold. And it seems unlikely that Congress will pass a legislative fix anytime soon—particularly because a draft bill previously under consideration was supported by Bankman-Fried.

In the meantime, however, there are some steps that policymakers and industry can take to prevent a calamity like this from recurring.

First, financial regulators and industry leaders should move toward what is known as “proof of reserves,” meaning that large, centralized exchanges and custodians have to actually prove (and document) their assets and liabilities. In other words, they cannot baldly assert that they possess one billion dollars in customer funds while quietly using those funds to make other risky investments and loans. Already, a movement is afoot across the sector to adopt this measure voluntarily. Policymakers could strengthen it by encouraging periodic reporting, audit standards, and other guidelines to avoid gamesmanship (e.g., moving money around right before a report is due).

Second, the industry needs to step it up in terms of self-policing. In traditional finance, there are groups known as self-regulatory organizations that have the power to establish and enforce industry standards. No such body yet exists with respect to cryptocurrency, although several trade associations that have emerged in Washington are doing good work and might join forces on this. Recent crises also underscore why the sector needs to proactively blow the whistle on bad actors, not just advocate for favorable legislation.

Third, regulators should reaffirm—and where needed, clarify—that US regulations still apply to products and services that are regularly sold in the United States. Currently, some big, centralized cryptocurrency companies essentially argue that they are everywhere but nowhere. The CEO of the largest exchange, Binance, has repeatedly insisted that he has no headquarters whatsoever. It is hard to see how that position is legally sustainable for a centralized, for-profit entity—particularly now. Going forward, dizzying corporate structures and unsupported assertions about decentralization will not readily escape established principles about regulators’ jurisdiction. Already, we are likely to see agencies such as the SEC redouble their crypto enforcement activities. Existing federal laws might be adequate to pursue claims of outright fraud and extraordinary financial misconduct, and it is not yet clear that new legislation or new regulation would stem the root causes of FTX’s implosion.

In addition to the significant harms to customers, the sad irony of the FTX crisis is that some prominent cryptocurrency projects were born out of a true desire to avoid the excesses and errors of the 2008 financial collapse. Indeed, the first Bitcoin ever minted literally embedded a 2008 headline about the bailout of big banks. If the industry wants to preserve that vision, it must improve transparency, rebuild trust, and get its own house in order.

JP Schnapper-Casteras is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center and a practicing attorney.

Further reading

Cryptocurrency Regulation Tracker

Cryptocurrencies may significantly alter financial structures and transform the next generation of money and payments. Governments around the world are looking to create regulations to prevent the harms caused by cryptocurrencies while encouraging the innovative capabilities of cryptocurrencies. We analyze how 45 countries have regulated cryptocurrency in their jurisdictions.

The post How to prevent the next FTX appeared first on Atlantic Council.

The post Econographics piece by Graham reprinted in the Estonian Free Press appeared first on Atlantic Council.

When Xi became China’s leader in 2012, he inherited a nation of newfound wealth growing at a rapid pace. Expanding at an average pace of around 7 percent a year, the Chinese economy nearly doubled in size over the course of Xi’s first two terms.

Now, the situation is markedly different. For the first time since 1989, China will miss its annual gross domestic product (GDP) growth target. Officially, Beijing points to the sweeping COVID-19 restrictions it has implemented across the country to explain the slowdown. However, deceleration in growth prior to the start of the pandemic and economic crises including a meltdown in the property sector, distressed local government finances, and rising youth unemployment suggest that the slowdown may have deeper roots.

As questions mount around China’s economic performance, new research from the Atlantic Council GeoEconomics Center and Rhodium Group’s China Pathfinder explores whether the growth slowdown is truly a temporary blip caused by Beijing’s pandemic response or a sign that China is splitting from market thinking.

In evaluating China’s progress, the data—spanning from 2010 to 2021 and covering financial system development, market competition, trade openness, moves toward a modern innovation system, direct-investment openness, and portfolio openness—shows that China’s economy has unequivocally converged with open market economy norms, although the progress has been uneven. Though China remains behind economies such as Japan, the United Kingdom, and the United States, it has seen significant improvement in innovation and trade, with modest improvements in financial system development. In contrast, its progress in implementing reforms that support market competition and investment openness has been more piecemeal.

Looking forward, China’s progress in trade openness and innovation will likely persist. The Twentieth Party Congress signaled no major changes in China’s economic-policy direction and Xi has pointed to trade and innovation as priorities for his third term. Still, there are gaps in that progress, suggesting deeper structural weakness that cannot be overcome quickly—putting China at risk of backsliding.

Trade openness

Over the past decade, Beijing has focused on integrating its economy with global trade flows of goods. It has lowered the tariffs it applies to imports—going from a mean tariff rate of around 10 percent in 2010 to 7.5 percent in 2021—and has increased the portion of global goods that flow through its economy from around 9 percent in 2010 to 12.5 percent in 2021. As Beijing follows an export-led growth model and pursues new trade deals, such as a possible deal with Uruguay, China’s barriers on trading goods will continue to fall through Xi’s third term.

However, China’s trajectory on trade liberalization has not been so unequivocal. Non-tariff barriers on goods, services, and digital trade (alongside subsidies and Beijing’s refusal to adjust exchange rates to correct its balance of payments) muddle the story of China’s progress. Beijing’s restrictions on digital trade are of particular note given the growing significance of digital trade for advanced economies. China’s score in this area has worsened since 2014, a reflection of additional restrictions Xi imposed over the past eight years.

Despite Beijing’s trade reforms, exports no longer represent the engine of growth they once were for China. As the rest of the world teeters towards recession, near-term demand abroad for Chinese goods is weakening, and a long-term focus on export-driven growth cannot supplant a shift towards domestic consumption. Beijing still needs to boost the country’s own household consumption for China to transition toward a sustainable growth model. 

Toward a modern innovation system

Like with trade, Beijing has also implemented policies to improve its innovation economy throughout Xi’s first two terms. As a result, China now scores higher than Spain, Italy, and Canada in innovation, according to China Pathfinder. This is primarily driven by boosts in China’s research and development (R&D) spending across both the public and private sectors. China’s R&D spending relative to GDP increased from 1.7 percent in 2010 to 2.4 percent in 2021, though it remains below the open-economy average and significantly below high-tech powerhouses such as South Korea, Japan, and the United States. This increase has been driven in large part by the private sector. Venture capital in particular has taken off in the past decade as China prioritizes the development of disruptive new technologies such as artificial intelligence, 5G and 6G telecommunications equipment, and biotechnologies.

However, this progress comes with caveats. Through government guidance funds and subsidies, the state still largely determines where innovation takes place. Recent moves such as Beijing’s crackdown on tech companies also risks undermining the innovation gains that China has made in recent years.

The past decade has also seen China turning away from the United States and European Union as partners on innovation and opting to look inward instead. Venture capital once again offers an example: When Xi first took power in 2012, Chinese companies represented 65 percent of investors in venture funding rounds for other Chinese companies. In 2021, the most recent year with complete data, they represented 82 percent of total investors. This trend will likely continue with Xi emphasizing the importance of greater “self-reliance and strength in science and technology” during the party congress. This is not without risk: Weakening foreign investment in China could diminish the country’s innovative potential by squeezing funds and reducing opportunities for international collaboration.

Despite China’s progress in R&D spending, the country still lags behind the open-market economy average in measures of innovation quality. For example, in 2021 the payments China received for foreign use of its intellectual property only reached around one-seventh the average amount that an open-market economy receives when adjusted for GDP; that implies that Chinese intellectual property remains unattractive relative to that in other leading economies. China’s commercial aviation sector shows how China’s R&D spending doesn’t line up with the quality of its output: The sector has swallowed extensive amounts of capital and resources over the past twenty years with little to show for it.

A statist shift

China’s reform progress during Xi’s first two terms in other economic areas tracked by China Pathfinder has been lackluster. Furthermore, China’s progress toward market economy norms slowed in most areas, including innovation, in 2021. Beijing’s reforms to develop its financial system and boost market competitiveness have stagnated, and its openness to both portfolio and direct investment has decreased since 2020. The Twentieth Party Congress showed no signs of bucking this trend, especially since for the first time since 1989, the Politburo Standing Committee is entirely composed of loyalists to the party leader. This will have dangerous consequences for China’s long-term growth rate.

China’s market reforms should not be seen as concessions to the West. Rather, they are the bedrock of China’s own economic growth prospects. There is a chance the damage done to China’s GDP growth prospects by its property sector collapse and its adherence to its zero-COVID policies will compel Beijing to return to the pro-growth reform path the CCP outlined in 2013 but largely abandoned during Xi’s second term. Unfortunately, the fear—and the more likely outcome—is that Beijing will instead fall back on statist solutions that have defined the economic direction of the end of Xi’s second term. This could mean a long-term GDP growth rate of around 2 to 3 percent, which is a far cry from the 5 percent analysts forecasted prior to the pandemic. The result: a Chinese economy five trillion dollars smaller than projected by the end of the decade, with somber implications for global growth.

Niels Graham is an assistant director at the GeoEconomics Center.

The post Will Xi take a new economic direction? China has trillions at stake. appeared first on Atlantic Council.

The European Commission recently announced that it will reexamine the European Union’s (EU) export control regime to determine if additional tools are needed regarding outbound strategic investment controls. Whether or not the EU will follow through with new outbound investment controls, and what those might look like, may not be purely determined by European deliberations. It will also depend on the evolution of American national security policy and transatlantic diplomacy.

US legislation enabling the review of outbound investment from the United States towards adversarial countries like China and Russia may pass soon. If the National Critical Capabilities Defense Act (NCCDA) is passed, increased US outbound investment review will likely impact the transatlantic relationship. Although the EU-China Comprehensive Agreement on Investment (CAI) was shelved in early 2021, some EU constituents still want to expand their investment relationship with China. Their appetite may be undermined by the NCCDA. The United States and the EU therefore need to carefully work with each other as they develop outbound investment screening mechanisms to prevent transatlantic tensions and conflict.

Extending US-EU cooperation into this area will be challenging, but not impossible.

The United States is highly motivated, having grown increasingly wary about the CCP’s hold over Chinese “private” businesses and the civil-military fusion approach which obliges Chinese “civilian” companies to share their technologies with the military-security industrial complex. US lawmakers have indicated that they want “to have a multilateral approach with partners and allies to ensure that [the United States] help them foster their development and implementation of similar, complementary mechanisms.”

The outward investment review is intended to prevent US capital from flowing towards America’s strategic competitors’ defense and security relevant sectors. The concern is not only that Chinese companies garner US capital, but that capital flows are accompanied by significant technological and knowledge transfers. The review would focus on technology companies, but it might be expanded to encompass other sectors relevant to national security, which can involve everything from steel manufacturing to banking and financial services.

The EU Commission’s announcement that it will explore outbound investment screening, seems to follow upon the prospect of US legislation passing soon.

Ideally, the American and European screening regimes should be developed in joint consultation. Why? The multilateralization of outbound investment screening is logical merely from a technical perspective. American capital, knowledge, and sensitive technology may be tied up in European companies, which can still invest in China, independently from US regulators. US legislation, once extant, may even have extraterritorial reach, automatically affecting European investors in China.

Previous US investment screening legislation already gave US authorities the capability to intervene in Chinese-European deals. For example, in 2017, the German lamp maker Osram had to get approval from the Committee on Foreign Investment in the United States approval for the sale of a part of its business to a Chinese group. The 2020 Foreign Investment Risk Review Modernization Act can prevent European private equity and venture capital funds from investing in US technology companies if they are co-funded by Chinese investors.

From a more strategic perspective, the multilateralization of outbound investment reviews is also advantageous. The United States wants to deny its adversaries’ national security complexes access to capital, knowledge, and technology from both the United States and US allies and partners—including the EU.

While clearly necessary, a transatlantic conversation about reviewing outbound investments may also lead to lengthy and sometimes frustrating negotiations. European financial and commercial interests and American national security policy do not always overlap. For example, US efforts to limit European business interactions with Russia over Nord Stream 2, with Iran through secondary sanctions, and with China over, chip manufacturing have led to significant fall-out.

In this case, difficulties may emerge on at least three levels: the interests of European businesses, the absence of European “national security” standards, and diverging strategic concepts.

Regarding European business interests, in early 2020, the EU-China Comprehensive Agreement on Investment seemed likely to pass. The EU only shelved the deal after significant pressure from the incoming Biden Administration. However, German businesses invested more than ever in China in the first half of 2022. Voices in favor of reviving the EU-China investment agreement remain strong. Chancellor Scholz’ recent trip to Beijing, accompanied by a large business delegation, was a case in point.

The second difficulty is that there is no single European system for investment screening and the screening standards are not harmonized, although the EU Commission can issue non-binding “opinions.” What is considered security-relevant in one EU member state may be ignored in another. A foreign investment in a specific kind of technology may be off-limits in France, while Swedish or Bulgarian authorities may allow such an acquisition to proceed. There is a growing need for a joint European understanding about the nexus of economics and security. Addressing this need could be the way forward to harmonize the European approach to foreign investment screening, inbound and eventually outbound.

Third, at the most profound level, the United States and the EU will have to reconcile their visions of world order, strategic competition with China, and how the management of capital markets, including outward investments, relates to this broader vision. Washington and Brussels need to get this conceptual question right at the start to prevent tensions from arising later on.

Brussels therefore has two options. Either it will passively await new US legislation and American diplomatic pressure, which may subject European investors in China and beyond to American rules and perspectives. Doing so may create significant tensions and harm the transatlantic relationship. Alternatively, the European Commission and European member states proactively prepare their own views on the geopolitical and security implications of European and Western investments in adversarial states like China.

The Commission now seems to be pursuing the second, better option but has yet to translate its geopolitical perspective on capital markets into policy proposals. But it takes two to tango. The US and the EU should engage with each other to work on a common understanding and, ideally, a joint approach to outbound investment screening. The better their mutual understanding on these issues, the more likely the United States and Europe are to commit to a truly transatlantic approach to strategic competition with China.

Dr. Elmar Hellendoorn is a nonresident senior fellow with the GeoEconomics Center and the Europe Center.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

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The post What US outbound investment screening means for Transatlantic relations appeared first on Atlantic Council.

As the digital landscape grows, the European Union (EU) is advancing its efforts to expand its indigenous technological capacities and establish global governance norms. This effort has significant implications for the economic and political underpinnings of the US-EU relationship.

Under the leadership of European Commission President Ursula von der Leyen, the idea of “digital sovereignty” has become a central—albeit nebulous and controversial—guiding principle for Europe’s engagement on digital and tech affairs.

Three years after von der Leyen first spoke of digital sovereignty, this Europe Center report explores what the concept has meant in practice, building on its 2020 report “The European Union and the search for digital sovereignty: Building “Fortress Europe” or preparing for a new world?”. The report identifies three common elements to digital sovereignty:

• a greater commitment to supporting technology development within the EU;
• an effort to elaborate global norms to govern data and the digital environment; and
• greater restrictions on non-EU actors in the EU market.

This direction has outsized implications for the transatlantic relationship. By concentrating on digitizing the European economy and investing in technology capabilities, the EU hopes to make up for current shortfalls and to compete more robustly with digital powerhouses based in the United States and China. In areas such as artificial intelligence—where global norms and standards have yet to emerge—the EU sees its own regulatory efforts as a potential international “gold standard”, like the role that the General Data Protection Regulation has played across the globe.

These measures are not without controversy. For example, the Digital Markets Act, which imposes restrictions on the largest platform companies operating in Europe, is anticipated to affect US firms predominantly, and current proposals for a cybersecurity certification of cloud service providers would limit ownership by non-EU companies. These moves have led to tensions in the US-EU economic relationship—at a time where transatlantic unity is critical in an increasingly geopolitical world.  

What is the future of EU digital sovereignty? The European Union will continue to insist that European technology and innovation respect its own concepts of fundamental rights. The report also sees opportunities for democracies to build coalitions to fight growing authoritarian challenges to the liberal order. The global digital realm remains unwieldy and difficult to govern. Yet through creative and determined collaboration in the US-EU Trade and Technology Council, among other fora, policymakers on both sides of the Atlantic can begin to craft a common democratic approach to digital governance, benefiting an open global economy.

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Introduction

Sector 1: Semiconductors

Sector 2: Telecommunications, 5G infrastructure

Sector 3: Equipment needed for the green energy transition

Sector 4: Active pharmaceutical ingredients

Sector 5: Strategic and critical minerals

Conclusion

Introduction

Weaponizing economic relationships in the service of national security and geopolitical goals has come of age with Russia’s 2022 invasion of Ukraine. The strategy had already been employed against small countries such as Iran, Venezuela, and North Korea, but the Trump administration’s trade war against China brought it to a new level. The COVID-19 pandemic has heightened concerns about relying on China for critical strategic and medical products. The United States and, to a lesser extent, Europe have floated various concepts to indicate how they would respond to these perceived vulnerabilities including reshoring or nearshoring in an attempt to reverse the consequences of the offshoring that has contributed to making China a global manufacturing and trade powerhouse. In her speech to the Atlantic Council in April, US Treasury Secretary Janet Yellen used the term “friend-shoring” to describe efforts to reconfigure global supply chains so that key manufacturing nodes would be relocated in politically friendly and reliable countries.

This comes at a time when China has embraced their dual circulation strategy articulated in its fourteenth five-year plan with a program called Made in China 2025 at its core—aiming to reduce China’s reliance on other countries while trying to increase their reliance on the Chinese economy. President Xi Jinping, in his opening speech at the Twentieth National Congress of the Chinese Communist Party (CCP), reaffirmed that China will strive for self-reliance in science and technology.

Attempts to decouple or diminish the economic and technological relationships between the West and China have presented difficult challenges to policymakers as well as corporate executives. Basically, China occupies a crucial position in global supply chains: being the top manufacturer, including of high-tech goods; accounting for 18 percent of the global gross domestic product (GDP) and 15 percent of world trade; and ranking among the top trade and investment partners to most countries on Earth. It is thus not an easy task to divert global supply chains away from China. This article aims to document the progress, potential, limits, and implications of friend-shoring—and China’s countermeasures—especially in the production and supply of critical high-tech and strategic products, focusing on five key sectors.

Sector 1: Semiconductors

The most visible example of the high-tech decoupling between China/Russia and the United States/West is about advanced semiconductors—triggered by the Trump administration’s ban on sales to Chinese companies of advanced computer chips and other critical high-tech products containing US inputs including intellectual property (IP) that is on the US Entity List, a Commerce Department roster of licensing requirements. President Biden has expanded the ban to include chip and memory-making equipment as well as chip design software to a lengthened list of Chinese entities—now numbering around six hundred. Many Russian companies were added to the Entity List in 2022 after the February invasion of Ukraine. On October 7, 2022, the Biden administration imposed new and extensive export controls on artificial intelligence (AI) and semiconductor technologies to China, with the goal of retaining US control over “chokepoint” technologies in the global semiconductor supply chains.

China has led the world in the manufacturing and exports of high-tech consumer goods; for example, the nation produced 250 million computers and 1.5 billion smart phones in 2020. Many of those products rely on semiconductors—especially advanced chips for sophisticated capabilities. China has increased its fabrication of semiconductors, mostly through foreign-owned firms in China—and now accounts for 15 percent of world production (of all chips, surpassing the United States at 12 percent). However, China still needs to import 85 percent of the computer chips used domestically. In particular, China seriously lags behind the West in critical phases of the semiconductor value chain: the design of integrated circuits (with Intel being the leader), the fabrication of chips (with TSMC and Samsung being the leaders, especially the only producers of 7- and 5-nanometer (nm) chips and soon 3-nm chips), and the production of semiconductor manufacturing equipment (with ASML of the Netherlands being the leader, especially in the extreme ultraviolet (EUV) lithographic etching devices required to produce the most advanced chips). China does produce run-of-the mill or legacy semiconductors (mainly 25- and 17-nm chips), but so far meets only 15 percent of domestic demand, relying on imports for the rest. According to ASML CEO Peter Wenning, it would take China up to fifteen years to catch up and become self-sufficient in semiconductors. In the meantime, the United States/Western ban on selling advanced chips, together with other restrictions, has greatly hindered sanctioned companies in their efforts to develop and produce more sophisticated products. The problem is, when China becomes self-sufficient in semiconductors, Western companies will have lost a huge market in China—accounting for more than 60 percent of global demand. This prospect will constrain their own future growth.

The Western advanced-chips ban on several Chinese entities has occurred alongside efforts by the United States, the European Union, and China to secure reliable supply of semiconductors and to reduce reliance on opponents. In August, President Biden signed into law the CHIPS and Science Act of 2022 (CHIPS+), which Congress passed after two years of debate. CHPS+ will provide $52 billion to subsidize the design and manufacturing of computer chips in the United States, a 25 percent investment tax credit to incentivize investment in chip production in the country, as well as about $200 billion to support science and development activities to spur innovation. Companies receiving US chip support will be barred from expanding production in China that is beyond “legacy semiconductors” (i.e., 25-nm and older chips) for ten years. In response to incentives from the US federal and state governments, several global corporations have announced plans to invest in semiconductor manufacturing plants in the United States. These include TSMC ($35 billion in state-of-the art wafer fabrication in Arizona), Samsung ($17 billion in Texas), Intel ($29 billion in Ohio), Texas Instruments (up to $30 billion in Texas), Micron ($40 billion), and Qualcomm ($4.2 billion). When implemented, these plants will add meaningfully to US semiconductor manufacturing capacity, reducing the need for imports.

The United States has also proposed a Chip 4 Alliance with Japan, South Korea, and Taiwan to cooperate more closely in all phases of the computer-chip supply chain, aiming to exclude China in the process. While Japan and Taiwan are likely to join the alliance, Korea’s attitude has been ambivalent: Seoul said that it will participate in a preliminary meeting in the near future, but has not clarified whether it will formally join the alliance. China has exerted strong pressure on Korea not to join.

Similarly, the European Commission has proposed a European Chips Act, aiming “to prevent, prepare, anticipate, and respond to future supply chain disruption, and enable the EU’s ambition to double its current market share of semiconductor production to 20 percent in 2030.” This act will also mobilize €43 billion ($42.01 billion) of investment in the semiconductor sector. The proposed act is currently going through the legislative process at the European Parliament and with member countries. Intel has committed $36 billion of investment to produce chips in Europe—as part of an €80 billion investment plan over the next decade. Furthermore, the Dutch government plans to invest €1.1 billion to build a new national champion in photonic technology, similar to Eindhoven-based ASML, which is the global leader in EUV lithographic equipment to make chips; this sophisticated equipment has been blocked from being sold to China by the US and Dutch governments.

In response, China has mobilized financial resources via a number of state-sponsored venture capital funds to invest in semiconductor companies and start-ups—accompanied by generous government support packages. Beijing has allocated more than $100 billion to develop a domestic semiconductor industry to break dependence on the West. Recently, $26 billion was invested in twenty-nine additional wafer-fabrication projects alone. Furthermore, existing semiconductor companies are raising their investments: Semiconductor Manufacturing International Corp. (SMIC), China’s leading chip manufacturer, has raised its level to $5 billion this year to expand its capacity. Notably, SMIC has announced that it has been able to produce 7-nm chips, something a Chinese maker had not been able to do before. (It’s not clear how soon SMIC can produce such chips at scale without access to advanced equipment). Those efforts have increased China’s chip production to 359.4 billion of integrated circuits (ICs) in 2021, 33.3 percent more than 2021 and doubling the growth rate in the previous year. Since China still cannot meet the lion’s share of domestic demand for semiconductor chips, imports rose more than 30 percent to $432 billion in 2021, compared to chip imports in 2020. In any event, China’s leadership has felt frustrated by the slow progress of the chip self-sufficiency effort, and has launched a series of corruption investigations into officials in the chip sector and the investment funds set up to fund the chip companies and start-ups.

These developments reflect the fact that China is dependent on the West (including Taiwan) for advanced semiconductors for some time to come, during which time China is vulnerable to US measures to block all sales to China of semiconductors as well as chip-making equipment and design software. In addition, the latest US measures also ban US persons from working for the listed Chinese companies—causing an exodus of foreign talent from these companies and hurting their operations. So far, sanctioned companies such as Huawei, being denied access to advanced semiconductors, have suffered steep declines in production and sales of smart phones and have to reorient their businesses to products requiring less-advanced chips.

Sector 2: Telecommunications, 5G infrastructure

Telecommunication services and infrastructure, especially using 5G technology, have been the first and most important case of technological decoupling between the United States and China—driven by national security concerns as China’s leadership position in 5G technology has significant commercial, intelligence, and military implications. China now is the largest 5G market in the world, accounting for 87 percent of 5G connections worldwide. Concretely, at the end of 2021, China had 368 million of 5G users compared to six million in the United States, and 1.43 million base stations to the United States’ 100,000. Huawei and ZTE of China have been the global leaders in providing 5G infrastructure including base stations—by offering acceptable quality solutions competitively priced and financed compared to its main competitors Ericsson, Nokia, and Samsung. The United States has accused Huawei of using its installed equipment to collect intelligence for the Chinese government and therefore has banned Huawei equipment in US telecom networks as well as sales to the company of high-tech products, either produced in the United States or internationally using US inputs. The United States has also waged a persistent campaign to dissuade other countries from using Huawei equipment to limit the risks of being spied upon by China.

So far, the sanctions on Huawei have significantly reduced its production and sales of smartphones requiring advanced computer chips, forcing the company to rely on domestic phone sales and further developing 5G infrastructure, software, and cloud services businesses. By contrast, the US effort to convince other countries not to use Huawei equipment has produced mixed results. Only a handful of countries including the United Kingdom, Japan, and Australia have decided to exclude Huawei equipment from their telecom networks; several others have not made a formal decision but said that they will closely examine the risks of using Huawei products in the critical parts of their networks. A majority of countries, especially in the developing world, have continued to do business with Huawei, mainly due to the lack of viable alternatives. For example, in Africa, where Huawei accounts for 70 percent of 4G telecom networks, it is easier and cheaper to upgrade to 5G using the same provider. As a result, Huawei has been able to maintain its global leadership positions, by large margins, in both 4G and 5G markets. China’s 5G market leadership position and track record in being well ahead of the world in rolling out that infrastructure (including base stations and services) and in customer usage, will give Huawei and other Chinese companies like ZTE strong competitive advantages in fully exploiting the potential of 5G and preparing to develop 6G technology in the foreseeable future.

In short, the US and its close allies will intensify their efforts to develop and source telecom equipment in their own markets or from friendly countries, while Chinese equipment (including from Huawei) will continue to be used by most other countries, especially in the developing world. Consequently, the telecom market will diverge into two competing systems, developing different technological and regulatory standards.

Sector 3: Equipment needed for the green energy transition

Solar panels, wind turbines, and high-capacity batteries are necessary equipment for the energy transition to produce solar and wind energy and to power electric vehicles. China has long prioritized these sectors in its development plans, including the Made in China 2025 program launched in 2015. With concerted and comprehensive support, China’s state owned enterprises (SOEs) have been able to dominate the global supply chains of these products. The United States and Europe have yet to develop systemic plans to address China’s dominance in these sectors.

For solar panels, China has been able to undercut Western competitors—especially US pioneers of the technology who led the industry for decades—and to drive them out of business. Consequently, Chinese companies have practically cornered the market of these products, controlling more than 80 percent of all manufacturing critical for the production of solar panels, including more than 95 percent of the world’s production of polysilicon and wafers.

Years after Washington increased tariffs on Chinese solar panels, the Department of Commerce is now investigating charges that Chinese companies assemble solar cells and modules in Cambodia, Malaysia, Thailand, and Vietnam—which now account for 80 percent of annual solar panel imports of the United States. The investigation reduced the importation of solar panels, stalling green energy conversion projects. Consequently, President Biden has signed executive orders invoking the Defense Production Act to boost domestic solar panel manufacturing. The president also announced a two-year halt in new solar panel tariffs.

China has significantly led in commissioning new offshore wind power generating capacity, adding, for example, 6.9 gigawatt (GW) out of the global total growth of 21.1 GW in 2021—bringing the global capacity to date to 57.2 GW. Leveraging the strong growth of domestic markets, Chinese wind turbine makers have become globally competitive, gaining ground on US and European players. Chinese firms have managed to take seven slots out of the world’s top ten manufacturers of wind turbines.

China controls 60% of the world lithium refining, and three-quarters of lithium-ion battery production—putting itself in a position to influence the development of high-capacity and long-lasting batteries, which are crucial for the mainstreaming of electrical vehicles.

Sector 4: Active pharmaceutical ingredients

Active pharmaceutical ingredients (APIs) are key components that treat illness and are put together with excipients such as lactose or starch to manufacture drug products. In the mid-1990s, the West and Japan produced 90 percent of the world’s APIs. Due to cost pressures and tightening environmental standards, the production of APIs has been outsourced to China to take advantage of lower costs and laxer environmental requirements. As a result, China now produces about half of the world’s APIs and an even higher portion of several key ingredients: e.g., 80 percent of the global market for heparin (used for blood thinner), and 86 percent of certain antibiotics (like tetracycline/doxycycline). Furthermore, China controls an even larger share of the world’s key starting materials (KSM) market—the raw chemicals used to make APIs.

It is instructive to examine the case of India, which has earned a reputation as the world’s pharmaceutical hub. India accounts for 20 percent of the global supply of generic drugs, but relies on China for 80 percent of the APIs and even more for the KSMs that go into making their own APIs.

Despite talks about reshoring or friend-shoring the supply of critical pharmaceutical products, nothing much has happened. Customers in advanced countries have complained about the high cost of medicines and thus have preferred generic drugs—which account for 90 percent of the prescription drugs used in the United States. The pressure on drugmakers to lower drug prices have made it practically impossible for them to move their supply chains from China given its significant cost advantages.

Sector 5: Strategic and critical minerals

Generally speaking, electricity networks and batteries mainly for electric vehicles will drive 75 percent of the demand for critical minerals by 2050. China and Russia control the reserves and production of a small number of minerals critical for the manufacturing of key strategic products including catalytic converters for automobiles; magnets used in military equipment such as lasers and guidance systems; high-capacity batteries and wind turbines that are important in making electric vehicles and the clean energy transition; fiber-optic cables; and consumer electronics.

On the other hand, the United States has become increasingly reliant on net imports of key minerals for domestic uses. According to the US Geological Survey (USGS), the number of minerals whose imports account for at least 25 percent of US needs rose from twenty-one in 1954 to forty-six in 1984 and fifty-eight in 2019. In particular, the import of seventeen out of the fifty-eight minerals needed in 2019 accounts for 100 percent of US requirements. China plays a key role in the global supply chains of many if not most of these minerals. By the way, China is dependent on imports of iron ore (mainly from Australia), copper concentrate (mainly from Chile and Peru), and bauxite (with Guinea holding the largest reserves). Consequently, China also is vulnerable to disruptions in the import and shipment of those minerals in the event of sanctions and trade embargoes. China has responded to this vulnerability by making investments to gain control of mineral resources overseas, especially in Africa and Latin America.

Most talked about are rare earth elements (REE), a group of seventeen minerals, separated into heavy and light rare earths, necessary for the production of catalysts and electric magnets critically important for the above mentioned products. China possesses 36.7 percent of world reserves (compared to 1.5 percent by the United States)—but controls more than 50 percent of the mining of REEs and 90 percent of their refining and processing. According to Germany’s Federal Academy of Security Policy, China’s share of the world’s production of rare earths recently fell from almost 100 percent to 80 percent. The US Geological Services put the decline from 80 percent to 60 percent at present. In any event, the predominant position of China can be traced back to a campaign it launched in 1975 to develop and attain dominant world positions in strategic materials like rare earth elements as well as new materials; the state supported the six state-owned rare earth mining companies so they would be able to manipulate supply and prices (including by export restrictions) in world markets to undermine competitors and win market shares. More recently, China has consolidated three RE-producing units of those SOEs to form China Rare Earth Group, second in output only to China Northern Rare Earth Group. The consolidation will give the Chinese government more direct control over the activities of those REE SOEs, with implications for world markets. Under these competitive pressures and stringent domestic environmental standards, Western companies have found it more profitable to outsource the production of rare earth elements to China and import those commodities—in several cases for 100 percent of their needs.

More importantly, China has never hidden its intentions to use control of rare earth elements as weapons for geopolitical purposes. In fact, in 2009 China did withhold supply of rare earths to Japan following disputes between the two about the Senkaku/Diaoyu islands. In response, Japan has extended financing to sustain Lynas Rare Earths Ltd., the largest REE producer outside of China based in Perth, Australia, which had been suffering losses. Lynas mines REEs in Australia, but processes most of them at Kuantun, Malaysia—however, that facility can only separate light REEs, sending heavy REEs to China for processing. The US Department of Defense has signed a $120 million deal with Lynas to build the first and only heavy rare-earth separation facility outside of China in Texas, to be operational in 2025. The US government has invested and revived companies to mine rare earths in Mountain Pass, Colorado, and US production already exceeds 40,000 tons of REEs per year—second only to China—yet still has to import refined and separated REEs from China. The EU has made statements about ensuring the secure supply of rare earths, but has yet to implement any concrete projects. All together, these activities have reduced the share of China in the world’s supply of rare earths, as mentioned above. However, given the current concentration and investment controls of rare earth mineral resources by China, especially in processing heavy REEs, it is not clear if the West can achieve its goal of self-sufficiency in these critical minerals anytime soon.

Conclusion

As a strategy to reduce reliance on and vulnerability to China for critical products and commodities, friend-shoring is appealing politically. However, it is not something that can be implemented quickly. After all, global supply chains for each product have evolved over decades to exploit comparative advantages in various countries and cannot be changed easily without costs. Furthermore, China enjoys size and incumbency advantages that are difficult for competing countries to erode and surmount. Importantly, friend-shoring and onshoring essentially involve government interventions to alter the cost-benefit relationships prevalent in a marketplace that motivates commercial decisions to outsource the production of those goods to China in the first place. Such interventions—including financial subsidies, tax giveaways, and regulatory forbearance—are not without costs, especially when there are competing and urgent demands on government resources such as meeting human and physical infrastructure investment needs.

It is therefore important to monitor the implementation of the friend-shoring strategy, comparing its benefits and costs to the extent possible. In this exercise, the challenge is to measure:

• benefits such as reducing vulnerability to China and economic gains including increasing manufacturing employment; and
• costs including lost efficiency in the global economy and opportunity costs vis-à-vis meeting other social needs.

This cost-benefit analysis will likely be done on a case-by-case basis, depending on the product. Basically, the ecosystem for each product is different, with different factor endowment distributed differently among friendly and unfriendly countries. Eventually, friend-shoring is likely to progress in a selective way, focusing on specific and critical areas such as semiconductors or rare earth elements, and probably is not going to happen widely across the board.

On balance, it is too early to say how much friend-shoring will be realized and how much that will enhance the security of the United States and Europe; and similarly, how much the high-tech self-sufficiency drive will help China. However, it is clear that friend-shoring and China’s countermeasures will deepen the division of the world into two economic spheres. Decoupling will impose a cost in terms of lost efficiency due to fragmentation and the fact that economic activities are increasingly being decided on national security and geopolitical grounds, and not purely on commercial calculations. This will slow the potential growth rate of the global economy, to the detriment of everyone but mostly the poor segments of society.

Hung Tran is a nonresident senior fellow at the Atlantic Council, former executive managing director at the Institute of International Finance, and former deputy director at the International Monetary Fund.

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By Atlantic Council

Yellen appeared at an Atlantic Council Front Page event ahead of the IMF and World Bank meetings to discuss the global response to Russia’s war, inflation, and more.

China Economic Sanctions

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And political weight matters. It’s a signal of leadership, which in this case is an ability to rally post-war Ukraine to rebuild better and to inspire trust among democratic societies that the reconstruction can take place in a transparent manner.

The conference did not lack ambition, at least in rhetoric. But what else should we pay attention to, and what lessons do these leaders need to apply in the challenging months ahead?

First, size matters—and so does the structure of aid. While estimates of reconstruction costs vary, one trillion dollars is an increasingly mentioned figure, reflecting a vast country that has already suffered great damage. This is a massive amount, but Ukraine’s forty-year-high inflation (with no end in sight) puts its rebuilding ambitions at risk. Loans with strings attached do provide a level of fiscal discipline, but grants can provide goodwill and yield a more positive impact on the ground. Sovereign and local governments are perfectly capable of managing debt, as even amid a disastrous war, Ukraine is able to issue its own bonds on international capital markets. Thus, it is evident that large infrastructure projects, a key part of Ukraine’s reconstruction, should be funded using a range of options customary for such transactions—from equity to debt capital markets, from project finance to bank funding, and from development finance to asset-backed financing. At the grassroots level, though, convincing small and medium-sized businesses to take out loans might be difficult.

Second, participation has to be all-encompassing, with public and private capital finding their respective niches. On the public side, developmental institutions, the United States, and, to an extent, other Group of Seven (G7) countries already lead the way in mobilizing capital, which is critical to stabilizing Ukraine’s wartime economy. Some might ask why the United States is leading (again) in supporting the defense (and rebuilding) of a European nation. Well, there finally seems to be a realization that Russia’s attack on a sovereign country is an attack on all democracies and on the international rules-based order. If this order is crippled and undermined, no “America First” policy can replace the prosperity of the democratic alliance that the United States leads. This is an existential battle for the freedom of everyone, and the United States, as the hegemon, is a primary beneficiary of the current world order. While the United States leads, the European Union’s (EU) inability so far to deliver the promised nine billion dollars in reconstruction funds serves as a disappointment.

On the private side, it is hard to imagine large amounts of private investment in Ukraine while the war continues. With the understanding that going into a war zone is not for the faint-hearted, there are pockets of high-risk, high-reward capital globally that thrive under extreme conditions. Private contractors were omnipresent both in Iraq and Afghanistan, among other tough spots globally. Hence, it is important to enable private capital to scout the opportunities in wartime and post-war Ukraine. European Commission President Ursula Von der Leyen’s proposal for a tiered approach—starting with immediate reconstruction of vital needs such as schools and energy infrastructure and then moving to a broader rebuild after the war is over—is a welcome development.

Third, transparency and accountability will make or break the reconstruction effort. Ukraine is among the most corrupt countries in the world, according to Transparency International. In May, at the World Economic Forum gathering in Davos, young Ukrainians loudly swore to the public that the people will no longer tolerate the wrenching corruption that had permeated the country. We shall see. This is where “advice” and recommendations from long-time donor institutions like the World Bank and International Monetary Fund can come in handy. US economic support, legislated through Congress, already holds significant accountability measures. Building trust in Ukraine’s ability to get it done right is paramount.

Fourth, a clear vision of Ukraine’s future is essential. It is a fundamental element that guides the entire reconstruction effort. It seems clear, with the initiation of EU accession procedures as well as Ukraine’s application to NATO, that the country’s future path is tightly interwoven with the democratic West. 

Economic integration with free markets, strong institutions, resilient energy architecture (which powers progress), Ukraine’s competitive edge in agriculture—all of these and more will require gargantuan commitments by the Ukrainian government and international donors. This integration is good for Ukraine, and it is good for the West. Yet on the ground, as rebuilding fatigue inevitably kicks in at some point in time, a clear vision and priorities set by the highest Ukrainian authorities will help the effort stay on the path. 

Rebuilding Ukraine is an overwhelming and complex challenge that requires strategic patience, unprecedented collaboration, vast resources, and exceptional leadership. This week’s conference proved that the intent is there, which is a good start. 

Giedrimas Jeglinskas is a former assistant secretary general at NATO and former deputy defense minister of Lithuania.

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Jump to an expert reaction

Ben Judah: One Truss legacy—a Britain more nervous to borrow and more keen to tax 

Peter Westmacott: Humiliation for the United Kingdom—and democracy

Frances Burwell: Disunity sends the UK spiraling toward irrelevance as a partner

John M. Roberts: Could Brexit be partially reversed? 

Livia Godaert: Expect a rise in nationalist and independence movements

Andrew Marshall: Chaos calls into question the UK’s choice between Europe and the world

James Batchik: Truss’s gains with Europe face setbacks with ongoing dysfunction

One Truss legacy—a Britain more nervous to borrow and more keen to tax 

Liz Truss will go down in history as a piece of pub quiz trivia—who was Britain’s shortest-serving prime minister? Considering that the previous holder of the title, George Canning, briefly first minister of King George IV, died in office in 1825, her failure is in fact even more stark. Trussenomics, however, as a phrase, an insult, or a warning in political life—that a British budget is dangerously uncosted and might spook the bond markets—will last a lot longer than her forty-four days in office. Fear of repeating her mistakes will curtail the ambition not only of the next leader of the Conservative Party that succeeds her, but almost certainly the next Labour prime minister, too. Her legacy—rightly or wrongly, given that market moves were not in fact straightforward—will be a Britain more nervous to borrow and more keen to tax. 

Of the country’s fifty-six prime ministers since the office is usually said to have begun in 1721 under Lord Walpole (who also was the longest-serving, with a monarchical twenty years to his name), Truss will join Lord North, “who lost America,” and Anthony Eden, who saw then US President Dwight Eisenhower humiliate Britain over the Suez Crisis, as a byword for disaster. A politician who lost control of her message, then her budget, then her party to the point that the Labour opposition was breaking records in the opinion polls with hypothetical vote shares of 54 percent. Every disastrous prime minister becomes a teachable lesson in British politics: Lord North’s lesson is not to get stuck trying to stop the anti-colonial tide by any means possible; Eden’s is not to defy the United States. Trussenomics will be remembered for reminding governments that any electoral coalition risks implosion when the public blames them for sharply rising mortgage costs. Her possible successors may be gleeful today, but this is what will be worrying them as soon as next week—when the Conservative Party is slated to have chosen its latest prime minister.

—Ben Judah is the director of the Europe Center’s Transform Europe Initiative. 

Humiliation for the United Kingdom—and democracy

The prime minister had hoped to be able to stay on until the new chancellor of the Exchequer, Jeremy Hunt, issues his medium-term fiscal plan on October 31. A further day of political chaos on Wednesday made that impossible. Liz Truss thus becomes the shortest-serving British prime minister ever. 

She survived this long in part because there was no agreed “unity candidate” to succeed her: It has been clear for weeks that neither the country nor the markets would accept two more wasted months of non-government while the Conservatives re-run their leadership contest under the usual rules. So Truss has agreed with party grandees that a successor will be chosen in just a week, probably by a fast-track process requiring all candidates to accept whoever does best in a single round of voting by MPs.  

It is not impossible that that person will be Boris Johnson, though the bookmakers’ favorite is Rishi Sunak. The one certainty is that Hunt, who has undone all of Truss’s ill-fated economic strategy since becoming chancellor of the Exchequer, will stay at His Majesty’s Treasury. 

The opposition Labour Party is calling for an early general election, on the grounds that whoever governs the country needs a democratic mandate. The Conservative Party, which still has a majority of seventy-one in the House of Commons, is unlikely to agree since the polls overwhelmingly favor Labour. 

Meanwhile, the United Kingdom is a source of amusement, disbelief, pity, and schadenfreude abroad. Humiliating for a country that has for so long been a model of functioning democracy. 

—Peter Westmacott is a distinguished ambassadorial fellow with the Europe Center and a former British ambassador to the United States, among other countries.

Disunity sends the UK spiraling toward irrelevance as a partner

With the resignation of Liz Truss and the beginning of a new leadership contest, the (dis)United Kingdom continues its devolution towards becoming a less relevant partner for the United States and its European allies.

Since the Brexit referendum of 2016—indeed since Prime Minister David Cameron’s announcement of that referendum in 2013—British politics has been driven by a civil war within the Conservative Party. Those who argued for “taking back” Britain from Europe never laid out a strategy for success as a global economic player but instead maintained that constructing barriers with Britain’s largest economic partner would not have any serious consequences.   

That deception has made it impossible for Conservative prime ministers to acknowledge that Brexit has stalled UK economic growth. But until Britain finds a way to move forward economically, its global role will be at risk. A strong defense stance requires economic growth and a strong budget over time, as does an active and global diplomatic role. The defense and rebuilding of Ukraine will require significant contributions from all allies; Britain has been a leader in this, but that cannot last without a stable government and healthy economy.  

US President Joe Biden has expressed his thanks to Truss for “her partnership‘’ and has reiterated his faith in the continuation of the US-UK relationship. But in the White House corridors, officials must be wondering how much longer this British drama will continue and what it will mean for Britain’s contributions to meeting the current geopolitical challenges. 

—Frances Burwell is a distinguished fellow with the Europe Center and a senior director at McLarty Associates.

Could Brexit be partially reversed?

Liz Truss has resigned, and Britain will have a new prime minister a week from now. 

There is no clear favorite for who will take over from someone who may well go down in history as Britain’s worst-ever prime minister. 

In just forty-four days, Truss has seen her program for growth destroyed by the reaction of international markets to the fact that she failed either to explain how she would fund her expensive program or to allow it to be scrutinized properly by either the Office for Budget Responsibility or the Bank of England, which handles monetary policy. 

In a chaotic premiership, she has sacked two of her most important lieutenants, Chancellor of the Exchequer Kwasi Kwarteng and Home Secretary Suella Braverman.  

Her failures contributed directly to massive poll leads, some of more than thirty points, for the opposition Labour Party, whose leader, Sir Keir Starmer, is now calling for an immediate general election—although the current Conservative Party mandate means there is no automatic requirement for an election until January 2025. 

The key question over the next few days is how the markets will react. It was the markets that destroyed the Truss administration after her chancellor’s disastrous mini budget was released on September 23. Markets hate instability, and there are still eleven days to go before Kwarteng’s replacement, Jeremy Hunt, is due to deliver his major financial statement. Hunt, who was himself a serious contender to take over from Truss but who has now said he will not stand, has already undone almost all of the Kwarteng mini budget.  

These are difficult days for the United Kingdom, which has in a few short weeks lost its reputation for both political and financial stability. 

Perhaps the most important immediate issue is how Conservative candidates for the premiership—which include former Chancellor Rishi Sunak and rising star Leader of the House of Commons Penny Mordaunt—conduct themselves during the campaign. There is a lot of support among Conservative MPs for Boris Johnson to return, but that would probably prove incredibly divisive both in the party and in the country at a time when all candidates will be calling for stability and unity. If there is to be a unity candidate, it might be Defence Secretary Ben Wallace, who is one of the few ministers with a consistently respected reputation under different Conservative administrations.  

There is little doubt that the biggest reason for the United Kingdom’s current economic disarray is the failure to secure substantial and sustained economic growth in the wake of Brexit. It is now almost two years since the United Kingdom effectively left the European Union (EU), a decision which the respected Institute for Fiscal Studies has said resulted in a 4 percent hit to its GDP.

The big question now is whether politicians from both the Conservative and opposition Labour parties will start to publicly raise the issue of whether the United Kingdom should seriously consider trying to regain access to the single European market, even if they no longer aspire to full EU membership. 

So far, for many politicians who voted “remain” in the referendum on European Union membership in 2016, revising or reversing Brexit is the thing politicians don’t want to talk about in public. But as the United Kingdom’s politics and economy have turned head over heels in the last few weeks, maybe this last taboo will be broken. 

And if Boris Johnson were to stand—and he is now reported to be taking soundings on that—his role in curtailing the United Kingdom’s relationship with its biggest trading partner is bound to come under close scrutiny.