The trip builds on Erdoğan’s previous visit to the UAE more than a year ago, which had opened a new chapter to bolster the two countries’ political and economic ties ahead of Turkey’s May 2023 elections.

After his re-election, Erdoğan reinstated Mehmet Şimşek as minister of finance, putting the former investment banker back in charge of the state coffers. Şimşek’s appointment signaled the return to economic orthodoxy and prioritization of market stability that provided confidence to Gulf investors about the investment climate in Turkey. This raised hopes for the Turkish economy, which faces runaway inflation, chronic current account deficits, the devaluation of the lira, and the depletion of much-needed foreign currency reserves.

Erdoğan’s re-election and his appointment of Şimşek also signaled building momentum for normalization with the Gulf region—momentum that began with reciprocal official visits in 2021. This June, Şimşek has already held high-level meetings in Saudi Arabia, Qatar, and the UAE to lay the groundwork for Erdoğan’s most recent visits and help promote bilateral economic partnerships.

Turkey’s developing relations with these three Gulf countries show a convergence of interests and agreement on many issues. These include agreement on their complementary comparative advantages, their eagerness to diversify trade partnerships, and their desire for strategic autonomy from the West. Reflecting their growing cooperation, Turkey announced that it had struck framework agreements for bilateral investment with the UAE that reached over $50 billion—it also announced agreements with Saudi Arabia and Qatar (the values of which are still undisclosed). Deepening partnerships in key sectors such as defense, energy, and transport indicate an interest among Turkey and Gulf countries to leverage financial capital, know-how, and geographic advantages for economic growth; they also indicate a realignment to share political risks in a volatile region and reduce dependence on the United States.

A solid foundation

The main rationale behind Turkey’s renewed interest in strengthening ties with the Gulf countries is to attract capital inflows and sustain Erdoğan’s legacy as a leader who delivered economic growth over the past two decades. After a brief slowdown during political upheavals between 2013 and 2020, the volume of Turkey’s trade with the Gulf has reached $22 billion, according to the Turkish government. Turkey has ambitious plans to almost triple this figure in the next five years.

The Gulf countries are also keen to scale up their footprint in Turkey. The Gulf Cooperation Council (GCC) countries account for 7.1 percent of foreign direct investment in Turkey since 2020, with $15.8 billion in stock as of 2022. Qatar provided Turkey with the most foreign direct investment of the GCC countries, investing $9.9 billion. The UAE comes in second with $3.4 billion, and Saudi Arabia is the third highest, with $500 million. This amount is likely to increase two-fold to $30 billion over the next few years through investments prioritizing the energy, defense, finance, retail, and transport sectors. Previously, the UAE and Qatar provided Turkey with $20 billion in currency-swap agreements and Saudi Arabia deposited $5 billion into the central bank to support dollar liquidity.

But the new package of agreements signed during Erdoğan’s trip focus on capital investments in productive assets such as land, factory plants, and infrastructure. Abu Dhabi Developmental Holding sovereign wealth fund (ADQ) alone signed a memorandum of understanding to finance up to $8.5 billion of Turkey earthquake relief bonds and to provide $3 billion in credit facilities to support Turkish exports. Collectively, these are evidence of a longer-term vision for closer coordination between the GCC and Turkey at a strategic level.

Economic cooperation also draws Turkish investment to the Gulf, primarily toward construction and services sectors such as information technology, telecommunications, and agricultural technology. Possible joint manufacturing in the defense industry between Turkey and Gulf states, such as manufacturing of Baykar’s Akıncı and TB2 unmanned aerial vehicles, carries the potential to upgrade this relationship beyond the economic realm. Even for Saudi Arabia, which has a domestic plant to produce Turkish Vestel Karayel drones primarily for reconnaissance missions, Akıncı could upgrade drone warfare doctrine to a new level.

Mutual advantages

This evolving partnership is a clear win-win situation. Turkey and the GCC countries’ combined geography connects three lucrative subregions—the Gulf, Eastern Mediterranean, and the Black Sea—that can help the countries build their connections and enhance their interdependence, when beneficial, in a volatile world. Saudi Arabia, Qatar, and the UAE, which boast a combined gross domestic product (GDP) of $1.8 trillion, have plentiful resources and tremendous comparative advantages, not only in the oil and gas sector but also in their solid legal framework, world-class infrastructure, and relative ease of doing business.

The UAE, for instance, implements social and business reforms to attract foreign investment. They also have a young, tech-savvy, and talented population open to learning and determined to make an impact on emerging fields such as artificial intelligence and robotics. Turkey, meanwhile, has comparative advantages in the defense, hospitality, and construction sectors. Turkey had traditionally been a capital-scarce, labor-intensive country that faced declining terms of trade, especially after joining the European Customs Union in 1995. But gradually, through upskilling in technology and investment in capital-intensive sectors, Turkey repositioned itself as an alternative industrial hub for the emerging markets of the Middle East. It has become a diversified, technologically advanced, and sophisticated economy as a member of the Group of Twenty.

Turkey is now more eager to expand its bilateral Comprehensive Economic Partnership Agreements into a multilateral agreement with the GCC. Moreover, the earthquakes in February 2023 are estimated to have cost Turkey $104 billion in infrastructural damage and economic loss—equivalent to 12 percent of its GDP—so Turkey needs to diversify and deepen its trade partnerships to recover quickly.

Nonaligned, interconnected

A major driving factor behind this rising economic cooperation is the quest to gain strategic autonomy from the West and distribute risks by hedging against changes in US policy toward Turkey and the Gulf’s neighborhood after the next US presidential elections and beyond. Turkey and the Gulf countries have emerged as nonaligned middle powers, adapting to a multipolar world as the global economy’s center of gravity shifts toward the Indo-Pacific region.

The war in Ukraine heightened Turkey’s geopolitical significance and provided it with leverage in negotiations with the United States and NATO, as witnessed at the Vilnius summit last week. Russia’s ongoing attack and consequential Western sanctions also turned countries’ eyes toward the Gulf countries in search of an alternative supplier of hydrocarbons. Windfall profits from oil and gas sales strengthened the war chests of Gulf sovereign wealth funds that are now looking to increase non-oil trade and diversify their portfolios into sustainable, long-term investments such as renewable energy, advanced technology, healthcare, tourism, and leisure.

A few major deals exemplify these diversification efforts. The Arab-China Business Conference—held in Riyadh this June—concluded with $10 billion worth of investment deals struck between Arab countries and China. Iraq is developing a $17-billion-dollar railroad, which is planned to run through Turkey to Europe, a project in which the GCC countries have also shown interest. Abu Dhabi Developmental Holding Company and the Turkey Wealth Fund launched a $300-million-dollar partnership to invest in Turkish technology startups. The UAE is also eager to invest in Istanbul’s metro and its high-speed railway to Ankara. The two countries aim to increase their trade volume from $18 billion to $40 billion in the next five years.

Ultimately, this flurry of new investments shows that the Gulf countries and Turkey view each other as mutually advantageous partners. Erdoğan’s visit to the Gulf this week further reaffirms their deepening partnership in the economic realm—with potential implications for the strategic realm in the long term.

Serhat S. Çubukçuoğlu is a senior fellow in strategic studies at TRENDS Research & Advisory in Abu Dhabi.

Mouza Hasan Almarzooqi is a researcher in economic studies at TRENDS Research & Advisory in Abu Dhabi.

The post What’s behind growing ties between Turkey and the Gulf states appeared first on Atlantic Council.

But many questions remain about whether creditors truly are prepared to meaningfully reduce debt burdens. These issues likely will be on the table in India this week (July 14 to 18) when the Group of Twenty (G20) finance ministers and central bank governors gather to discuss debt restructuring and other global economic issues.

In Zambia, which defaulted on its debts in 2021, government creditors led by China have resolved months of jostling and agreed to a restructuring of $6.3 billion of the country’s more than $8 billion of debt. The agreement extends for 20 years the country’s debt-repayment schedule and lowers its annual interest bill to one percent until economic growth recovers. Now, the country’s private-sector lenders, who hold billions of dollars of government IOUs, are talking about writing down some of their Zambia loans, and in Ghana are writing off loans and restructuring dollar-denominated bonds. Meanwhile, both classes of creditors are deep in restructuring discussions with Sri Lanka, which has requested a 30 percent haircut on some bonds.

These settlements would pave the way for assistance from the International Monetary Fund (IMF) and provide a way forward—albeit a difficult one—for dozens of low-income countries that are in or nearing debt distress. This represents progress compared with a year ago, when China and the private sector were balking at a transparent negotiating process. But there are still many issues to address—especially how far China really is prepared to go in reducing the burden of its vast lending. Unlike previous global debt episodes, notably the Latin America debt crisis of the 1980s and debt relief to low-income countries early this century, there is unlikely to be a grand bargain this time around.

While the preliminary agreement with Zambia has been heralded as “an epochal shift in global finance,” the reality is that negotiations there and elsewhere are following a well-trodden path: first the seal of approval of an IMF rescue program (which in Zambia’s case was reached in 2022), with promises of IMF money once a debt restructuring is agreed to. Then the hard bargaining with government lenders, followed by talks with private creditors. This slow progress is a far cry from late 2020 when the G20 agreed on a restructuring process for the poorest countries called the Common Framework that briefly raised hopes of a rapid succession of debt reductions—hopes that were dashed largely because of foot-dragging by China and foreign lenders.

Before the emergence of China as a major creditor to middle and low-income countries during the lending spree that accompanied its Belt and Road Initiative, debt negotiations went through the IMF and the Paris Club of advanced-economy lenders. It was arguably a simpler world, not least because private-sector lenders’ debt exposure in developing countries was marginal. That changed after 2010, when institutional investors joined China in shoveling money out the door to what became known as “frontier economy” borrowers. Between 2007 and 2020, an unprecedented 21 African countries accessed international debt markets. Today, debtors must proceed on multiple tracks—the Paris Club, the Chinese government, China’s state banks and state-controlled commercial banks, and Western fund managers and money-center banks.

Some creditors question the true nature of the debt restructuring now on offer. For example, private sector lenders and analysts say privately it is not clear whether, in Zambia’s case, China has negotiated bilateral conditions that have been concealed from other lenders. They say that this could cast doubt on assurances that government creditors have provided to the IMF about restructuring arrangements. In addition, China’s insistence on extending debt repayments for decades conflicts with the Paris Club’s track record of providing relief in the form of reductions in principal owed. That could become an issue if China pursues its approach in countries where other governments are major creditors—for example, India and Japan in Sri Lanka. In that case, the model of the Zambia agreement could quickly become a muddle.

The private sector has arguably made significant strides in recognizing their loan losses, as the situation in Ghana illustrates. Lenders such as the big four South African banks are writing off as much as $270 million of their loan exposures, which equates to a haircut of almost 60 percent. And Standard Chartered Bank has set aside some $160 million for Ghanaian write-downs. This loan-loss recognition serves two purposes. First, it is an effort to inform shareholders about the banks’ overall sovereign exposure and the steps they are taking to reduce it. Second, by setting a floor on the losses they are prepared to absorb, they have a better negotiating hand in the restructuring conversations.

Meanwhile, bondholders are likely to face increasing pressure to restructure Eurobond issues—and accept haircuts—as the repayment schedule accelerates in the next two years.

A looming issue may be the response of Western banks and bondholders to China’s success in having some of its loans by state-controlled banks exempted from the Zambia agreement and classified as commercial lending. How those Chinese loans are treated—in Zambia and elsewhere—while the real private-sector creditors negotiate settlements will be a test of China’s willingness to accept the principle of “comparability of treatment” for all creditors, a key principle that Beijing publicly insisted upon as recently as April.

There are real-world ramifications to these nuts-and-bolts issues that extend beyond the politics of the restructuring process. The human cost of the debt crisis for poor countries has been severe. The UN estimated last year that fifty-four countries with severe debt problems represented about three percent of global gross domestic product, but accounted for more than one-half of the 600 million people worldwide living in extreme poverty. That number has risen sharply since the pandemic hit in 2020.

Debt payments by these countries siphon off resources that are desperately needed for health, education, and other social programs. Defaults and restructuring only make this scarcity worse. That points to the need for new sources of funding. The World Bank is under pressure to free up more money for grants and lending. Meanwhile, the IMF has increased funding for two trusts designed to meet the needs of low-income countries, including one created to help developing countries meet the immediate and long-term challenge of climate change and pandemics. About $100 billion of new resources come, in part, from the 2021 allocation of $650 billion of Special Drawing Rights to IMF member countries.

But demand for help is rising faster than the available resources, especially for the Poverty Reduction and Growth Trust, a perpetually underfunded IMF vehicle that subsidizes zero-interest loans to the poorest countries. As new lending to these nations from China and private creditors dries up, the World Bank and IMF will be hard-pressed to pick up the slack. Debt restructuring that merely extends repayment for decades without any forgiveness will only entrench the imbalance between needy borrowers and lenders whose priority is to recoup their capital.

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.

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.

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 completion or near completion of those measures is indeed helpful to DLICs, even if the measures fall short of what is needed—the sustainable development gap of those countries has been estimated to be $2.5 trillion per year. What the DLICs really need are concrete initiatives and the less said about grand strategy the better. Dressing those initiatives up as parts of a “new global financial architecture” risks conflating them with the geopolitical conflict centered around changing or preserving the current world order. That conflation will only make it more difficult to develop the international consensus required to adopt those measures. 

The Paris Summit showcases the potential and limits of the plurilateral approach  

The Paris Summit brought together senior representatives of about thirty-two countries, international organizations such as the World Bank (WB) and the International Monetary Fund (IMF), civil society organizations advocating debt relief and climate financing for DLICs, as well as private-sector businesses. Besides Macron, presidents and prime ministers from South Africa, Brazil, Germany, China, and a dozen or so African countries attended. The United States was represented by Treasury Secretary Janet Yellen and Special Climate Envoy John Kerry. The Summit represents an example of a plurilateral approach where a relatively small group of countries get together around a common agenda instead of the multilateral approach involving all members of the international community. Other examples include the World Trade Organization (WTO), which has been able to push through a few plurilateral trade agreements on specific issues, having failed to facilitate any round of multilateral trade liberalization since its inception in 1995; and the IMF which has recognized that working with smaller groups of like-minded countries can be a practical way forward. 

The Paris Summit exhibited the potential and limitations of the plurilateral approach. The results of the Summit were contained in the Chair’s summary of discussion, essentially reflecting participants’ appeals and statements of wishes rather than new commitments by countries. In fact the United States—a key country in any international undertaking—has been lukewarm at best about several proposals to raise funding, including worldwide taxation of CO2 emission in shipping and aviation, of financial transactions, and of fossil fuels in general. Yellen reiterated that multilateral development banks (MDBs) should try to optimize the use of their balance sheets to provide more finance to climate-related projects before asking members for more capital. 

Concrete results from the Paris Summit 

Nevertheless, the Paris Summit managed to produce two sets of results. One is a Road Map highlighting important events and meetings such as the G20 Summit in September in New Delhi and the IMF/WB annual meetings in October in Marrakech. Also noteworthy is the meeting of the 175-member International Maritime Organization in July to discuss the idea of taxing emissions from shipping, and the United Nations Summit on the Future in September 2024. The road map is useful in focusing international attention on important gatherings to push for further progress on the various commitments and initiatives already on the table. 

More useful to DLICs are announcements of the completion or near completion of previous pledges. Specifically, President Macron expressed confidence that the 2009 pledge by developed countries to spend $100 billion a year to help DLICs deal with the impacts of climate change will be fulfilled later this year. The OECD has reported that in 2020 the total amount reached $83 billion—the failure to meet this promise on time has been a disappointment for DLICs. More positively, the IMF reported that it has met its goal of asking countries with excess SDR reserves to re-channel $100 billion of the SDRs allocated in 2021 to help DLICs—with $60 billion pledged for its Resilience and Sustainability Trust (RST) and Poverty Reduction and Growth Trust (PRGT). In particular, the RST is aiming to help DLICs deal with climate change through an exception to the short-term nature of IMF lending, offering loans with a 20-year maturity and a 10-year grace period. 

The WB also outlined a toolkit that had been in the works for some time and includes offering a pause in debt repayments during extreme climate events (but only for new loans, not existing ones), providing new types of insurance for development projects (to help make those more attractive to private sector investors), and funding advance-warning emergency systems. In particular, it has announced the launching of a Private Sector Investment Lab to develop and scale up solutions to barriers to private investment in emerging markets. Progress has been reported in efforts by MDBs, especially the WB, to optimize their balance sheets according to the G20-endorsed Capital Adequacy Framework in order to be able lend $200 billion more over 10 years—with the hope of catalyzing a similar amount of investment from the private sector (which is easier said than done). 

Most concretely, after years of procrastination, the official bilateral creditor committee agreed to restructure $6.3 billion of Zambia’s bilateral debt, a portion of its total public external liabilities of more than $18 billion. The deal extends maturities of bilateral debt to 2043, with a 3-year grace period; an interest rate of 1 percent until 2037 then rising to a maximum of 2.5 percent in a baseline scenario; but up to 4 percent if Zambia’s debt/GDP ratio improves sufficiently. In the baseline scenario, the present value (PV) of the debt will be reduced by 40 percent, assuming a 5 percent discount rate. This is lower than the 50 percent PV haircut accorded to some other countries in debt crises and is insufficient to meaningfully reduce Zambia’s debt load. Nevertheless it is helpful, especially in allowing Zambia to receive a $188 million disbursement from its $1.3 billion IMF program. The deal was reached contingent on Zambia negotiating comparable agreements with its private creditors and after the multilateral development banks (MDBs) pledged to provide concessional loans and grants to DLICs in crises. 

Key takeaways  

First and foremost, the results of the Paris Summit show that it is useful to maintain pressure on governments and international organizations to deliver on their pledges and commitments to various initiatives, as well as to agree to new ones to help DLICs. Even though each of the measures is insignificant compared to the overall needs, cumulatively many of them can provide tangible support to DLICs.  

Secondly, progress on any of these initiatives requires agreement by all key countries, including China. For example, the Zambia debt restructuring deal was achieved only when China’s preferences have been honored—including no cut in the principal amount of debt, relying instead on maturity extension and low interest rates; classifying several loans including from China Development Bank as commercial, not official; and requiring other creditors including MDBs and private sector investors to participate on a comparable basis in the debt relief. Hopefully, the Zambia deal can represent a template to speed up the restructuring process for DLICs, as flagged in an earlier Atlantic Council post.  

And that leads to the last takeaway from the Paris Summit, mentioned earlier. Countries should not let debt alleviation and climate change mitigation initiatives be used as political scoring points in the geopolitical conflict between the West and China. This will make it difficult to build the consensus required to move forward in these efforts.  

Hung Tran is a nonresident senior fellow at the GeoEconomics Center, Atlantic Council, and 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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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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Historically, US consumers used checks to make payments directly from their bank accounts, but check payments do not translate to online payments. Today, US consumers are left with a gap in their payment options: they cannot pay directly from their bank accounts (as allowed by a check), and real-time payments can only be made through expensive third-party credit cards. The lack of a real-time digital payments network holds the US back: It creates delays and risks for consumers and businesses and ties up capital needlessly.

The US has some catching up to do. Many countries in Europe stopped issuing paper checks more than two decades ago, transitioning instead to an electronic payments network. The United Kingdom introduced instant payments in 2008. The Single Euro Payments Area (SEPA) was launched in 2017, allowing instant payments among 36 countries using a unified framework for direct bank payments, including cross-border transfers. Globally, 79 countries have already implemented at least one instant payment network.

This year, the US will take a major step toward faster payments when the Federal Reserve launches its planned FedNow payment network. But even after FedNow launches, the US will still have a ways to go before consumers can access instantaneous digital payments.

Faster payments in the US

The US was originally at the forefront of electronic payments. In the 1970s, it introduced the Automated Clearing House (ACH) for processing electronic payments. This initiative happened because a group of California bankers became concerned about the growing volume of paper checks overwhelming the processing equipment and the technology to clear the checks.  ACH became—and still is—the method for issuing payroll, vendor payments, and other direct deposits.

While the ACH network made electronic payments possible within the US, it is far from instantaneous. ACH settlements typically take several business days from the time they’re initiated. ACH transactions are processed in batches, either at the beginning or end of the day, or as several batches throughout the day, necessitated by the extremely robust but 60-year old COBOL mainframe systems on which ACH runs. The ACH network moved $77 trillion in 2022.

In 2016, the ACH Network introduced Same-Day ACH which settled transactions within the same business day. Still, same-day ACH falls short of instant payment processing. Wire transfers are another payment option, with real-time transfer capabilities through the FedWire system. However, wire transfers need to be submitted during FedWire operating hours. Wire transfers typically support critical business transactions involving large sums rather than everyday payments between consumers and companies, and often incur significant fees.

A few consumer-friendly options have emerged, such as the RTP network. Governed by some of the largest banks in the US, the RTP network offers real-time payment processing for financial institutions. Unlike ACH, however, RTP only has the ability to credit payments to an account (“push payments”), whereas ACH also has the ability to debit payments from an account (“pull payments”).Meanwhile, checks are still a regularly used form of payment for consumer and business transactions in the US. In 2003, Congress passed The Check Clearing for the 21st Century Act (Check 21), as a way for banks to accept an electronic substitution (image) of a check instead of the original. The purpose was to “foster innovation in the payments system” according to the Federal Reserve, but is still no more than a patch on an antiquated technology.

FedNow: One step closer to real-time payments

In 2019, the Federal Reserve announced its plans for the FedNow Service, the U.S. attempt to create a European-style network of real-time payments. As a complement to the ACH Network, FedNow (with an initial launch planned for July 2023) will offer instant payments between bank accounts. Transfers will take mere seconds instead of hours or days that ACH and Same-Day ACH offer. And, unlike FedWire, FedNow will be available 24/7. FedNow will be governed by the Federal Reserve instead of a private banking association. Like the RTP network, FedNow will have transaction fees of only a few cents per transaction, which makes it cost-effective. Initially, FedNow will have a cap of $500,000 while the RTP network has a limit of $1 million per transaction. For now, FedNow also only supports domestic “push payments”  but not “pull payments,” so it is still missing half of the equation that ACH enables.

The key variable for these real-time payment solutions is “participating financial institutions.” The RTP network has close to 280 participating financial institutions, including some of the largest banks in the country, but with nearly 10,000 banks and credit unions in the US, this offers far from universal coverage. FedNow is only just beginning its rollout and, again, financial institutions have to opt to implement FedNow. Consumers will not be able to access FedNow directly, and can only access it if their bank opts in. Eventually, FedNow is expected to have interoperability with ACH, which could broaden its reach and perhaps get the US closer to instant payments.

Financial institutions, even if they opt in to FedNow, will still have to figure out how to make it available to their customers. FedNow only operates as a payment rails system; access for consumers needs to be provided by the financial institution through their online banking or a third-party app. Adoption among the general population may be slow and limited as a result. Also, the lack of support for “pull payments” means that instant payments directly from a consumer’s bank account—as well as other solutions requiring “pull” capability—are still not possible.  For these reasons, FedNow will also not work as payment rails for the P2P space. Finally, there are legitimate concerns that FedNow does not adequately protect against fraud, as it does not provide a solid method for recalling erroneous or fraudulent payments that is available when making payments by wire.

FedNow will likely change the face of bank to bank payments in the US, particularly with respect to business-initiated payments. But the FedNow system as currently imagined falls short of being a fully-integrated real-time payments network supporting a broad range of instant consumer, business and international payments use cases (both “push” and “pull”) that Europe has proven is possible. 

The US may still be waiting for its true solution to real-time payments.

Piret Loone is a contributor to the GeoEconomics Center and the General Counsel and Interim Chief Compliance Officer at Link Financial Technologies.

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 <strong>Can FedNow bring the US closer to real-time payments?</strong> 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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By legal mandate, the Bank of Japan is primarily tasked with achieving price stability—avoiding inflation and deflation. However, as with many other central banks, it has two additional unwritten mandates. The first is “financial stability”: a mix of regulatory authority and emergency powers that give it the capacity to intervene in markets in the event of a systemic shock. The second is what might be called a “fiscal separation mandate”: a commitment to avoid conducting monetary policy in ways that substitute for or badly distort fiscal policy.

These three mandates have become dangerously intertwined such that making progress on one may require ceding ground on the others. And while the specifics of the Japanese case are inevitably unique, it’s only a matter of time before the difficult choices facing the BOJ show up in Washington, London, Brussels, Frankfurt, and beyond.

The Bank of Japan has struggled with price stability since 1989

Prior to the COVID-19 pandemic, the BOJ was in a long-running struggle against deflation, which prompted it to pioneer an extraordinary combination of exceptionally low interest rates and quantitative easing (QE).

Japan’s problems with low inflation began with the real estate and stock market bubble of the late 1980s, which ended with a financial crash that put the economy into a tailspin. That crash shocked companies and households into saving as much of their income as possible. Events were so severe that the “precautionary savings” mindset has never really abated, resulting in persistently low domestic demand, and downward pressure on prices.

However, in the post-bubble years two other global factors kept prices down, in Japan and across the developed world. Technology and global trade fundamentally changed the cost and location of producing goods and services. A typical product sold in the year 2020 was produced using far less labor than the equivalent product in 1990 and was more likely to be produced in an emerging market. Less demand for labor meant that household incomes in developed markets struggled to rise even as GDP went up substantially. Less labor pricing power and lower household incomes meant less upward pressure on overall prices. Put simply, technological advances together with increasing amounts of global trade were deflationary.

And Japan was early to face an additional challenge to price stability: a rapidly aging population. Japan’s prime working age population started to decline in the early 1990s. There is no expert consensus regarding the relationship between population growth and inflation, but in Japan’s case there’s a plausible argument that a declining population added to deflationary pressure. In a rapidly aging (and declining) population, the demand for goods and services may decrease more quickly than the supply.

Fast forward to 2023, and inflation has replaced deflation as the prevailing issue in Japan. Inflation is well above the BOJ’s 2% target, but policymakers still need to factor in the trends that kept inflation too low for decades: very high savings rates, global trade and technology, and an aging population. Two of the three are applicable well beyond Japan, and as the BOJ’s experience shows, they’re challenging to deal with—even before factoring in the central bank’s two other mandates.

Financial instability after years of low interest rates

Globally, instances of financial instability have become more frequent as central banks have raised interest rates to combat inflation in the US, Europe, and elsewhere. Further instability isn’t a certainty, but the events of SVB, First Republic, and others suggest it’s a good bet. Against that backdrop, Japan may be the poster child for an unpleasant paradox: the low interest rates and quantitative easing which rendered the Japanese financial system remarkably stable for almost 20 years may have sown the seeds of extraordinary financial instability to come.

Why a poster child? Because the BOJ started its “exceptional” policy interventions as early as 2001, which implies that the banks, borrowers, and securities markets have internalized historically abnormal BOJ policy settings as “normal.” The result has been stability but not normality. Trading volumes in government bonds (JGBs) have become anemic to the point where the benchmark 10-year bonds don’t trade at all on some days. And over this period, Japanese markets have been operationally hollowed out. The largest of the global brokers have reduced trader headcount and moved trading staff offshore due to minimal activity. There is little or no “living memory” among JGB market participants of how to operate amid volatility. And operational infrastructure may not be up to the task either: There’s reason to doubt that Tokyo market makers invested in state-of-the-art trading and risk management systems.

Finally, the “real economy” is vulnerable to higher rates and increased volatility—especially real estate, “mom-and-pop” businesses, and “zombie firms” with high debt.

The third imperative: fiscal separation

The third mandate—set by law in some countries and by tradition in most—is that central banks are committed to minimizing interference with fiscal operations. Rule One of fiscal separation is don’t lend to your government. The theory is that governments which borrow money that is “funded with a central bank’s fountain pen” lose all fiscal discipline, and that people stop believing that their government will return to anything like properly balanced budgets. They also stop believing that the central bank cares about price stability.

Alas, Rule Two is that there is always some linkage between monetary and fiscal policy, irrespective of commitments to “non-interference.” Why? Because governments which fund themselves in their home currencies do so at interest rates which are immediately and continuously impacted by central bank policy rates, and expectations about changes in those rates. When central bank rates go up, governments pay more to refinance maturing bonds and to finance any new deficits.

Japan, again, may provide the world with a test case that will either mitigate concerns, or magnify them. Japanese government debt as a percentage of GDP is the highest in the G7, according to the IMF, followed by Italy and the US. If the BOJ makes a material change to its interest rate policy, the flow-through to the fiscal accounts will be substantial.

Japan on the horns of a trilemma

The BOJ is in a difficult spot: a trilemma where strictly adhering to any one of its mandates may require sacrificing the other two. If it raises rates aggressively to fight inflation, financial stability will be threatened, and the fiscal consequences may be large enough to provoke political counter-reactions. By contrast, a focus on maximizing financial stability implies keeping rates too low for too long, and may result in ongoing, elevated inflation. Lastly, a compulsive focus on “non-interference” in fiscal affairs—for example, by staying out of the market for government bonds—could spark financial instability.

So now what?

Schadenfreude is not the appropriate response. Japan’s challenges are or will be common to much of the G7, if not the entire West. The West should be working constructively with Japan as it strives to balance its three mandates. Its success will be ours too, and we all need to learn what we can from the steps the BOJ takes and the consequences that follow. Our own “trilemmas” are not far behind.

Mark Siegel is a contributor to the GeoEconomics Center and Managing Partner at Chancellors Point Partners LLC. He previously worked in banking and investment management.

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The post <strong>Japan’s monetary trilemma is a warning to the world</strong> 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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For roughly two decades, cooperation on sanctions and anti-money laundering and combating the financing of terrorism (AML/CFT) served as a cornerstone of US relations with the countries in the Middle East, particularly in the Gulf. Over that time, successive US administrations invested heavily in bolstering institutional capacity to identify and disrupt terrorist financing in the Middle East. The United States provided technical assistance to local financial regulators and law enforcement partners and encouraged them to comply with international standards and best practices on AML/CFT. Washington has also supported efforts to strengthen policies and enforcement mechanisms needed to fight financial crime, with the goal of building sustainable, effective partnerships in the region that could enhance the scope and power of its own sanctions programs and AML/CFT efforts.

Years of deep collaboration proved to be more than just diplomatic show—the United States took coordinated action with Qatar against a network of Hezbollah financiers, stood up a Gulf-wide coalition to formalize cooperation on countering terrorist financing, and worked jointly with the Iraqi government to prevent leaders of the Islamic State of Iraq and al-Sham from accessing the global financial system.

Despite assurances from the Biden team that the United States remains committed to the Middle East, however, US engagement—and with it, US influence—is waning. The changing international playing field, with Russia’s war in Ukraine and the United States’ simmering tensions with China, has driven much of this change. Washington has limited bandwidth to prioritize Middle East policy, even on issues like AML/CFT and sanctions that once drove the regional agenda. And clumsy missteps and miscalculations under the current White House, such as US President Joe Biden’s widely criticized visit to Saudi Arabia last year, have likely reinforced this geopolitical realignment.

Beijing waits in the wings

Ironically, as the Biden administration rebalances its strategic priorities to focus on allies in the Asia-Pacific region—with the hopes of countering China—it has left the back door unguarded in the Middle East. China has stepped in to fill the void, building on its trade and investment-centered international playbook but with none of the same commitment to international norms and standards surrounding counter-illicit finance that the United States demands of its allies. It’s a development that further weakens US relationships in the Middle East but also puts US national-security interests at stake.

Most notably, China’s recent diplomatic outreach to the region has chipped away at US geopolitical leverage in the Middle East. For example, in March, China brokered a deal in which long-standing rivals Saudi Arabia and Iran agreed to restore relations. While it remains to be seen how committed Riyadh and Tehran are to rapprochement over the longer term, Beijing’s role in brokering the deal has elevated its diplomatic profile in the region and sidelined Washington in the process.

The deal also raises important questions about whether the Biden administration will be able to maintain a sufficiently broad coalition against Iran, as Saudi Arabia is one of the coalition’s key members. With no signs of progress on talks to reenter the landmark Iran nuclear agreement, the United States will continue to rely on sanctions to try to force change in Tehran. But China’s diplomatic rise—and its role in these talks—may weaken the effectiveness of US sanctions on Iran, as isolating Iran from the global economy becomes more difficult.

This is already happening: For instance, the Treasury Department recently sanctioned a China-based network for selling and shipping aerospace components to Iran that could be used in unmanned aerial vehicles. One Iranian company receiving the parts produces a type of unmanned aerial vehicle that has been exported to Russia for use in the invasion of Ukraine. Procurement networks like these will be increasingly difficult to target effectively as China extends its reach in the Middle East.

Officials in the Middle East have taken note of Washington’s pivot away from the region and are exploring expanded economic ties with Beijing. In February, the Central Bank of Iraq announced that it would allow trade with China to be settled directly in yuan in an attempt to improve access to foreign currency. The move comes after reports last year indicated that Saudi Arabia was in talks with China about pricing some of its oil sales in yuan. The yuan is still far from being internationalized, and most global trade—especially in the energy and commodity markets—remains dollar-pegged. But a gradual shift toward yuan settlement in the Middle East is a concerning trend. This should give the Biden administration pause before further retreating from the region; while China’s ability to create a parallel financial system that doesn’t rely as heavily on the US dollar is far from a foregone conclusion, even modest steps in this direction could erode the effectiveness of US sanctions globally.

Beijing’s desire to use the yuan as a foreign-policy tool with Middle East partners has extended even into the digital realm. In 2022, the Digital Currency Research Institute of the People’s Bank of China and the Central Bank of the United Arab Emirates, along with two other central banks, launched a pilot through the Bank of International Settlements to develop a prototype for an interoperable wholesale central bank digital currency (CBDC). The project, called mBridge, is exploring whether CBDCs can facilitate inexpensive and immediate cross-border transactions and address frictions in today’s cross-border payment systems. Yet the long-term geopolitical motivations cannot be ignored. Although China’s own CBDC—the digital yuan, or e-CNY—is mainly used for domestic retail payments and is only in its early stages of development, Beijing is laying the groundwork to influence how international standards around digital currencies are shaped, potentially edging out the United States from playing a leading role in this effort.

A legacy at stake

The Biden administration’s shift away from the Middle East is, at least in part, a necessary correction from the Donald Trump presidency—a period in which US fawning over autocrats in the region held Washington back from addressing thorny human-rights and governance challenges. But the pendulum may have swung too far: Washington’s current approach threatens to chip away at a critical piece of its bilateral relationships across the Middle East, undo years of meaningful progress on developing effective counter-illicit finance regimes in the region, and weaken US AML/CFT and sanctions efforts globally.

US national security is dependent on a robust, global infrastructure to protect against illicit finance threats. That infrastructure relies on cooperative action, information sharing, and joint standard setting. Yet as Beijing courts countries in the Middle East with its “no strings attached” approach, there is increasingly less incentive on the part of governments in the region to uphold and enforce US sanctions programs or support counter-illicit finance efforts. It’s a trend that should be deeply concerning for US national-security interests.

In public remarks last month, US Treasury Secretary Janet Yellen said the United States is seeking “healthy competition” with China. But that will take more than enhancing US hard-power capabilities and increasing diplomatic engagement in China’s backyard. To maintain its global leadership position, the United States must adopt a broad strategic effort, both geographically and functionally. In this case, that means remaining engaged with Middle East partners who were main characters in the United States’ alliances in the post-9/11 years. And it means investing in all forms of engagement, particularly economic statecraft.

Otherwise, future US administrations may look back decades from now, wondering how and why partners in the Middle East built stronger bridges to Beijing, leaving Washington without an invite to the majles.

Lesley Chavkin is a nonresident senior fellow with the Economic Statecraft Initiative of the Atlantic Council’s GeoEconomics Center and served as the US Treasury Department’s financial attaché to Qatar and Kuwait from 2017 to 2020.

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When one counts the major financial markets in Iran, it includes the gold market alongside the foreign currency exchange and stock exchange markets. Like any other investor, the average Iranian seeks a low-risk portfolio where the value of their savings is not diminished by inflation. In the past four decades, Iranians have continually increased their belief and trust in gold as a method of reducing risk, since Iranian officials have failed to reduce uncertainty in the markets and have intervened in ways that have only made things more confusing. 

On April 26, the officially minted gold coin, known as an Imami, cost 318,850,000 rials (about $611). An Imami coin weighs 8.14 grams (0.29 ounces) and is of 0.90 purity. Its price has increased by 169,610,000 rials compared to six months ago, signaling an increase of 113.6 percent as Iranians began to take to the streets to demand justice for Mahsa Jina Amini, the twenty-two-year-old Kurdish-Iranian woman who was killed by the so-called morality police for “violating” mandatory hijab. In contrast, gold prices began a rapidly increasing trend in Iran. It is noticeable that, prior to Amini’s murder, gold prices had been growing slowly. For example, between spring 2022 and fall 2022, gold prices increased by approximately 28 percent or 17,910,000 rials. However, from September 2022 to March 2023, the change in gold prices jumped by a factor of nine. 

Iranian officials blame the increasing gold prices on US imposed sanctions, a breakdown in the Joint Comprehensive Plan of Action (JCPOA), and on social networks where gold market prices are reported based on market transactions, not official prices. In an effort to tame the market, the police arrested 241 gold dealers in December 2022, charging them with distorting the market and causing abnormal volatility in the gold market. Some, like Mohammad Reza Farzin, the governor of the Central Bank of Iran (CBI), claim gold prices in Tehran do not reflect the realities of the Iranian economy. However, Iranians are ignoring such proclamations. They are witnessing rising prices while their nominal income is diminishing. The CBI has announced that prices have increased by 43.6 percent from February 2022 to February 2023. However, many Iranians are paying twice more for food and shelter. 

As volatility and confusion about the future increase, Iranians want to avoid risking their livelihoods by keeping their savings in cash or deposit accounts in Iranian banks. Market analysts and observers of the Iranian economy are also baffled by government officials’ contradictory statements. On April 5, a month after claiming that gold prices and currency exchange rates were inaccurate, Farzin confirmed that the government continued to borrow from CBI and Iranian banks. In other words, President Ebrahim Raisi and his ultra-conservative allies were printing money to pay for public expenses. As a result, the monetary base is expanding in Iran, with many expecting the inflation rate to rise during 2023 and well into 2024. (The Statistical Center of Iran reported that the point-to-point inflation rate reached 63.9 percent in March 2023 compared to March 2022.)

While some argue that lifting sanctions or freeze-for-freeze measures might help Iranian consumers, Iranians know that government policies are the most significant factor influencing the economy. Unfortunately, government policies have gone from bad to worse, being overwhelmed by domestic opposition and lacking the skills and foresight to implement effective policies. As authorities hope to crush Iranian calls for Women, Life, Freedom using brute force, gold prices and currency exchange rates tell a different story. Iranians do not believe in the ability of the Islamic Republic to bring either economic stability or prosperity as a governing body, which is why they are looking for ways to reduce financial risk. In the coming years, history may refer to Iran’s financial markets as predictors of a significant structural change in Iran’s politics.

Ali Dadpay is an associate professor of finance at the University of Dallas. Follow him on Twitter: @ADadpay.

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The speed and scale of digital bank runs have upended regulatory guardrails and left regulators no time to formulate proper responses. As a result, regulatory reforms are needed. In addition to changing the 2018 law that exempted US banks with assets of less than $250 billion (instead of $50 billion) from the full force of the 2010 Dodd-Frank law and strengthening bank supervisory practices, reforms should focus on the liquidity coverage ratio (LCR) requirement and the deposit insurance scheme. Reform is urgent, since banking crises can happen at any time and a possible recession is looming. At the same time, the Biden administration should proceed carefully, given the important ramifications of the measures in question.

Strengthened liquidity coverage requirements

A key plank of the Basel III reforms following the 2008 global financial crisis is the LCR, designed to address bank liquidity risks. Under the LCR requirement, banks must keep enough high-quality liquid assets (HQLA)—those that can be monetized quickly with no or little loss of value—to cover outflows of at least 3 percent of stable deposits and at least 10 percent of less stable deposits over thirty days. This requirement is intended to allow time for bank executives to take corrective actions and regulators to formulate appropriate responses. However, these ratio and time specifications are now rendered obsolete by the speed of digital bank runs. For example, SVB suffered a $42 billion deposit outflow on March 9 and a scheduled outflow of $100 billion the next day, when the Federal Deposit Insurance Corporation (FDIC) stepped in—totaling $142 billion, or 81 percent of the bank’s total deposits, in two days. In other words, banks satisfying their LCR requirements, as SVB did, can still be brought down by digital bank runs.

Moreover, the calculation of HQLA is flawed because it focuses on credit risk and not interest rate risk as well. HQLA consist of Level I assets (such as government bonds, which do not need to have haircuts, or discounts in calculating the numerator of the LCR); and Level II assets (such as corporate bonds, which have a 15 percent haircut). However, when SVB tried to sell its high-quality bond portfolio, including many US Treasury securities, it realized losses due to the increase in interest rates. This was another blow to the ebbing market confidence in SVB, accelerating the collapse. 

To address these shortcomings, the LCR should be strengthened to increase the coverage of expected outflows of at least 25 percent of deposits—and probably more for uninsured deposits. Furthermore, all securities included in the HQLA should be marked to market, or priced according to prevailing market conditions, to avoid surprise losses when needed to cover deposit outflows. Interest rate risks—not just credit risks—must be fully incorporated in regulatory frameworks and supervisory practices.

A better way to protect deposits

US authorities invoked the “systemic risk exception” to protect large uninsured deposits at SVB and Signature Bank to prevent contagion to the banking system. They are expected to do so again if another bank with large uninsured deposits fails. However, they cannot raise the current $250,000 deposit insurance limit per customer per bank without congressional approval. Leaving aside the low chances of congressional action in this time of political polarization, two important issues need to be considered in deciding whether and how to insure all deposits.

First, costs matter. The FDIC insures $9.9 trillion, or 56 percent, of total bank deposits. Its Deposit Insurance Fund (DIF) has accumulated $128.2 billion from assessments on banks, amounting to 1.27 percent of insured deposits. The assessment rates range from 2.5 to 32 basis points (of total liabilities) for small banks and 2.5 to 42 basis points for large banks—the actual rates depend on banks’ risk profiles.

Resolving SVB and Signature Bank while protecting all their depositors has generated $22.5 billion of losses to the FDIC—which it will have to recoup by making additional assessments on banks ex post. Obviously, the FDIC would need more resources if it insures all deposits, as requested by the Mid-Size Bank Coalition of America, among others. At a minimum, the FDIC would have to double the assessment rates, significantly increasing the costs to US banks (and to their clients).

More importantly, even with higher assessment rates, the DIF would likely be in no position to deal with a widespread banking crisis if it has to protect all deposits—worth $17.7 trillion, or 75 percent of US gross domestic product. The public backstop to the FDIC would likely be used more often than just in “exceptional” cases if the government stands ready to protect all bank deposits. This would significantly enhance the extraordinary privileges accorded to banks in exchange for their provision of payment and other banking services. In other words, banks would take and create (when making loans) government-protected deposits at low or zero cost. Then they would reap the profits by investing the money while the government assumes the risk of their possible failures threatening the deposits. Such a business model would draw ample and justified criticism. It’s not the right move.

A better approach is to confirm that deposits rank higher than debt and equity in bank capital structure; and in case of failures, large depositors will get paid—beyond the insured minimum of $250,000—by using the bank’s HQLA as collateral to borrow from the Federal Reserve. This can be done either through the recently launched Bank Term Funding Program or, better still, the Discount Window, which does not involve any government subsidies. Any residual claims depositors have would be settled out of the proceeds of the sale or liquidation of the failed bank—accepting possible losses if these proceeds fall short. This procedure would expedite the payment of a meaningful chunk of uninsured deposits to avoid disrupting business transactions but still subject large depositors to some degree of market discipline.

In short, reforms are needed to address the problems revealed by the March banking crisis—even though there could be strong resistance from various quarters. But the implications of inaction and of some reform measures, especially protecting all deposits, are so important that they should be discussed publicly—and more seriously than they have been so far.

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

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Distinguished guests at the workshop included H.E Laurence Boone, Minister of State for Europe for the French Foreign Ministry; Ms. Kerstin Jorna, Director General of the Directorate-General for Internal Market, Industry, Entrepreneurship and SMEs (DG GROW); Mr. Olivier Guersent, Director-General of the Directorate General for Competition; Mr. Emmanuel Moulin, Director General at the French Treasury; and Mr. Benoît Potier, Chief Executive Officer of Air Liquide, among others. In addition to these guests, the Atlantic Council, DGAP and GEG were honored to host other key policymakers, analysts, and private sector representatives.  

One year on from the Russian invasion of Ukraine, Europe has managed to mitigate the worst effects of the energy crisis and maintain its support for Ukrainians’ defense of their homeland. Participants noted the significant number of initiatives taken at the European level on a vast array of subjects, including diversifying imports, deploying clean energy, and building supply chain capacity. The conversation in Paris ranged from how to meet basic energy needs now to building a resilient net zero economy in the future, with a focus placed on industrial strategy, infrastructure needs, and scaling up public and private funding, and infrastructure needs.

Whereas participants at the first workshop in Berlin highlighted the successful cooperation between European member states in the face of the energy crisis, discussants in Paris underscored increasing tensions between member states on several vital issues. Attendees emphasized the crisis of trust between member states, evidenced by disagreements on electricity market reform, divergences on the role of nuclear and natural gas in the energy transition, state aid rules, and even the lack of progress made towards a Capital Markets Union. Some panelists argued that Franco-German disagreements on nuclear energy inhibit Europe’s ability to make progress in its energy transition, while others expressed concerns around the necessity of nuclear support schemes at the EU level. There were also diverging perspectives around how loosening the state aid rules would impact market unity.  

Participants also emphasized the need for European cooperation, especially in building common energy infrastructure. Indeed, renewable energy deployment must go hand in hand with infrastructure investments, such as electricity grids, hydrogen pipelines, and electric vehicle charging stations. Panelists shared the view that, to meet these many goals, Europe would need to strengthen its infrastructure planning capacities, accelerate reforms in project permitting, and scale up access to funding if it is to meet its ambitious decarbonization objectives. Increasing and diversifying the number of long-term energy contracts signed with producers, such as contracts for difference and power purchase agreements, could help incentivize investments in clean power.  

Looking beyond the continent, European participants described the United States’ Inflation Reduction Act (IRA) as a welcomed shift in US climate policy and positive shock for Europe’s own decarbonization efforts. Several participants argued that the IRA would encourage Europe to build its own resiliency in clean industry supply chains and open potential avenues of cooperation with the United States. But European panelists also expressed concerns regarding its impact on European industry due to the law’s national preference rules, seen as discriminatory against European manufacturers, even though the EU offers comparable, but perhaps harder to navigate incentives. This highlighted a remarkable shift in focus from the workshop in Berlin a few months prior, where policymakers and analysts had debated Europe’s capacity to meet energy demand. In Paris, however, the conversation focused not on energy supply, but on low-cost, low-carbon energy as a prerequisite for a competitive industry.  

The Atlantic Council looks forward to continuing this workshop series throughout 2023.  

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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.

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Debt limits—which act as a ceiling on the central government’s ability to borrow money to finance existing legal obligations—are self-imposed. They are not a legal obligation to any lender. Ceilings are often intended to signal fiscal discipline to international investors or to enact checks and balances on a country’s public finances. But investors rarely like them because they can be easily skirted, making them a mild irritant. Worse, they can trigger full-scale political chaos and directly jeopardize investments.

In the United States, debt limits are set as a nominal value. Two important pieces of legislation concerning the debt limit were adopted during World War I in 1917 and right before World War II in 1939. The ballooning and unknowable costs of war and the intervening economic depression made it cumbersome for Congress to oversee each instance of debt issuance. Congress therefore gave the US Department of the Treasury considerable flexibility on the issuance and management of debt—while imposing a ceiling on total debt. Since 1960, Congress has permanently raised, temporarily extended, or revised the definition of the debt limit seventy-eight times under both Democratic and Republican presidents. 

Many of these negotiations have been fraught with political deadlock, leading to serious concerns over a possible default on US debt obligations. Hitting the debt limit could paralyze the government’s ability to finance its operations—including national security initiatives, Medicare, and Social Security. It could result in a downgrade from credit rating agencies, making borrowing more expensive for the public sector, private sector, and households alike. It could also shake the dollar’s foundations, threatening its centrality in the global economy. Even the mere prospect of any of this happening worries global investors.

Debt limits like the United States’, however, are not the norm—and they rarely cause major deadlocks in the few countries that have adopted this tool. Other countries have avoided deadlocks through one of these four routes: 

1. The ceiling is intentionally set sufficiently high such that it will not plausibly be crossed.
2. The law is either amended or suspended during periods of heightened stress necessitating indebtedness.
3. No punishments are tied to the legislation, meaning states often cross the limit with impunity.
4. The law was scrapped altogether when it was severely curtailing the government’s policy space.

How do other countries manage debt limits? 

Denmark

Like the United States, Denmark also sets its debt limit as a nominal value. But that’s where the similarity ends. The Danish Parliament intentionally sets the ceiling sufficiently high such that it will not be crossed, rendering it no more than a formality.

The Danish Parliament first passed debt ceiling legislation in 1993 as a constitutional necessity resulting from administrative reorganization of government institutions. Since then, the debt limit was amended just once in 2010, when the country’s debt remained far under the limit. The ceiling was doubled to DKK two thousand billion or 115 percent of 2010 Danish gross domestic product (GDP), far higher than actual debt levels. Denmark’s outstanding general government debt in 2023 is DKK 327 billion, which is only 16 percent of the debt ceiling. The 2010 doubling was executed with the explicit intention of avoiding any risk of nominal gross debt ceilings affecting ongoing fiscal policies in response to the 2008 recession.

Kenya

Like the United States and Denmark, Kenya also has a nominal debt limit. However, it is under the process of replacing the nominal limit with a limit as percentage of GDP at 55 percent. The intention is to make debt management more sustainable—or in other words, to finance budget deficits in the medium term without needing to repeatedly negotiate the debt limit.

The government has typically stayed within the constraints of debt limit legislation. But when push came to shove, the Parliament of Kenya has increased the limit in advance to avoid an economic impasse. Parliament recently increased the debt limit from KES nine trillion to KES ten trillion to enable complete financing of the 2022 / 2023 budget. The legislation had a majority in parliament. Opposition from a few members of parliament leading up to the limit raise had less to do with political infighting, and more to do with concerns regarding vulnerability to debt distress. This raise is nevertheless understood to be an interim measure while Kenya moves to debt limits as a percentage of GDP.

European Union 

The European Union (EU) joins the United States as the only other Group of Twenty member to stipulate a formal debt limit—albeit of a different type. The EU’s Stability and Growth Pact (SGP) stipulates that a member’s debt cannot exceed 60 percent of its GDP. If a state breaches that ceiling, the excessive debt procedure (EDP) is automatically launched by the European Commission. It consists of several steps—culminating in sanctions—that intend to pressure the state to return to that 60 percent figure. This debt limit is meant to safeguard the stability of the common currency. 

The EU’s debt limit legislation imposes strict penalties on transgressors, but exhibits adaptability to extreme economic duress. The legislation includes a “general escape clause” which can only be triggered in a severe economic downturn. It was triggered in response to the pandemic in 2020 and has yet to be reinstated. The EU is now actively exploring fiscal reforms including the debt limit, particularly to help countries implement the green and digital transitions, meaning the debt limit may not return in its current form.  

Poland 

Within the EU, Poland also has domestic laws to limit debt. Constitutional articles stipulate that national public debt cannot exceed 60 percent of the annual GDP. Here too, the law has shown flexibility to circumstance.For instance, some of the toughest measures to manage debt levels were suspended to facilitate response to the economic slump in 2013. 

Malaysia 

Malaysia’s debt limit is set at 60 percent of GDP, lifted from 55 percent in 2020 to aid the government’s response to the pandemic. It was lifted further temporarily to 65 percent of GDP in 2021 to make room for additional borrowing and fiscal stimulus, and this temporary provision lapsed on December 31, 2022. Unlike the United States, the debt limit is not governed by any act and is self-imposed by the Ministry of Finance. Parliamentary approval is not necessary to raise the debt ceiling and the government will not “shut down” in the event of exceeding the limit. The government can simply revise the limit when needed. Subsequent governments have nevertheless remained approximately within bounds of the debt limit. Now that the limit has returned to 60 percent following the temporary raise to 65 percent, the Malaysian prime minister has assured that the government will gradually lower the nation’s debt and return within bounds of the debt limit.

Namibia

The Namibian debt ceiling is set at 35 percent of its GDP. However, this figure is non-legislative and the Namibian debt-to-GDP has been above that level for years. In 2021, Namibia’s debt was 72 percent of its GDP.

The Namibian government has attempted to return to that 35 percent figure. It has cut its national budget and created a sovereign wealth fund. These efforts, however, have been severely hampered by government spending during the COVID-19 pandemic and food shortages resulting from the war in Ukraine. 

Pakistan

The Fiscal Responsibility and Debt Limitation Act of 2005 requires the Pakistani government to reduce total public debt to 60 percent of GDP by 2018. But the legislation does not stipulate any punishment for breaching that limit. Without an incentive to stay under it, Pakistan’s debt has continually been over the limit. The debt-to-GDP ratio this fiscal year is 75 percent. 

Limitations of the debt limit

Australia briefly experimented with a debt limit similar to that of the United States, experienced the political infighting that Washington is familiar with, and abolished it soon after. In response to the Global Financial Crisis, the government introduced a debt ceiling of AUD seventy-five billion in 2008 to signal its commitment to fiscal prudence. But deficits persisted, and the government raised the ceiling multiple times to staunch resistance from the opposition, culminating at a limit of AUD three hundred billion. When the new government in 2013 was met with strong resistance to increasing the limit yet again, it ultimately decided to scrap the law altogether. 

Debt limits are self-imposed tools to facilitate sound fiscal policy. But in practice they serve as orienting goals or tools of political bargaining at best, and triggers of economic chaos at worst. It is unsurprising that most of the world chooses to have no such limit.

The United States is one among the few polities that have adopted and retained debt limits. Within that tiny group, it is unique in its inability to find workarounds which could inadvertently harm its national interest.

Mrugank Bhusari is an assistant director with the GeoEconomics Center focusing on international finance and global governance. Follow him on Twitter @BhusariMrugank.

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The Atlantic Council, the German Council on Foreign Relations (DGAP), and Groupe d’études géopolitiques (GEG) were honored to host “Decarbonization solutions for addressing Europe’s green industrial policy challenge,” a high-level workshop on decarbonization in Paris on March 20. The event promoted an open discussion between policymakers, analysts, and the private sector on Europe’s energy challenges, and to discuss what could be a common approach to on Europe’s energy security and climate challenges, and to discuss what could be a common approach to resolving threats to US-EU solidarity as well as Europe’s internal fissures.

Featuring

H.E. Laurence Boone

Secretary of State for European Affairs

Ministry for Europe and Foreign Affairs of the French Republic

Kerstin Jorna

Director General, Directorate-General for Internal Market, Industry, Entrepreneurship and SMEs (GROW)

European Commission

Fellow

Ben Judah

Director

Europe Center Transform Europe Initiative

Economy & Business European Union

Sena Latif

Acting Chief of Mission

Embassy of Romania in Paris

Benoît Potier

Chief Executive Officer

Air Liquide

Laurence Tubiana

Chief Executive Officer

European Climate Foundation

In conversation with

Board director

Ambassador Paula J. Dobriansky

Vice Chair, Scowcroft Center for Strategy and Security

Scowcroft Center for Strategy and Security

Latin America China

Guntram Wolff

Chief Executive Officer

German Council on Foreign Relations

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Fifty-three economies—including Argentina, Egypt, Pakistan, and Nigeria—are in an especially fragile condition because they have either defaulted on some of their debts, or have debt levels that the IMF considers unsustainable. Given their 5 percent share in the global economy, this may not sound alarming. However, considering the contagion phenomenon in financial markets—and the fact that these fifty-three economies are home to about 20 percent of the world’s population—debt distress, and its social, political, and economic ramifications could pose serious threats to the global economy. Acknowledging these dire conditions, the IMF has redoubled its efforts to help its member countries avoid the worst of debt crises.  

How does IMF financial assistance work? 

The IMF’s financial assistance is intended to provide financial support for countries that are experiencing or at risk of financial crises, including balance of payment (BoP) crises, banking crises, currency crises, or external/internal debt crises. The IMF’s financial assistance provides breathing space for governments to devise and gradually implement corrective policies. Hence, the IMF’s financial assistance is always associated with a set of reform policies tailored for the country in crisis. These may include monetary policy and exchange rate policy reforms, and other sets of economic-wide reforms broadly referred to as Structural Adjustments or Reforms. By implementing these reforms, the country is expected to restore long-run financial stability and growth in its economy and rebuild domestic and foreign investors’ faith in the country’s economy.  

Table 1 provides a breakdown of the IMF’s financial assistance accounts and types. Broadly speaking, IMF financial assistance can take three forms. First is lending at an interest rate determined by the average of interest rates in world major currencies. Loans extended under the General Resources Account (GRA) are of this type. Second is lending at concessional terms which are extended at very low or no interest rates to low-income economies. Financial assistance through the Poverty Reduction and Growth Trust (PRGT) falls under this category. The third form of IMF financial assistance is through the Catastrophe Containment and Relief Trust (CCRT). This is a debt relief grant for heavily indebted, low-income economies facing debt distress and financial turmoil. Figure 2 shows the value of all IMF financial assistance between 2020 and 2022 for each type and recipient country. More than three-quarters of all IMF financing during the 2020-22 period was through the Flexible Credit Line (58 percent of the total) and the Extended Fund Facility (19 percent of the total). 

Latin America and the Caribbean have been the IMF’s largest clients. 

In fiscal year (FY) 2022, the IMF provided $113 billion of financial assistance to twenty three of its member countries, 90 percent of which is dedicated to Latin American and Caribbean economies. Two economies in Latin America accounted for $91 billion (or 80 percent of the IMF’s financial assistance in 2022): Argentina with $43 billion and Mexico with $48 billion. FY2022 was not an anomaly in the IMF’s financial assistance pattern. As seen in Figure 3, 71 percent of all IMF financial assistance between 2020-22 (including FCL) was allocated for the Latin America and Caribbean region.

However, it is important to note that the type of financial assistance IMF has provided in the form of FCL —for example to Mexico and Columbia— is drastically different in nature from the assistance provided to Argentina in the form of EFF. In particular, FCL is designed as a crisis-prevention and crisis-mitigation credit line for countries that have strong policy frameworks and solid track records in their economic performance. Hence, the country may or may not decide to use all or even a portion of this line of credit that is allocated to them. For example, Mexico has drawn nothing from the total amount of 80.214 billion SDR made available to them through FCL facility between 2020 and 2022. In contrast, Argentina has drawn 17.5 billion SDR from the 31.914 billion SDR EFF assistance provided to them. It must be noted here that IMF extends EFF to a country facing major medium-term BoP challenges because of various structural issues that will necessitate some time to address. IMF’s lending commitments site provides updated detailed information on the type and amount of assistances IMF has allocated for each member country from its first day of inception, the amount drawn from the allocated funds, and the outstanding balances.    

After Latin America, the Sub-Saharan Africa region is the IMF’s main client. It is followed by a few countries in other regions such as Egypt in the Middle East and North Africa, and Pakistan in South Asia, which are highlighted in Figure 4.

The IMF should reexamine the uneven distribution of its financial resources.

The case in hand is the IMF’s uneven response to economies in Latin America versus those in Sub-Saharan Africa. While both regions suffer frequently from debt and BoP crises, Latin American economies tend to get larger IMF packages than African economies, even when their IMF quotas are considered. For example, Argentina’s most recent IMF package (arranged March 25 2022) was about $43 billion, which is about 1,000 percent of its quota and $950 million per capita. Moreover, program aimed to help Argentina repay its outstanding IMF debt from an unsuccessful 2018 $57-billion IMF program.  

In contrast, Zambia’s most recent IMF package (approved August 31 2022) was about $1.3 billion, or 100 percent of its quota and about $73 million per capita. A careful look at the IMF’s financial assistance history will surface many more such examples of potentially uneven treatment. Pakistan and Egypt are two other countries that have received substantial and frequent financial assistance from the IMF over the past decades while other countries in their respective regions have had less luck in that front.  While citizens and policymakers in Latin America, Pakistan, and Egypt may reject the notion that the IMF has treated them favorably over the years, a close look at other countries such Sri Lanka and Lebanon provides a glimpse of what could happen to economies in crises when IMF assistance is not immediately there to support them.  

Conclusion 

The global economy is facing multifaceted challenges that are increasingly interconnected and transnational in nature. Bretton Woods Institutions, such as the IMF and the World Bank, are tasked with addressing many of these challenges—including the debt distress faced by many low income and emerging economies. However, as shown above, their responses to crises have not been equitable across different regions and countries. As firefighters of the global economy, these institutions should respond to crises on equitable terms across all their members. Otherwise, they risk being viewed as politically motivated, undermining their effectiveness and relevance in the governance structure of the global economy and financial relations.  

Recent debt relief grants allocated to many low-income economies in Sub-Saharan Africa through the CCRT and the last month’s visit of IMF’s managing director, Kristalina Georgieva, to Africa and engaging with African leaders are steps in the right direction. However, they must be followed by more favorable and creative financing schemes for debt-distressed low-income African economies, where debt vulnerabilities were exacerbated by the global pandemic and skyrocketing global food and energy prices. 

Amin Mohseni-Cheraghlou  is a macroeconomist with the GeoEconomics Center and leads the Atlantic Council’s Bretton Woods 2.0 Project. He is also an assistant professor of economics at American University in Washington DC. @AMohseniC

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Europe faced a perfect storm in 2022, following the Russian invasion of Ukraine. Russia cut off gas supplies at a vulnerable time for Europe: a combination of low European gas storage levels and hindered domestic production capacities in nuclear and hydropower from climate change-related extreme heat and drought. Participants noted the war has challenged Europe’s prevailing energy and security policies, as well as the continent’s climate prestige and green industrial ambitions. It is also a challenge to achieving Europe’s climate change ambitions and green industrial growth. Several participants argued that Europe now faces a new impossible trilemma: to reduce greenhouse gas emissions, maintain continuity in its energy supply, and ensure the survival of industry and affordable energy prices for households. The last issue is especially difficult to navigate, as Europe’s industry is threatened by high energy prices, rendering it uncompetitive against US and Chinese counterparts with access to cheaper fossil fuel energy.

Participants agreed that while the energy crisis has affected individual member states in different ways, the response must be found at the European level. This requires increased coordination within Europe, notably on emergency measures to address the crisis,  simplification of regulatory frameworks, enhanced energy interconnections, and agreements on how various clean energy and low-carbon energy sources can enhance security and decarbonization. In particular, while nuclear energy remained a point of contention, all participants stressed the need to move forward in a constructive and cooperative manner. Panelists widely shared the view that Russian aggression in Ukraine must “shift attention, not the priorities”, meaning that Europe’s climate objectives, in terms of renewable energy generation, energy efficiency and electrification, remain more relevant than ever.

Participants argued that, while Europe now looks to Africa as an alternative supplier of fossil fuels to replace Russian imports, Europe should increase cooperation with the African continent for clean energy imports, green hydrogen, and critical raw materials, all key components of Europe’s decarbonization trajectory. Looking eastwards, participants noted the importance of China in renewable energy supply chains, and warned against the threat that European industry faces in several key sectors including wind, noting China’s long-established near-monopoly in the solar industry as an example.

In 2022, Europe responded to Russia in a decisive manner, ensuring its domestic energy needs were largely met by attracting LNG cargoes (albeit at high prices) and reducing demand. Participants agreed that this was a result of critical policy decisions, combined with beneficial external factors: low demand in COVID-stricken China, and record-breaking warm weather over the European winter. Discussants acknowledged that Europe had narrowly avoided a catastrophe, but that coming winters would provide new challenges and opportunities due to resurgent demand from China and uncertainty over whether future winters will be so mild. In short, the energy crisis of 2022 has offered key lessons for Europe to continue its decarbonization journey.

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This work empirically examines China’s growing footprint in Sub-Saharan Africa’s investment, trade, cultural, and security landscape over the past two decades. It highlights China’s increasing appetite for Sub-Saharan Africa’s natural resources and growing young labor force—identifying the region’s consumer market as an important destination for Chinese goods and services over the next few decades. 

The analysis identifies more than 600 Chinese investments and construction contracts in Sub-Saharan Africa (SSA), valued at over $303 billion, signed between 2006 and 2020. Four sectors attract 87 percent of China’s investment and construction in the region: energy at 34 percent; transport, 29 precent; metals, 13 percent; and real estate, 11 percent. This is very similar to the Middle East and North Africa Region, where the energy sector attracts close to 50 percent of China’s investment, followed by transport, 19 percent; real estate, 15 percent; and metals, 6 percent.

In terms of trade, this work shows that between 2001 and 2020, China’s merchandise trade with the region increased by a whopping 1,864 percent—surpassing SSA’s trade with both the United States and the European Union. In other words, from 2001 to 2020, China’s share in total merchandise trade in SSA rose from 4 percent to 25.6 percent, while during the same period, the shares of the United States and the EU in SSA’s total trade declined by 10 percentage points and 8 percentage points, respectively.

The report also takes a look at China’s arms trade with the region. Twenty-two percent of SSA’s arms imports are sourced from China, making China the region’s second-largest supplier of arms and military equipment, with Russia in the lead (24 percent). 

Finally, the report highlights the fact that the size of Chinese migrants in Africa is estimated at one to two million, with around one million permanently residing in the region. The largest numbers are in Ghana, South Africa, Madagascar, Zambia, and the Democratic Republic of the Congo.This work is the first in a series of empirical analyses that will be conducted on China’s presence in developing economies and low-income countries.

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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.

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Friendshoring includes the concept of nearshoring (bringing production near to consumer markets) and reshoring (repatriating production back to the home market). It was intended to be a defensive posture to enhance the resilience of supply chains. Efforts to friendshore have been observed in several important sectors—as highlighted in “Our guide to friendshoring: sectors to watch.” For example, the US government has invested in rare earth mining and processing facilities in the United States and Australia to reduce its reliance on China. In the process they have reduced China’s global market share in these critical minerals from 80 percent to 60 percent.

However, friendshoring has recently been used as an offensive policy tool, rather than defensive. As articulated by US policy makers, their goal is to ring-fence international supply chains for strategic goods, such as advanced computer chips, in friendly countries. They hope to use friendshoring to exclude China from essential supply chains to delay its economic and military modernization. This aggressive approach is part of the high-tech war between the United States and China, which has become the main arena for their strategic competition.

The weaponization of friendshoring escalates US-China strategic competition. It is therefore important to identify its implications. First, offensive friendshoring will make it more difficult for the United States to encourage the European Union, Japan, and other allies to fully align their China policy with the United States. Second, it could push China to respond more aggressively than the mainly defensive measures adopted so far. This will make managing US-China strategic competition, and preventing open military conflicts, more difficult going forward.

The weaponization of friendshoring

The United States weaponized the concept of friendshoring by continuing to elevate the goals of the strategy, as summarized last September by US National Security Adviser Jake Sullivan. Though initially intended to reduce US reliance on China in global supply chains, the recent aggressive approach is designed to help the United States “prevail in strategic competition with China.” It is driven by the assessment, articulated in the 2022 US National Security Strategy, that “the People’s Republic of China…is the only competitor with both the intent to reshape the international order and, increasingly, the economic, diplomatic, military and technological power to advance that objective.” Friendshoring is now expected to go beyond just preserving  the US lead over China—for example, in advanced computer chips by two chip generations. It also aims to widen such strategic leads as much as possible, in the process derailing, delaying, and retarding China’s economic and military modernization. Essentially, this strategy aims “to impose costs on adversaries, and even over time degrade their battlefield capabilities.”

The United States has taken several actions to implement this approach, with varied success.

In October 2022, the United States significantly widened the scope of its ban on sales to a greater number of Chinese entities. The ban now included not only advanced chips, but also the equipment, designs, and software necessary to manufacture them—as well as banning US persons from participating in those activities. The United States also used its Foreign Direct Product rule to prohibit non-US companies from providing China with banned products if they contain US ingredients—including intellectual property.

After a period of intense negotiation, the United States convinced the Netherlands and Japan to agree to join its ban on the export of crucial equipment—such as the extreme ultraviolet lithography systems—necessary to fabricate the most modern chips (smaller than 14nm). However, Japan has already indicated that it will opt for milder restrictions than the United States. It is likely that the Netherlands may do likewise as details of the agreed ban are ironed out. Their reticence reflects the incomplete alignment of China policy between the United States and its allies. The more aggressive the US measures, the more challenging it is for the United States to obtain full buy-in from its allies.

The United States and India agreed last month to elevate and expand their joint initiative on Critical and Emerging Technology—or iCET—to foster “technology partnership and defense industrial cooperation.” The agreement covers artificial intelligence, quantum technology, high performance computing, advanced wireless, space activities, defense systems, and resilient semiconductor supply chains.

The United States has also launched its proposal for a CHIP 4 Alliance with Japan, Taiwan, and South Korea to coordinate steps to secure the supply chain for advanced chips in the region. However, the proposal has encountered resistance from the invited countries, mostly South Korea, given their substantial economic links to China—and has yet to take concrete shape.

Most recently, after shooting down the Chinese spy balloon flying over US airspace, the Biden Administration added six Chinese government-backed entities with links to the balloon program to the Entity List. The recently formed House Select Committee on the Strategic Competition between the United States and Chinese Communist Party “might also press for tougher measures to slow advancement of Chinese military capabilities.”

All together, these measures intend to exclude China from international supply chains crucial in producing advanced chips—and potentially other high-tech products. After all, the industry leader accounting for more than 90 percent of the global output of advanced chips—Taiwan Semiconductor Manufacturing Company—cannot operate in isolation. It depends on the United States for chip design and software; on the Netherlands and Japan for chip making equipment; and other countries including China for raw materials.  It cannot function without close international collaboration with leading companies and suppliers in many countries. It will be very difficult and costly—if not impossible— for China to replicate the advanced chip ecosystem all by itself. If fully implemented, these exclusion measures could delay and retard China’s efforts to modernize its economy and military.

China’s responses

The US offensive use of friendshoring risks pushing China to take strong countermeasures.

So far, China has primarily responded to US chip restrictions with defensive steps. Besides filing a complaint with the World Trade Organization against what it called “US trade protectionist practice,” China plans to roll out a $143 billion package to support its semiconductor sector, as part of its effort to become self-sufficient in high tech.

China has increased domestic production of legacy chips (those from 14nm and above—not subject to the US bans but still required in most modern products)—to increase its global market share.  Its market share grew from a negligible amount in 1990, to 10 percent around 2010, and about 15 percent now—just ahead of Japan, the United States, and Europe, but lagging behind Taiwan (22 percent) and South Korea (21 percent). China’s progress cuts into sales and revenue opportunities for US and Western firms and strengthens China’s central role in supplying manufactured goods using legacy chips. In addition, China’s top chip maker, the Semiconductor Manufacturing International Corp, has announced that it can now manufacture 7nm computer chips. However, there is doubt about its ability to do so at scale without the advanced equipment—which has been banned.

Most recently, two of China’s influential scientists wrote in the bulletin of the Chinese Academy of Sciences that the country should launch a counter strategy by amassing “a portfolio of patents that govern the next generation of chip making, from novel materials to new techniques…giving China the clout to push back against US sanctions”.

Theoretically, China can respond more rigorously to US tech containment measures. For example, it could limit or withhold the supply of goods it enjoys dominant market shares for. These include key minerals such as rare earths or chemical ingredients crucial for the West to produce many goods including pharmaceuticals. However, doing so will hurt the Chinese economy as well, since global production and consumption would likely plummet. While this dismal prospect has constrained China so far, more aggressive countermeasures cannot be excluded if the US tech containment strategy gains traction with allied countries and effectively derails China’s modernization plans.

In short, the increasingly offensive use of an offensive US friendshoring policy will make it more challenging to manage US-China strategic competition, and make a military conflict—with disastrous global consequences—more not less likely. Containing China’s high-tech development will make it more difficult to encourage China to cooperate with the United States in other areas, such as climate change and disease control, among other global issues. Despite Biden’s intention to “seek competition and not conflict” with China, the US-China relationship continues to deteriorate. The stakes are rising for all.

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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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.

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How grave is Britain’s stagnation?

As Britain faces a historical rupture from its historical trend with flatlining productivity growth, Ben Judah spoke with Professor Adam Tooze, Director of the European Institute and Kathryn and Shelby Cullom Davis Professor of History at Columbia University on how this crisis looks from a historical perspective.

Why does the economic data suggest this is more serious than previous moments of feared decline? How does this stagnation compare to previous instances in the 1930s and 1970s? What impact has Brexit had on this trend? Would a Labour government under Keir Starmer be able to turn this around?

You can watch #BritainDebrief on YouTube and as a podcast on Apple Podcasts and Spotify.

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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.

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The Fed’s overnight repo and reverse repo facility (ON RP/RRP) allows MMFs to borrow from or lend to the Fed, using government securities as collateral and agreeing to buy or sell back those securities at agreed rates, on an overnight basis. The ON RRP facility has attracted a record amount of cash after enjoying growing daily transaction volume since mid-2021. It consistently reached above $2 trillion since June 2022—swelling notably at the end of quarterly reporting periods. This happened despite Fed officials’ earlier expectations that such a volume would dwindle when the Fed started to tighten monetary policy to fight inflation. This phenomenon is driven by the way the Fed has used its reverse repo facility, which currently pays 4.3 percent to eligible participants such as MMFs, as a soft floor; and payment of interest—currently at 4.4 percent—on bank reserves at the Fed as a ceiling, to guide the effective Fed funds rate. The effective Fed funds rate currently trades around 4.33 percent—within the targeted range of 4.25 percent to 4.5 percent. There are two related reasons for the recent surge in Fed reverse repo activity.

Firstly, recent regulatory policy changes have prompted the increased use of the Fed reverse repo facility. The supplementary liquidity ratio (SLR), regulating the amount of liquidity commercial banks need to hold relative to its balance sheets, was relaxed in 2020 during the acute phases of the Covid-19 pandemic. The decision gave banks more flexibility in taking deposits and holding reserves and US Treasury securities. The SLR was then restored in March 2021, causing banks to lose willingness to accept deposits and holdings of US Treasury securities and reserves at the Fed. Their reluctance pushed customer money to the MMFs, which must find a place to invest the funds that are required to be kept in instruments of high quality and short maturity. In fact, the SLR decision designed to reduce risk in the banking system seems to have pushed money to non-bank institutions, mainly the MMFs. Additionally, the Fed may have facilitated the move into ON RRP by relaxing the facility’s eligibility standards, raising the daily counterparty limits, and raising the offer rates.

Secondly, as the ON RRP has been made more attractive on a risk-adjusted basis during a period of policy uncertainty, MMFs have found few alternatives to invest the inflow of money. This led to the increase of their assets under management from around $3 trillion in 2012-2019 to around $5 trillion since early 2020 after the onset of the Covid-19 pandemic. As mentioned above, banks have reined in their appetite for taking deposits and other short-term borrowings. Additionally, over the same period, the outstanding amount of US Treasury bills has declined by $1.5 trillion as the United States extended the maturity of its borrowing to take advantage of low interest rates. As a result, the volume of ON RRPs has grown significantly at the expense of dealing with private counterparties such as during private repo/reverse repo transactions. ON RRPs now account for more than 63 percent of the portfolios of MMFs.

The importance of the Fed in intermediating the supply and demand of short-term funds has several implications for the US financial system and economy.

On the positive side, the Fed’s daily dealing with MMFs and other eligible participants through its ON RP/RRPs has enabled it to be aware of, and continually adjust to meet, the changes in MMF demand for cash or government securities. The Fed thus avoids the need for extraordinary and emergency interventions to calm market turmoil as in the September 2019 and March 2020 episodes.

However, this has come at a high cost: the intrusive role of the Fed in money market activities. MMFs and other players have been incentivized to rely on the Fed’s ON RP/RRP facility. They enjoy practically zero counterparty risk and use top quality government securities as collateral at remunerative rates. But they tend to reduce dealings with other private sector entities using private investment instruments as a result. This has already been reflected in the daily transaction volume in various money markets at the end of 2022: $2.55 trillion in the ON RRP market; around $1 trillion in all private repo markets used to calculate the secured overnight offer rate (SOFR) as the new money market benchmark rate replacing the Libor (London Interbank Offer Rate—being discontinued due to accusations of rate manipulation by banks); and around $100 billion in the interbank Fed funds market. If these trends continue they will marginalize the role of private markets for short-term funds, weakening the usefulness of market price signals arising through the autonomous supply and demand for funds among private entities.

Specifically, the rates calculated from the private money markets—such as SOFR from private repo transactions and the Fed funds rate from the Fed funds market—will risk losing their relevance as benchmarks for pricing short-term funds in the United States. Generally speaking, this could hamper the optimal allocation of short-term funds in the US economy, impairing its efficiency over time.

Moreover, the Fed has generated net earnings, mainly from interest income on its holdings of government and other securities as well as on its lending to banks. This has allowed it to transfer about $1 trillion to the Treasury department cumulatively since 2010, reaching a record annual payment of $109 billion in 2021. However, as the Fed has begun to reduce its holdings of government securities through QT and pays interest in ON RRP transactions and on bank reserves at the Fed, it is estimated to post a loss of $80 billion by the end of 2022. In other words, the US government stands to lose a stable and painless source of revenue from the Fed when such an income can be useful given many urgent needs for government spending.

The way the Fed implements its monetary policy decisions has incentivized MMFs to deal with the Fed at the expense of other private entities. By guiding the effective Fed funds rate within targeted ranges and implanting other prudential regulations, especially the Supplementary Liquidity Ratio for banks, it has led the US economy to rely on the Fed for its normal operations as a money market maker of first resort, rather than a traditional lender of last resort during financial crises. This development could, over time, undermine the efficiency and robustness of the market economy the United States claims to have.

Hung Tran is a nonresident senior fellow at the Atlantic Council GeoEconomics Center; 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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Mark Linscott: Results in the Trade Policy Forum will be disappointing but predictable

Dr. Ajay Chhibber: The world’s two largest democracies have huge untapped potential for expanding trade ties, but they need a roadmap

Adnan Ahmad Ansari: An opportunity to reignite US-India trade talks

Ridhika Batra: Progress on iCET is a win-win for India and the United States

Anand Raghuraman: The Digital Data Protection Bill opens the door for increased US-India digital cooperation

Dr. Kyle Gardner: Progress is likely to be incremental but should be appreciated nonetheless

Atman Trivedi: The US-India Trade Policy Forum is likely to be short on tangible outcomes

Results in the Trade Policy Forum will be disappointing but predictable

Despite the best efforts of US trade negotiators to deliver meaningful results for US stakeholders on bilateral trade with India, they had limited leverage with their Indian counterparts and the results will make that crystal clear. There will be some glossing over of serious bilateral trade problems, positive language on the architecture of TPF discussions across goods and services, and repackaging of specific areas of the agenda, such as labor, environment, and good regulatory practices, as part of a new working group on “resilient trade.” But it will be difficult to avoid the conclusion that the current approach on bilateral trade is not working. These are the first and fifth largest economies in the world that have compelling national interests in solidifying and expanding their strategic partnership, yet the trade relationship is stuck with prospects for improvements dim.

Two possibilities for 2023 could substantially alter the dynamics and put the trade relationship on a better, healthier course for the future. The first would be reauthorization of the US Generalized System of Preferences (GSP) program by Congress so that the two sides could come back to the table in the TPF with enticements to offer for concluding a wide-ranging trade agreement. If the United States could offer the reinstatement of India’s GSP benefits, the prospects are strong that the two sides could reach an agreement on a series of issues, covering agriculture, health-sector products, digital services, and new trade issues (e.g., environmental sustainability and more equitable distribution of the benefits of trade).

The second would be a reversal of the Biden administration’s allergy to negotiating free trade agreements (FTAs), which has handicapped the United States in competing in global markets as their trading partners negotiate preferential trade terms among themselves (India concluded an FTA with the United Arab Emirates (UAE) and an interim FTA with Australia in 2022 and is actively negotiating with the United Kingdom, European Union, and Canada). The playing field has become less level for US export interests as a result, and a more captive US domestic market is neither realistic nor more beneficial. While it is unlikely that India would be at the top of the list for early negotiation of an FTA if the Biden administration changes course (the United Kingdom and Kenya are more likely candidates), even the start of an exploratory process for a US-India FTA would kick-start the expansion of the trade relationship. The two governments would experience new, exciting dynamics in their bilateral engagement, more attention from stakeholders on both sides, and enhanced leverage to fix problems and venture into new frontiers on trade.

If neither of these possibilities emerge over the next year, it is likely that the TPF will continue to fall short of expectations. Both governments should consider the consequences of a trade relationship that has been going nowhere for too long.

Mark Linscott is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

The world’s two largest democracies have huge untapped potential for expanding trade ties, but they need a roadmap

If India and the United States have to reach the laudable goal of five hundred to six hundred billion dollars by 2030, the upcoming US-India Trade Forum must lay out a clear roadmap to achieve it. The world’s two largest democracies have huge untapped potential for expanding trade ties in goods and services—especially in wellness and pharma, agriculture, information technology, digital services, and green technologies and energy. I hope that some concrete outcomes are made possible during this Forum that benefit both countries. 

Dr. Ajay Chhibber is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

An opportunity to reignite US-India trade talks

India-US trade talks have not gained as much traction in the Biden Administration as during President Donald J. Trump’s tenure when the two sides were close to a mini-trade deal. The restart of the Trade Policy Form provides an opportunity to change that. In the past two years, the Indian government has shown significant interest in forging bilateral trade deals with its key trading partners. This includes a Comprehensive Economic Partnership Agreement between India and the UAE and a trade agreement with Australia. Talks on a proposed India-UK FTA have also moved forward significantly.

A trade deal with Canada is also in the pipeline and likely to be signed in 2023. India would be keen to relook at its trade relationship with the United States as well—especially if Washington reconsiders the providence of GSP benefits to India. India has also signaled to soften its stance on digital trade between the two countries by removing hard data localization provisions in the latest draft of the Digital Data Protection Bill released in late 2022. This is likely to sit well with the US side. India is entering a critical year with general elections scheduled for early 2024 and holding the presidency of the G-20 forum this year. A favorable movement in the trade relationship between the two countries may also benefit Prime Minister Narendra Modi politically.

Adnan Ahmad Ansari is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

Progress on iCET is a win-win for India and the United States

The November 2021 TPF meeting in Delhi made significant expansion on commitments and collaboration between India and the United States. For example, healthcare was identified as a priority for resilient supply chains, the Initiative on Critical & Emerging Technologies (iCET) such as semiconductors, artificial intelligence and 5G were identified as priority sectors to work on, and mobilizing finance and scaling up clean technology initiatives were moved up in the priority list. If the upcoming TPF this week can inch forward on one of the above, it should be the iCET with a focus on semiconductors.

Both governments and industries align on the need and the potential. Both sides must also be mutually complimentary. Currently, India does not contribute to semiconductor production, but it has managed to be make some space in the all-important semiconductor design industry. India holds 20 percent of the world’s semiconductor design industry. Incentivized by the CHIPS and Science Act—when US semiconductor manufacturing companies are looking at the “China plus one” strategy—India might look like an attractive option. Much of the Indian private sector is venturing out on semiconductor research and design and manufacturing themselves. This is a space to watch as iCET becomes part of the TPF dialogue.

Ridhika Batra is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

The Digital Data Protection Bill opens the door for increased US-India digital cooperation

This year’s Trade Policy Forum comes with relatively low expectations as both countries continue to define and recalibrate their approaches to trade and concentrate on their domestic political agendas. With past elements of a mini-trade deal seemingly stalled, the pathway to advance progress on a host of trade irritants remains unclear. However, there are some bright spots to consider: India’s recent draft Digital Data Protection Bill has walked back its hardline stance on data localization and raised the possibility of allowing cross-border data flows into countries designated as trusted partners. While the bill has yet to become finalized into law, it opens the possibility of a more substantive conversation on digital trade between the United States and India and potentially defuses tensions on a longstanding irritant in the relationship.

It also begs the question of whether India would be willing to sign on to a future digital economy agreement with the United States that could incorporate the eventual digital components of the Indo-Pacific Economic Framework (IPEF). India had avoided participating in the trade pillar of IPEF, citing concerns over potential commitments related to cross-border data flow and labor and environment standards. And, while the Indian position on IPEF is unlikely to change, Washington and Delhi would be wise to use the TPF to discuss areas of alignment on inclusive digital trade as well as potential digital cooperation during India’s G-20 presidency.

Anand Raghuraman is a non-resident fellow with the Atlantic Council’s South Asia Center.

Progress is likely to be incremental but should be appreciated nonetheless

The US-India trade relationship has grown steadily over the past two decades despite a list of mutual concerns that has only grown longer even as the figures have grown larger. Trade has grown substantially—more than tenfold since 1999. Indicators suggest that the early post-pandemic era may be no exception, with record-setting foreign direct investment signaling continued US investment in India. But there is nothing inevitable about the long-term trajectory of US-India trade. Last year, in a positive sign of India’s willingness to strengthen bilateral trade relationships, India inked trade agreements with the UAE and Australia and renewed talks with others. But these were not the sort of high-standards deals that will ensure long-term trade growth. In the absence of such a comprehensive deal between the United States and India, active engagement, patience, and an appreciation of incremental wins will be needed on both sides to maintain the current positive trend line. 

This week’s meeting of the relaunched US-India Trade Policy Forum is a welcome opportunity to ensure that the obstacles to two-way trade that hampered past TPF meetings are dealt with constructively. As with last year’s delicious deal on mangoes and cherries, progress in each of the focus areas is likely to be incremental. This is especially so until Washington has the ability to offer GSP benefits to India as an incentive. But there are also broader policy opportunities that neither side should lose sight of, particularly on digital trade and services. Ensuring commitments to cross-border data flow to maximize the growth of both countries’ digital economies will have a far bigger impact on long-term trade growth than tit-for-tat tariff reductions. Despite a long list of irritants, there is much to celebrate. As every investor knows, however, past performance is not always indicative of future results.

Dr. Kyle Gardner is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

The US-India Trade Policy Forum is likely to be short on tangible outcomes

Expectations are conspicuously modest for the TPF with stakeholders anticipating a summit short on tangible outcomes. The sides may be meeting primarily out of recognition of the importance of high-level trade dialogue between the two responsible cabinet officials.

The United States and India habitually enter trade discussions from different vantage points that reflect starkly different economic circumstances, traditions, and systems. At present and for the foreseeable future, neither country is keen to make concessions on tariff and non-tariff barriers. 

With far lower average tariff rates and fewer non-tariff barriers, the United States often starts this conversation from a position of less positive leverage. Washington’s stockpile of carrots has shrunk even further given the expiry of the congressional statute authorizing preferential tariff treatment to qualifying developing countries. Current President Joseph R. Biden’s predecessor had revoked India’s status under the GSP program, and so US trade negotiators could theoretically use the prospect of reinstatement to secure Indian compromises. However, Congress was unable to reauthorize GSP benefits for India in the ”lame duck” session last fall.

Those searching for a silver-lining can hope the ministerial will inject new momentum into bilateral trade discussions for when the GSP is back in play. Ambassador and US Trade Representative Katherine Tai and Indian Minister of Commerce and Industry Piyush Goyal are thought to enjoy a good rapport. A positive and constructive session would be welcome in advance of India hosting the next round of Indo-Pacific Economic Framework negotiations on February 8-11. Those discussions will center on supply chains, clean economy, and fair economy, but not market access. India opted not to join IPEF’s trade pillar last September but signed-up for the other trade-adjacent topics.

Atman Trivedi is a non-resident senior fellow with the Atlantic Council’s South Asia Center.

The South Asia Center serves as the Atlantic Council’s focal point for work on the region as well as relations between these countries, neighboring regions, Europe, and the United States.

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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.

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Introduction 
Multifaceted partnerships, intricate interests: India and China in Africa
Chasing opportunities: India and China in Ghana
Coexisting and competing with China in Ghana
Key takeaways
Conclusion

Introduction 

Today, a fragmented Global China¹ operates in African landscapes. The artisanal miners in Kumasi, Ghana, contractors in Dar es Salaam, Tanzania, entrepreneurs in Harare, Zimbabwe, managers in Nairobi, Kenya, agroscientists in Lusaka, Zambia, and officials from both provincial and national governments are the face of the “new type of international relations” that President Xi Jinping claimed China and countries in Africa are collectively crafting.²

This is perhaps most evident in the infrastructure sector. The influx of capital vital to meeting Africa’s tremendous infrastructure needs is estimated to be between $130 billion to $170 billion a year, with a current financing gap of $68 billion to $108 billion.³ Today, Africa accounts for almost 25 percent of the global revenues of Chinese construction companies.⁴ To put this in context, in 1990, American and European companies had over 85 percent of the construction contracts in the continent. Now Chinese firms dominate with reports of market shares ranging between 31 percent to 62 percent, and in some cases—such as the Kenya National Highways Authority’s road projects—this number is even higher, with Chinese firms controlling 85 percent of all projects.⁵ 

Chinese construction companies, with their unique advantages characterized by high speed, enormous scale, easy financing, and low costs enjoy a critical edge over other competitors.⁶ Additionally, Chinese-built industrial parks and economic zones in Africa are attracting low-cost, labor-intensive manufacturing units that are relocating from China. Chinese tech companies are laying critical telecommunications infrastructure even as, venture capital funds are investing in African fintech firms, and other smaller enterprises are expanding across the region.

Partly due to the lack of alternative options, China is quickly becoming a partner of choice, and several African countries are keen to explore the many possibilities of working together. Some governments, like Zambia, are hiring Chinese citizens in investment promotion agencies to ease processes made complicated by the oft-quoted gaps in communication, with departments conducting road shows in China to attract potential investors.⁷ Others, like Ethiopia, are making policy decisions to offer a slew of incentives to increase Chinese investments with the aim of diversifying the domestic industry, such as the pharmaceutical manufacturing sector.⁸

Beijing also gains tremendously from African countries’ collective political support in multilateral forums. According to late professor and author Ian Taylor,⁹ China was always acutely aware of the collective power of the African states in multilateral organizations: 

• African countries played a crucial role in the debate and final acceptance of the People’s Republic of China into the United Nations. The pro-Beijing resolution was supported by 76 votes, with 35 against and 17 abstentions. Over a third of the votes in favour of the PRC were from Africa, including from four countries which still had diplomatic relations with Taiwan; and of the 23 co-sponsors of the “important question,” 11 were African. It is certain that without the African votes, China would not have succeeded in being admitted to the UN at the time.

Contemporary discussions on Chinese great power aspirations, the promise of the Belt and Road Initiative (BRI), and the “win-win” concept, are often substantiated by illustrations of how Beijing has changed the status quo in Africa.

Examining China in Africa from India is unique on two main counts. First, African nations, particularly in eastern and southern Africa, have long been traditional partners for India, sharing ideological, political, economic, and sociocultural relations. The immense geopolitical and economic sway Beijing appears to have cultivated, requires New Delhi to reimagine its engagement with the region. This includes stepping up triangular cooperation with other democracies already active in the region, such as Japan and the United States, or practical cooperation through partnerships like the Quadrilateral Security Dialogue, or Quad,¹⁰ a grouping of the United States, Australia, India, and Japan that works on a range of issues in the Indo-Pacific region including countries in Africa.¹¹ Development projects already underway, such as the “Feed the Future India Africa Innovation Transfer Platform” where USAID partnered with a US NGO Technoserve to share and transfer innovative Indian soil and water management techniques known as Khadins and Taankas in Kenya and Malawi is a case in point.¹² A reimagination of engagement in the current context calls for a granular examination of Beijing’s instruments and approaches, and a better understanding of its grassroots impact. 

Second, India-China relations are currently at an all-time low. The border standoff and loss of life from clashes, inherent lack of trust, a steep trade deficit, the BRI’s China-Pakistan Economic Corridor, have resulted in a decline in India-China relations, with many in the strategic community stating that it has reached the lowest point since the 1962 Sino-Indian War.¹³ While the implications of India-China competition if not rivalry—in the Indian Ocean region, South Asia, and the Asia-Pacific region—are being studied closely, it is crucial to examine this in Africa: a region where India has tremendous interests and where pursuing them is becoming increasingly complex.

A 2021 report titled India’s Path to Power, crafted by some of the New Delhi’s leading intellectuals, stated that India’s relations with developing countries “have atrophied” and a fraying of ties within the subcontinent is also reflected in India’s relationships with countries in Africa. The authors argue that:¹⁴

• The great powers are facing internal stresses and challenges, having been diminished by the pandemic and the economic crash of 2020. China, which is perhaps an exception, has turned increasingly adversarial and is attempting to mould the multilateral system to its own purposes. We believe that a discombobulated world requires flexibility and broad coalitions, both to produce acceptable outcomes and to avoid conflict. This requires a new outreach by India to our traditional partners in the developing world. They are significant today as the locus of economic opportunities, as sources of support and commodities essential for India, and as necessary allies in reviving those parts of the multilateral system as would be useful in the decade ahead.

For New Delhi to craft “a new outreach” to its traditional partners, especially those in Africa, examining China’s active engagement and increasing footprint in the region will be key. The extent of this footprint can be analyzed by putting together the picture emerging from many growing African countries with significant Chinese presence. Ghana is an interesting case in point, and the focus of this study.

One of the fastest growing economies in West Africa, Ghana has shared deep historical, ideological, economic, and political relations with both Asian powers. The West African country also houses a significant Indian diaspora,¹⁵ and has become a popular destination for Chinese migrants,¹⁶ providing an interesting canvas to evaluate perceptions. 

To learn about the experiences of coexisting and competing with Chinese actors, the extent of backward and forward linkages, and to collect impressions of the growing Chinese community in the country, the methodology followed for this study included two steps: desktop research and key stakeholder interviews. From a list of twenty-three prominent Indian businesses in Ghana received from the High Commission of India in Accra, the researchers were able to interview representatives of twelve companies in Accra as well as in Tema in August 2022. Additionally, they conducted interviews with local Ghanian businesses, academics, tribal chiefs, and trade union representatives. 

In examining Chinese impact, the research team built on the analytical work of Xiaoyang Tang, a professor in the Department of International Relations at Tsinghua University, on Chinese investments in Ghana from 2000 to 2014,¹⁷ using data from the Ghana Investment Promotion Center (GIPC). The team asked GIPC for information on Chinese investments in Ghana from 2014 to 2021. Of the 261 Chinese companies listed in the data set, the researchers were able to establish contact with eighty-three, and thirty-three companies agreed to a telephonic interview. To fill the gap that this lack of in-person access presented, scholars who have been examining China in Africa and had recently interviewed small and medium-scale Chinese companies in Ghana were interviewed to learn from their findings. 

Multifaceted partnerships, intricate interests: China and India in Africa

A brief overview of China in Africa

China’s engagement with Africa is not of recent origin. Chinese contacts with Africa date back to the early Han dynasty, while it was sea ventures under the command of Admiral Zheng He during the Ming dynasty when relations peaked.¹⁸ In more recent history however—Ethiopia, Egypt, Liberia, and apartheid South Africa were among the few independent African countries —when the PRC was established in 1949.

Today, with a two-way trade of $254 billion and investments exceeding $2.07 billion in the first seven months of 2021 alone,¹⁹ China is the largest trading partner, biggest investor, and creditor for most African countries. Four Chinese lenders—The Export-Import Bank of China, China Development Bank, Industrial and Commercial Bank of China, and the China International Development Cooperation Agency—have participated in debt restructuring, leveraging multilateral institutions like the Group of Twenty’s Debt Service Suspension Initiative, the International Monetary Fund’s Catastrophe Containment Relief Trust, and the debt cancellation programs of the Forum on China-Africa Cooperation (FOCAC).²⁰

The 2022 African Youth Survey conducted by the Ichikowitz Family Foundation across fifteen countries and based on 4,507 interviews found that: 

• Of all the foreign actors seen to have an influence on the continent, youth see China as having by far the biggest impact, with more than half (54 percent) of African youth saying that China has a lot of influence on their country and almost a further quarter (23 percent) saying it has some influence. The United States is seen as the second most influential foreign power, with four-in-ten (41 percent) youth saying it has a lot of influence on their country and another quarter (26 percent) saying it has some influence.

Respondents who mentioned China’s positive influence pointed to the affordability of Chinese products (44 percent), assistance in developing infrastructure (41 percent), and its creation of employment opportunities (35 percent). Meanwhile, those who viewed it as a negative appear concerned about Chinese companies exporting resources without fair compensation (36 percent), Chinese workers taking job opportunities away from locals (24 percent), and a lack of respect for the country’s values and traditions (21 percent), among others.²¹

Similarly, Afrobarometer, a pan-African, nonpartisan survey research network, found that 63 percent of Africans surveyed in 2019-21 across thirty-four countries “hold positive views of China’s assistance and influence”—attributed largely to China’s projects in infrastructure, development, and investment in Africa. However, the survey also said that: 

• Positive views of China’s influence do not appear to affect Africans’ attitudes toward democracy. China remains second to the United States as the preferred development model for Africans. And majorities of those who are aware of Chinese loans and development assistance to their countries are concerned about being heavily indebted to China.²²

While China’s growing engagement with Africa is said to have had a positive, albeit uneven, effect on Africa’s economic growth, economic diversification, job creation, and connectivity,²³ it also has received sufficient pushback—with allegations of unfair business practices, violation of local laws, and poor compliance with safety and environmental standards.²⁴ The current discourse on China’s engagement in Africa has led to the creation of an entire subfield of study, with writers, journalists, and artists weighing in. 

A brief overview of India in Africa

Historically, it was proximity to African shores and the promise of fortunes to be made that enabled early migration from the Western coast of India to the Eastern coast of Africa. According to the historian Savita Nair, records of these movements of people can be found in travellers’ notes at the time of The Periplus of the Erythraean Sea, a first century CE account at a time when Indian traders had agents in areas of East Africa.²⁵ Later,  while many Indians were brought to Africa by the British Government as indentured labourers, others referred to as ‘Passenger Indians’, traders, artisans, teachers and shop assistants, mainly from the western coast, came in search of opportunities.

Today, descendants and members of the Indian diaspora are deeply integrated in many African societies, raising families, running businesses, and often becoming citizens in the host country. Official estimates suggest there are over three million people, spread over forty-six African countries, with the largest concentration in South Africa, Mauritius, Kenya, Uganda, Tanzania, Malawi, and Mozambique.²⁶ Given the many waves of migrants and entrepreneurs who have reached Africa, presently there are people of Indian origin who have varying degrees of familiarity with the motherland.

African nations are also crucial economic partners for India. Total trade with the region for 2020-21 was valued at $55 billion, and India is the fifth-largest investor in Africa, with cumulative investments of $54 billion. The acquisition of critical assets by Indian SOEs to diversify the energy basket away from West Asia, commercial ventures by Indian corporations looking to expand into untapped markets, and small and medium-scale Indian entrepreneurs operating across countries and sectors, the economic cooperation between these regions takes on multiple forms.

While state-level interactions are driven under the auspices of the India Africa Forum Summit (IAFS), there are also a plethora of development cooperation mechanisms that make Delhi a key developmental partner for many countries in the continent. Indian sub-national actors, including civil society and voluntary organizations are also setting up linkages across these geographies, scaling up innovative development solutions and sharing knowledge. From agriculture and health, to education, existing frameworks prioritize individual and institutional capacity building and are driven by priorities set by partner countries in Africa.

What makes this seemingly straightforward geopolitical development – of Asian powers reengaging Africa – complex to document is the fact that many different Indias exist in Africa: i.e., the third-generation, Indian-origin industrialist, the successful first-generation entrepreneur, the contractor of an Indian multinational corporation looking to win bids. They have all have felt the change in status quo brought on by the multitude of Chinas that are operating in these geographies: whether it is the contractor in a Chinese state-owned enterprise (SOE) that seems to have access to virtually unlimited funding, the small-scale manufacturer with an entire supply chain in China, or the artisanal miner working in the gold mines. The range of Indian actors, despite their differences, have all felt the impact and have something to say. Their perspective offers a unique vantage point to examine nuances of the phenomenon that is Global China.

Chasing opportunities: India and China in Ghana

The 1955 Asian-African Conference (also called the Bandung Conference), involving representatives from twenty-nine newly independent nations from the developing world during the Cold War, was a watershed moment that shaped both India’s and China’s early relations with countries on the continent. Their shared ideological fight against colonialism and imperialism strengthened the idea of Afro-Asian solidarity. The foundation of Ghana’s relations with both India and China were laid by the close friendship and political exchanges of Ghana’s first president, Kwame Nkrumah, with Indian Prime Minister Jawaharlal Nehru and Chinese Premier Zhou Enlai.

China-Ghana relations

Among the many diverse countries on the African continent, Ghana presents an interesting case study. It is one of the earliest countries in Africa to establish diplomatic ties with China, and it has been central to China’s Africa Policy. Taylor states: “The overthrow of Kwame Nkrumah of Ghana in 1966 was a major setback for Chinese policy in Africa, particularly since it happened when Nkrumah was in Beijing on an official visit. Almost immediately, the new Ghanaian military government ordered the expulsion of Chinese ‘experts.’ The military training camp headed by Chinese instructors was also closed, and its instructors expelled. On 20 October 1966, after Sino-Ghanaian relations had deteriorated further, diplomatic relations were suspended.”²⁷

Today, China is Ghana’s biggest trading partner. Ghana’s imports from China between 1995 and 2020 have increased at an annual rate of 20 percent, $71.3 million to $6.75 billion (and the top import, at $232 million, was coated flat-rolled iron); its exports to China have increased at an annual rate of 26.5 percent, rising from $4.23 million to $1.52 billion (and the top export, at $1.24 billion, was crude petroleum).²⁸ The humongous trade imbalance notwithstanding, the increasing economic incentives and opportunities for social mobility have made Ghana a destination for Chinese migration, housing between ten and thirty thousand Chinese today.²⁹ However, these estimates vary, with the Chinese government placing the number at between thirty thousand and fifty thousand Chinese expats and diaspora in Ghana.³⁰ Conversely, there has also been an uptick in the number of Ghanaian youth choosing to study in China, with over eight hundred students registering in doctoral programmes in China in 2018.³¹ The current president, Nana Akufo-Addo, stated that Ghana is aiming to replicate China’s development model with the industrialisation policy of ‘1-District-1-Factory’, during a FOCAC roundtable in 2018.³² 

According to the latest data received from the Ghana Investment Promotion Center, 261 Chinese firms were registered in eight sectors of the Ghanaian economy. A majority of these firms are wholly owned by Chinese shareholders. The Chinese enterprises operating in Ghana that were interviewed for this study in August 2022 ranged from companies engaged in the production and export of cashew nuts, agrochemicals, roofing sheets, fiber-artificial hair, and security doors; recycling of plastic bottles; traders of electrical appliances; and those engaged in construction and agriculture. A few common threads from their responses include:

• No previous experience in Africa: Several companies interviewed stated that Ghana was the first country in Africa where they had established businesses. Broadly, respondents said that they had two to ten years of experience in Ghana. Three companies had no experience operating in any other part of the continent. Though Ghana was their first foray into Africa, they declined to explain what brought them there. 
• Job creation: It appears that most enterprises employ local staff. Though a crude oil refining company employed 1,600 workers and a company running a mall employed 1,000 people, the number of jobs generated by other companies ranged from four to one hundred. The breakdown of employees by nationality was not available. This notwithstanding, the majority of the Chinese firms claimed to have employed more local staff than Chinese workers.
• Challenging business environment: Respondents described business as “currently very difficult.” This was attributed to a weak cedi/low dollar rate. Several representatives indicated their company was no longer in operation—either “shut down due to large electricity bills” or because they were “temporarily closed.”
• Government as resource: While one enterprise mentioned receiving help from the government, most stated that they did not receive financial assistance from their government- but had its support if they faced any difficulty. 

A comparative analysis of GIPC data sets from 2000 to 2014 and from 2014 to 2021 presents some interesting trends:

• Manufacturing sector leads FDI: Chinese firms injected $2.8 billion into the Ghanaian economy from 2014 to 2021. The manufacturing sector accounted for the largest number of companies (145) and contributed the highest foreign direct investment ($2.3 billion). The tourism industry had the least projects (two) and contributed the least FDI ($184,800).
• Short-lived businesses: While 560 Chinese companies were registered with the GIPC from 2000 to 2014, 261 Chinese companies were registered under GIPC from 2014 to 2021. Of the 261 companies registered from 2014 to 2021, 251 were new entrants (96.17 percent). In essence, only 3.83 percent of the companies registered from 2000 to 2014 continued to exist over the 2014-2021 period. All the companies that remained, operated within their original sectors, and some of them had made slight alterations to their original company names. 
• Decrease in joint ventures: Out of the 560 (30.2 percent) registered from 2000 to 2014, 169 were jointly owned by Ghanaian and Chinese partners, while only 38 out of the 261 (14.5 percent) companies registered from 2014 to 2021 were joint ventures.
• Change in geographical distribution: From 2000 to 2014, Chinese companies operated in nine out of ten regions in Ghana, with the Upper West region recording zero registered Chinese companies. From 2014 to 2021, Chinese companies were operating in seven out of the ten regions (sixteen in 2018), with none operating in the Bono Ahafo, Upper East, and Upper West regions.

India-Ghana relations

India and Ghana, with their postcolonial legacies, have historically enjoyed good bilateral relations and were the founding members of the Non Aligned Movement. India opened its consulate in Accra in 1953 and full-fledged relations were established immediately after Ghana’s independence in 1957. The country also has a traditional Indian diaspora, with official estimates of ten thousand nonresident Indians and persons of Indian origin,³³ and unofficial estimates suggesting close to twenty thousand persons. There have been frequent and regular ministerial exchanges: the Indian president, Pranab Mukherjee, visited Ghana in 2016, and President Afuko-Addo participated in the founding conference of the International Solar Alliance on March 11, 2018, in New Delhi. 

The two countries also are key developmental partners. Since the establishment of relations in the late 1950s until now, India has extended around $450 million for various projects like rural electrification, establishment of the Ghana-India Kofi Annan Centre of Excellence in Information and Communication Technology (ICT), construction of the presidential palace, agriculture mechanization, upgrades to the water supply systems, and establishment of a foreign services training institute.³⁴ During the COVID-19 pandemic, India delivered 650,000 doses of vaccine under the COVAX initiative.³⁵ In the education sector, Ghana is part of the pilot broadband technology project in tele-education and telemedicine (known by the acronym e-VBAB ), and six hundred Ghanian students enrolled in various Indian universities in 2021-22. The 2022 African Youth Survey (cited earlier in the report) stated that 68 percent of respondents viewed India as a positive influence.³⁶

India is among the top trading partners of Ghana, with total trade in 2021-2022 amounting to $2.6 billion, with India exporting $1.1 billion to Ghana in 2020-21 and importing $1.49 billion, with gold accounting for almost 80 percent of all Indian imports, valued at $853 million.³⁷ Ghana also exports cocoa, cashew nuts, and timber, and imports from India include pharmaceuticals, packaging material, rice, electrical equipment, transport vehicles, and agricultural machinery, among others. 

In terms of investments, India’s FDI accounted for 7.61 percent of the total FDI of 1.29 billion in Ghanain 2021. Between 1994 and 2021, Indian wholly-owned companies and Joint Ventures invested $2.2 billion in 870 projects and generated thousands of jobs.³⁸ In 2021, India was the second largest investor by number of projects (25), after China and the third largest by value with FDI aggregating to $98.84 million.³⁹ The major sectors receiving Indian investments were General Trading (170 projects, $149.72 million), Export Trading (126 projects, $49.73 million), Agriculture (45 projects, $377.04 million), Building and Construction (54 projects, $74.18 million). In terms of business activities, manufacturing accounted for the greatest most number of projects with an investment value of $1.1 billion with 275 projects.⁴⁰ Other major business activities receiving Indian investment in Ghana are ICT and Internet infrastructure ($148.6 million), followed by extraction ($98.3 million), business services ($47.7 million), and technical support centers ($17 million).⁴¹

The forces that have drawn the Indian entrepreneur to various geographies in Africa are as diverse as the three million strong Indian diaspora in the region. However, a commonly shared sentiment among Chinese and Indian businesses appears to be belief in the African growth story. 

One respondent of Indian origin stated that his grandfather came to Ghana in 1937 believing “where there’s gold, there’s money” and started a trading business that has now diversified and is run by his descendants. Decades later, drawn to this promise of opportunity was Gopal Vasu, who after graduating from Indore Christian College in 1969, was excited to join his elder brother working in Lagos. Decades later, in 1989, Kingsway Chemist Ghana Ltd., a division of a company now known as Unilever (Ghana) Ltd., decided to halt its pharmaceutical production lines in Ghana and sell its production equipment to a pharmacist who worked for them. The pharmacist then joined forces with a local partner to start M&G Pharmaceuticals. In 1993, Gopal and his associates (under the Ghana Investment Promotion Centre Act) took over the company and started manufacturing four products. Today, they produce more than eighty generic drugs. This is indicative of the multigenerational Indian business families who have been operating and growing in Ghana, which stands in strong contrast to Chinese businesses, who are not only relatively new entrants to the market, but also wind down their operations comparably faster.

Similarly, in 1988 another interviewee said he was visiting his wife’s family in Accra and was excited about opportunities in the West African country. Two weeks into his holiday, he registered a company; in 1991, he set up his first retail store. Today, his group leads the formal retail space in the country, with fifty-six shops and four more planned.

Managers of Indian corporations share that optimism about the potential of African markets. According to Kaushic Khanna, chief manager of KEC International Limited, a $1.8 billion engineering, procurement, and construction (EPC) company headquartered in Mumbai, “the next ten to fifteen years belong to Africa. If Indian companies can work closely with the government of India in identifying and delivering projects in Africa, there are tremendous opportunities for growth.” One of the successful projects KEC executed in Ghana is the 330 kilovolt transmission line built from the Volta region substation in Tema to Tornu, near Dzodze. This roughly $9 million order was secured from the Volta River Authority and completed in twenty months.

Rajesh Nair, regional manager of Shapoorji Pallonji (SP) echoes this sentiment: The market is so big, with several infrastructure opportunities. “While the competition with Chinese firms is rife, there is no need to compete among (sic) Indian companies,” he says. “Ghana is a $72 billion economy, SP’s growth in the last five years, despite increasing Chinese footprint, has been positive.” He adds that SP’s familiarity in Africa, with operations in Ghana for more than sixteen years, helps highlight the fact that “Indian companies can also pull off large scale projects.”

The Tema-Mpakadan line is one of Ghana’s biggest railway projects and a case in point. It is being built by Afcons, a subsidiary of SP, and is funded by the Export-Import Bank of India (EXIM Bank). The 100-kilometer, standard-gauge railway line, costing $447 million, is part of a multimodal transportation network designed to connect Tema port to the country’s northern regions and landlocked countries like Burkina Faso, Mali, and Niger, and is expected to bring in huge revenues for Ghana.

Coexisting and competing with China in Ghana

Enterprising—but “they don’t contribute to the local economy”

Several Indian entrepreneurs attest to the fact that the work culture of Chinese actors is unique. According to one, “small time traders in groups of ten and twenty, live and work out of warehouses, do everything themselves—from loading the truck, driving it to the market, selling products—operating on absolutely minimum overheads.” Adds another Indian businessman: “They are incredibly enterprising. Most of them do not speak a word of English, but they establish businesses with a local translator. Pretty gutsy, if you ask me.”

A scholar who recently interviewed several Chinese miners working in the gold mines of Kumasi and Obuasi pointed out that for many, Ghana was the first point of arrival. While a few had prior experience in the gold sector in China, others hoped to improve their financial situation and social mobility. Some others had moved due to the competition within China. It’s difficult to say if they have short- or long-term aspirations, according to the scholar; their move is more opportunistic, pragmatic, and there is a lot of pressure to be successful. “You lose face if you don’t send back money.” While there was one respondent who had familial ties to the business, with a father who was a gold miner and a sister with a gold-trading store, most of the interviewees were middle-aged married men who send money earned in Africa back to China.

However, larger Chinese companies entering markets that Indian businesses have dominated are being met with sufficient resistance. An Indian entrepreneur complained that Chinese counterparts often underprice their products, making it difficult for them to compete. Similarly, small-scale traders who sell Chinese wares right outside stores owned by Indian-origin Ghanian traders are also a source of competition “Customers who come to us must walk through a crowd of hawkers, selling cheaper Chinese products, to get in.” While the local authorities routinely act against complaints, there are usually no long-term consequences. Chinese businesses also don’t contribute to the local economy, says another respondent: “The effort is not to develop the economy, but grab small shares.” 

The African agency and the “China option”

The president of Ghana Union of Traders Association (GUTA), Dr. Joseph Obeng, sees the Chinese presence in Ghana as quite worrying and calls for stricter oversight: “Ghana is a conduit for dumping goods manufactured in China.” In the imported goods market, he adds, locals have 15 percent, while the rest is dominated by expats, primarily the Chinese. “While some Indians could also be involved in problematic pursuits, they at least invest money in Ghana, buy houses, settle down, send their kids to school here, and get involved in the community, building health centers and schools.”

Isaac Odoom, an assistant professor of political science at Carleton College in Canada, argues that the Chinese are getting three things right in Africa that bear attention.⁴² First comes a courtship: “Ghanaians and the Africans seem to like Chinese economic courtship. They come to the table with the rhetoric of partnership and win-win for both parties, without necessarily the salvation discourse that comes from the West,” he says. Second, their unique focus has been on infrastructure development, meeting African deficits directly. Third, China is open to very innovative ways of financing projects that are critical to the long-term development of African countries in Ghana. “What these three factors essentially do is present a viable ‘China option,’ where engaging with Beijing offers African countries some leverage in its relations with other foreign actors,” Odoom says.

When asked if there is an African strategy for China, he says “in practice, the Chinese engagement across Africa has been very bilateral. It is very difficult to have all African countries converging in their political and economic objectives, even though they are all interested in reducing poverty and eradicating diseases. But because of [the] historical colonial nature of our countries, there is always a national interest as defined by the elite or history. Any talk of African strategy is bound to suffer these deficiencies or dysfunctions because of the nature of how China engages Africa and because of the makeup of African countries.”

Differences in corporate strategies

According to an Indian executive, “the question is not whether Indian and Chinese companies are competing in Africa. The fact is that the Indian and Chinese governments are vying for influence in the region, and they operate with different philosophies.” For one, information about Indian companies and details about specific projects are readily available; they show a degree of transparency that Chinese companies do not. 

An Indian businessman who gets spare parts manufactured by both Indian and Chinese companies also referred to the differences in corporate approaches between the two. “There is no need to micromanage the Indian producer—we drop our orders and move on. However, with the Chinese, we have to monitor very closely, every step of the way. Although we have worked with the same manufacturer for almost ten years, there is a serious lack of trust as they have the ability to quickly change the terms of engagement.” Another interviewee underlines the fact that not everything Chinese is bad: “Large Chinese companies in the industrial sector, like ceramics, add value to the landscape, but smaller companies tend to flout rules.”

There have been situations when both Chinese and Indian contractors have continued work in the face of nonpayment of bills, which have, in the long run, resulted in generating goodwill. However, this is feasible only for the larger corporations, as the smaller players in the industry would be hard hit. One of the major criticisms facing Indian companies is implementation delays. This was attributed to a combination of factors including bureaucratic bottlenecks, issues with land acquisition, and delayed decision-making. 

Advantage, China: Access to supply chains, finance, and government support

According to several Indian respondents, Chinese companies have demonstrated the ability “to buy companies along the entire supply chain.” In the pharmaceutical-manufacturing sector, this has meant purchasing companies that supply bulk drugs, intermediaries, and fill and finish operations. In infrastructure, it includes buying quarries that supply construction companies.

“We cannot compete with Chinese companies’ pricing or economies of scale. The costs for Indian companies are higher,” says an Indian manager. “Finance is king,” adds another, saying: “Whoever brings the funds gets the projects, and the Chinese are everywhere.” Moreover, he says, “people criticize the quality of Chinese projects, but what matters on the ground is who can execute, and the Chinese are often the fastest.” An Indian contractor explains, “some governments in Africa are closer to the Chinese government than others, and in these countries it’s near impossible to win projects. So, we are forced to explore other underexplored markets.”

According to them, one of the main advantages Chinese businesses enjoy in Ghana vis-à-vis their Indian counterparts is support from their government, which manifests in various forms. “When executives from Chinese companies go to visit [African] government clients, they are sometimes accompanied by someone from their embassy.” In some other instances, when a company runs into trouble or faces backlash, the issue is quickly “taken care of,” they say. “As an Indian business operating in Ghana for decades, I can tell you, they get away with so much,” says one Indian entrepreneur. The Indian government, respondents say, supports the Indian community, but not individual businesses. Indian contractors also pointed out that they are excessively scrutinized at airports, including their documents at ports and customs, in a way that the Chinese are not. “Why don’t they have tax officials regularly visiting their offices? Complaints to the Chinese embassy are quickly taken up at the governmental levels, affording them a degree of protection,” said one. 

Key takeaways

In this context, the following section provides some key recommendations for Indian stakeholders to deepen economic engagement in African markets. 

Need to urgently diversify from Chinese supply chains

Several Indian manufacturers operating in Ghana stated that more than 90 to 95 percent of their raw materials used to be sourced from China. However, the pandemic has forced them to reassess. Today, some procure material from new markets that include India, Brazil, Malaysia, Europe, the United States, and Dubai. A manufacturer that produces plastic injection molding has reduced imports from China and sources plastic pellets from India and countries in Europe instead, but many are still reliant on China for raw materials.

Opportunities in pharmaceutical manufacturing 

There is tremendous potential for Indian companies to enter the pharmaceutical manufacturing sector across African nations.⁴³ This study has identified that an efficient way to do this would be to extend support to and encourage Indian-origin businesses already operating in Ghana. For example, Atlantic Life Sciences, owned by a person of Indian origin, has recently set up the first pharmaceutical manufacturing plant in West Africa. Funded by the Ghana Export-Import Bank, the Standard Chartered PLC, and Pharmanova Ltd., the plant was inaugurated by President Akufo-Addo in 2022 and has partnered with Bosch machines for vaccine manufacturing. According to the founder and CEO, Atlantic Life Sciences has been looking for partners to start the fill and finish business for anti-rabies treatments, tetanus, and snake-bite vaccines, with a capacity to produce 70,000 vials a day, but during the time of interview in August 2022, the company had only been approached by a Chinese firm. While this would be an opportunity for Indian companies to tap into the West African markets, it also presents India an opportunity to work alongside its partners in the Quad to prioritize vaccine manufacturing in Africa.⁴⁴

Fast-tracking bureaucratic processes

An Indian company in the power-transmission sector stated that the firm’s technical acumen, familiarity of dealing with similar challenges in India, and success in finding localized solutions enable it to retain a competitive edge in Ghana. However, the Chinese have systems and institutions in place that allow seamless processes. “China realizes the power of tiny bureaucratic functions,” he says. The task of validating the authenticity of a report in a government-accredited lab in India, for instance, would take him much longer than his Chinese counterpart. It would be helpful if there was a channel through which Indian companies operating in competitive ecosystems abroad could fast-track select bureaucratic processes. 

Encouraging private-sector investors

There appears to be tremendous opportunities for businesses looking for joint ventures or providing services, especially in the technology sector. A leading Indian entrepreneur in the tech space tells us how his company has conducted business with Indian and US firms for years and has recently begun working with a Chinese service provider. Attributing this to quick decision-making and prompt delivery, he says “I didn’t want to do business with the Chinese, but the American companies weren’t delivering on time. They probably have bigger clients to cater to whereas the Chinese persistently followed up with us for business.” 

Creating innovative sources of funding

One of the challenges facing the Indian investor has been gaining access to funds. While nonconcessional funding in the form of a buyer’s credit provided by the Indian EXIM Bank directly pays contractors, the lines of credit it offers often take years to mature. “If an African government requests a power plant in 2015, for instance, the project is sometimes only realized in 2020,” explains an Indian contractor. Not only does the tendering process sometimes takes years to complete, but individual contractors who have identified and convinced potential clients, who then approach the Indian government, have to wait excessive amounts of time for a decision. This has meant that Indian companies that primarily worked on projects funded by the EXIM Bank have had to quickly diversify and find alternate, innovative modes of funding to grow their portfolio. 

Focusing on technology, knowledge, and skills transfer

For investments to be truly sustainable, creating assets that improve livelihoods and develop economies, it is vital to ensure that technology and knowledge are transferred seamlessly. While India already has in place several frameworks of cooperation that focus on building individual and institutional capacity, there is room to expand on this work, with sector-specific courses. While studies have shown that Chinese investors do transfer technology,⁴⁵ cultural factors sometimes impede its efficiency. For instance, an academic who has worked closely with Chinese firms as an interpreter in Accra noted that, despite some Chinese firms’ policy for skills and knowledge transfer, some Chinese managers tend to work on highly technical aspects of a project after working hours, after the Ghanaians have left, which undermines the process of skill transfer.

Creating viable alternatives: Leveraging Indian contractors 

To compete with Chinese firms gaining traction in Africa in the long run, the government of India will need to support its large contractors with decades of experience operating in African markets. The Indian government can work with partners in Africa to identify strategic projects and support the major Indian infrastructure companies—with a track record of delivery and execution—to fulfil the mandates of the host governments. This will not only lead to several intangible benefits, but will work toward providing African governments with alternatives in their efforts to fill the continents’ massive infrastructure gap. 

Enforcing local laws strictly

GUTA President Obeng says that if the aim is to industrialize Ghana, then enforcement of local laws needs to be stronger. “When you give Chinese traders looking to enter Ghana approvals to trade, send them some questions: How many containers will you buy this year? What will be the value of the container? Do you have the money here? If yes, then lodge it with the Bank of Ghana. They can’t come here to drain the forex of Ghana” he says. “We need to reduce dependence on the Chinese—I’m scared, I’m afraid of how things are going now. It’s our own folly. You have to enforce rules, laws, security.”

Conclusion

The broad spectrum of Indian perspectives, ranging from a quasi “insider” to a familiar “outsider” and an outright foreigner to the Ghanian landscape, provides a unique lens to observe China’s growing role in the country in all its complexity. While there are similarities in the approach, drivers, and instruments of these Asian powers, Beijing’s overtures have been distinct. Examining the impact this has had on Ghanian stakeholders and documenting Indian experiences alongside, contributes to the discourse on how other powers engaged in the region can create viable alternatives for African decision makers.

It is, after all, a global marketplace with myriad options for those open to engagement and new approaches. Perhaps Odoom has said it best:⁴⁶

• What the pandemic has taught us is that we still live in a global society, a global village, but the norms that govern that global village are undergoing some disruption. The traditional gatekeepers have had control and dominance for a long time. What we are seeing is an emerging disruption of that structure. And China is a key part of that disruption, and China sees Africa as a companion in that enterprise. So, it will do everything to get African support, whether economically or politically. Engagement from China and India and other southern countries is going to rise. However, this rise does not automatically lead to benefit for the Africans. It boils down to how Africans engage their counterparts.

Lead researcher and writer 

• Veda Vaidyanathan

Contributor, research 

• Arhin Acheampong

Collaborating institutions

• Institute of Chinese Studies (ICS), New Delhi, India
• Afro-Sino Centre of International Relations (ASCIR), Accra, Ghana

With sincere thanks to

• Ashok K. Kantha, former director, ICS, New Delhi
• Aubrey Hruby, nonresident senior fellow, Africa Center, Atlantic Council
• Ewedanu Grace Selase Abla, research associate, ASCIR, Accra
• James Hildebrand, former associate director, Global China Hub, Atlantic Council
• Mark Kwaku Mensah Obeng, senior lecturer, Department of Sociology, University of Ghana
• Pamela Carslake, director, ASCIR, Accra
• S. Chinpau Ngaihte, first secretary, High Commission of India, Accra
• Shruti Jargad, research assistant, ICS, New Delhi
• Xiaoyang Tang, professor, Department of International Relations, Tsinghua University
• Cate Hansberry, Publications Editor, Engagement, Atlantic Council
• Nancy Messieh, Deputy Director, Digital Communications, Engagement, Atlantic Council
• Andrea Ratiu, Digital Production Assistant, Engagement, Atlantic Council

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As headline inflation shows signs of moderating, this piece puts the three central banks’ final monetary policy decisions of 2022 into context. It then focuses on the impact and outlook of central banks’ balance sheet tightening, the other mechanism in banks’ toolkit to fight inflation. 

Lower inflation readings in November allowed the Fed, ECB, and BoE to step down from their most recent 75 to a 50 basis points (bps) hike in December.

The Fed now has two consumer price index data points for October and November that indicate US headline inflation might have passed its peak. While a recession in 2023 remains likely, this data suggests that there is still a window for the US economy to stick a soft landing. Chair Powell’s remarks indicate, however, that the Fed is concerned about price pressures broadening across the economy and becoming entrenched. With price increases for services now outpacing goods inflation and a still-resilient US labor market, the Fed’s December dot plot projects rates will remain at around 5 percent throughout 2023 to combat stickier core inflation. Maintaining higher rates for longer opens the door for the Fed’s balance sheet tightening to have a larger impact on its policy stance.

In contrast to the US economy, the BoE estimates that the UK economy has already entered a protracted recession, which is expected to continue until the end of 2023. The BoE’s monetary policy committee seems divided about how to follow-up this week’s 50 bps hike that increased the policy rate to 3.5 percent. Market estimates for the UK terminal rate in 2023 range from 3.75 to 4.75 percent.  The continued energy price shock, tight labor market, and the looming threat of stagflation make additional rate increases likely, but a severe recession might force the BoE’s hand to ease conditions earlier than expected. This uncertainty also clouds the future path of the BoE’s quantitative tightening.

Like the UK economy, the eurozone has already entered recession territory in Q4. Germany reporting a downside surprise in headline inflation is welcome news, but projections of at least a technical recession, the ongoing energy crisis, and persistent fragmentation risks in the euro area complicate the ECB’s choices in 2023. ECB President Lagarde is expected to oversee additional, albeit smaller, rate hikes to increase the deposit rate to near 3 percent. In addition, the ECB will also begin to reduce the size of its balance sheet in 2023.

The balance sheet tightening, or quantitative tightening (QT), by the Fed, BoE, and ECB comes in response to the significant increase in the size of their cumulative balance sheet as result of quantitative easing (QE) to stimulate economic activity during the pandemic. When a central bank conducts QT, it drains liquidity from the economy by reducing the supply of securities such as US treasury bonds. A lower supply increases the yields of these securities and tightens financial conditions. Please read my previous article on this topic for a more in-depth explanation of how QT works and what might be some of the associated risks.

There are several important reasons why central banks reduce the size of their balance sheets. First, QT can amplify the restrictive monetary stance achieved by higher interest rates. In a best-case scenario, this could allow central banks to forego a rate hike or begin lowering rates earlier. Second, by raising policy rates to rein in inflation, central banks, including the Fed, might incur losses because the interest payments on their liabilities increase while earned interest on their previous asset purchases remains the same. In the case of the Fed, BoE, and ECB, such losses are unlikely to create financial stability concerns, but could result in political complications. Third, there is a finite number of securities a central bank can purchase. For QE to remain an effective tool during a future crisis, it is important to ensure an ample pool of securities.

Between these three central banks, only the BoE and the Fed are already undertaking QT. They are on track to reduce their balance sheets by roughly 45 billion pounds and $500 billion in 2022 respectively. If both banks’ QT programs remain on schedule through 2023, the Fed would unwind approximately 35 percent ($1.6 trillion) of the assets purchased since the beginning of the pandemic, whereas the BoE would only shrink its pandemic related portfolio by around 15 percent (120 billion pounds). The ECB announced at its December meeting that it would begin in March to slowly roll-off securities in its Asset Purchase Program at a 15 billion euros per month pace. This will likely result in a balance sheet reduction of 150 to 200 billion euros or roughly 4 percent of the ECB’s pandemic related asset purchases by the end of 2023. When measured against the pandemic related balance sheet increases of these three central banks, the Fed is currently pursuing the most significant QT program.

The question remains, however, about what the impact of QT might be when expressed in basis points of additional tightening of financial conditions. When the Fed first commenced its post-pandemic QT in June 2023, Fed Chair Powell cautioned: “I would just stress how uncertain the effect is of shrinking the balance sheet.” In a recent analysis, a researcher from the Federal Reserve Bank of Atlanta estimated that a $2.2 trillion balance sheet reduction could be equivalent to an increase in the Fed’s policy rate of between 29 and 74 basis points. The wide gulf between the two numbers is based on the financial conditions in which QT is implemented. When financial conditions become strained, for instance during a recession, QT has a larger tightening impact. This insight suggests that the Fed’s target of $1.6 trillion in QT until the end of 2023 could equal at least a small interest hike (25 bps) in tightening. Similarly, the smaller scale of the BoE’s QT program could still have a fairly significant impact in a stagflationary environment. Of course, this also points to the risk of QT causing a financial accident by constricting liquidity too much. Other reasons why a central bank might pause QT could include a severe recession or the goal to significantly ease financial conditions.

The decisions and statements this week from the Fed, ECB, and BoE show that 2023 will be a year full of new monetary policy challenges. Central banks have tools at their disposal, but they will have to be deployed in different ways across these economies in the months ahead.

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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

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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.

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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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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.

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In 1983 one in five US workers were members of a union; today roughly one in ten are. Private sector union membership in 2021 was just over 6 percent. The union membership rate temporarily increased in 2020 to 10.8 percent, but it has since fallen to pre-pandemic levels as the increase was largely due to labor force composition effects. During this time the share of national income going to labor has decreased, inequality has increased, productivity has been inconsistent, and many industries have had significant consolidation. Evidence suggests that the decline of unions during this period has been a major factor in these macroeconomic trends.

Unionization in the United States has declined in part due to long-running structural changes to the economy. Technological advancement and globalization altered supply chains and business processes, negatively impacting some workers who lost their jobs to automation or outsourcing. However, the United States has among the lowest unionization rates of advanced economies due to specific policy choices as well. “Right to Work” laws in many states, worker classification rules, and changes to the National Labor Relations Board’s (NLRB) regulatory authority have weakened workers’ bargaining power. In addition, the present enforcement apparatus for labor law compliance does not incentivize strict adherence from firms. Violations are infrequently caught, and financial penalties are often too low to affect behavior.

Encouraging and incentivizing more unionization in the United States would have micro and macro benefits. For example, unionized workers receive higher wages. A worker represented by a union earns 10.2 percent more in wages than a peer in the same sector with comparable experience, education, and occupation. Unionized workers are also far more likely than equivalent nonunion workers to have essential benefits such as health insurance, retirement benefits, and paid sick leave. Lastly, unionized workers are likely to work in safer working environments and unions help ensure more extensive job training.

Evidence shows that unions not only benefit workers, but employers as well. Firms with unionized workers benefit from higher labor productivity and retention. Research also notes that unions do not have a negative impact on employer solvency rates.

Aside from individual unions and firms, the economic benefits of unionization have positive macro spillovers. Higher wages for union workers create competition in local labor markets, which leads nonunionized firms in the same geographic area to raise wages. Benefits such as health insurance and job training also frequently spill over to nonunion workers in local labor markets. In addition, workplace standards that unions negotiate and advocate for have often become industry norms. Unionization also helps address racial economic disparities. Finally, unionization has intergenerational effects. Union density is a strong predictor of economic mobility compared to similar non-union households. Collectively, these spillovers create a more productive labor force and equitable economy.

Although unionization rates have declined in recent decades despite clear economic benefits, the pandemic may have instigated a shift in dynamics. Some workers have changed their attitudes about which working conditions and level of pay are acceptable after enduring the pandemic and working in challenging circumstances. Union organizing has increased this year, public support for unions is the highest it’s been since 1965, and the tight US labor market has created leverage for workers. In the years to come workers may have additional leverage because there will be even fewer prime-age US workers due to aging demographics.

US policymakers have recently taken important steps to advance union efforts. For example, the Biden administration has pushed forward a variety of regulatory steps to make union organizing easier for federal workers and private-sector employees. The Department of Labor released a proposal to reclassify gig workers, and the NLRB proposed a rule that would make parent companies more legally liable for labor law violations committed by associated contractors or franchisees. The administration also included prevailing wage and apprenticeship requirements in major legislation such as the CHIPS Act and Inflation Reduction Act. While these are positive steps, Congress should pass the Protecting the Right to Organize Act as soon as possible. Innovative organizing efforts at the state level also need to be fostered. For example, California recently passed a law that would establish “sectoral bargaining,” which is more common in other advanced economies.

As stakeholders navigate the opportunity to grow union membership they should recognize the benefits of new technology and globalization, even though they also present risks. Increased unionization can help harness these benefits and manage the risks. Stakeholders must also be cognizant of the macroeconomic environment—inflation is a substantial problem and US GDP growth is slowing—and act accordingly to gain labor rights in a sustainable manner that won’t reverse should a recession occur.

Jeff Goldstein is a contributor to the Atlantic Council’s GeoEconomics Center. During the Obama administration he served as the Deputy Chief of Staff and Special Assistant to the Chairman of the White House Council of Economic Advisers. He also worked at the Peterson Institute for International Economics. Views and opinions expressed are strictly his own.

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But geopolitical tensions have destabilized this relationship. Most recently, the United States was on the verge of delisting more than 150 Chinese companies by 2024. In July, it appeared that Beijing was ready to let go of US capital markets but then, in August, China reached a surprising deal with US regulators, promising to give US regulators access to the audit trail of Chinese companies listed in the United States.

Beijing’s sudden willingness to agree to US regulators’ data-sharing demands indicates that delisting more than 150 Chinese companies is a bigger hit than Chinese private sector can take at this time. However, we don’t yet know whether Beijing will follow through on its side of the deal. 

The deal could also be a ploy to give Chinese companies time to apply for new primary or secondary listings at home or in Europe. Chinese companies’ recent applications for primary and secondary listings outside the United States do suggest they are preparing for a scenario in which the United States confronts Beijing for failing to deliver on its audit-sharing promises.

US and China: Capital markets connection

Listing in the United States has given Chinese companies access to the world’s largest public capital pool and allowed them to gain international recognition, while exposing them to a more diverse group of investors. But the relationship is far from one-sided. American investors are also eager to invest in Chinese companies. 

US stock exchanges have a special appetite for big Chinese company listings, and sometimes go above and beyond to attract them. For example, in 2014, the New York Stock Exchange (NYSE) and Nasdaq OMX Group, Inc. battled over the listing of Alibaba Group Holding Ltd. NYSE went as far as to fly its executives to Hong Kong to make a pitch. Alibaba’s IPO (initial public offering) raised a record $25 billion, by far the largest ever IPO in the United States. Large listings are desirable for stock exchanges because they boost trading revenues more significantly than smaller companies do. Bigger companies trade more and thus provide more exchange fees to the stock exchanges that control their trading. 

Meanwhile, large Chinese companies are keen to reduce their exposure to domestic stock exchanges as these are more volatile and prone to heavy-handed government interventions, negatively affecting investors’ confidence in them. For example, the Chinese stock market crashed in 2015 following rapid gains after the Chinese government’s state media-sponsored campaign actively encouraged investment in the market. Eventually, the media blitz-driven bubble burst and the government was forced to intervene by purchasing huge amounts of stock. 

Recent escalation of delisting tensions

The mutually beneficial relationship between US stock exchanges and Chinese companies has not been without turbulences. In the past two decades, US regulators have demanded transparency and access to audit papers, while China has consistently denied them full access. Tensions escalated in 2020 when then-President Donald Trump signed into law the Holding Foreign Companies Accountable Act. The Act bans the trading of securities in foreign companies whose audit papers cannot be inspected by US regulators for three years in a row. The Securities and Exchange Commission (SEC) expected that, in 2022, US regulators would flag companies whose 2021 audits were not accessible. 

In July 2022 the SEC added Alibaba Group, a Chinese multinational tech company, to the list of Chinese companies at risk of being delisted if they failed to show their audits to US regulators by Spring 2024. Shortly afterwards, five of China’s largest state-owned enterprises—China Life Insurance, PetroChina, China Petroleum & Chemical Corporation, Aluminum Corporation of China, and Sinopec Shanghai Petrochemical—announced plans to delist from the New York Stock Exchange. Chinese officials have stated that the decision was mainly a result of business considerations such as high administrative costs. However, another clear factor is the Chinese government’s lack of willingness to share state-owned companies’ data with US regulators.

On August 26, Chinese and US officials reached an agreement allowing Chinese accounting firms to share more data with US regulators, and potentially preventing the 150 companies from getting delisted in 2024. It turns out China is not ready to lose access to US capital markets after all, and the US is using this leverage to obtain more transparency. 

Whether Chinese companies deliver on the promise and give US regulators full access to audit work papers remains to be seen. In 2013, the United States and China negotiated a Memorandum of Understanding for audit oversight but US regulators never gained full access to Chinese public companies’ records. The precedent of not delivering on the promises in the agreement hints that the same scenario is possible again. 

In preparation for such an eventuality, Alibaba applied for a primary listing in Hong Kong, regardless of the fact that Hong Kong cannot compete with the depth and liquidity of US capital markets. 

Plan B: European stock exchanges

Apart from domestic capital markets, Chinese companies have been eyeing European stock exchanges. Chinese authorities have been working with several European countries to set up programs connecting Chinese and European stock exchanges. For example, in late July, China and Switzerland launched a new China-Swiss Stock Connect program between the SIX Swiss Exchange, and the Shanghai and Shenzhen exchanges. Shortly after launching the program, four Chinese companies operating in energy or manufacturing industries issued global depository receipts on the Swiss stock exchange. While these listings are not initially public offerings, they have opened an avenue for Chinese companies to offer shares in the Swiss capital markets. A dozen more companies have declared their intention to take advantage of the Sino-Swiss Stock Connect program. Thus, European capital markets might become a new destination for Chinese companies. 

Conclusion

The recent agreement between the US and Chinese officials on Chinese public companies’ data-sharing indicates that Beijing is not ready to let more than 150 companies become delisted from the US stock exchanges. While the initial delisting of five state-owned companies made it appear that Beijing was ready to allow more delistings from Wall Street, the process might be much slower than expected. For the time being, US-Chinese capital markets interconnectedness still brings more benefits than harm to both countries’ private sectors. Still, Beijing will continue setting up stock connect programs with non-US stock exchanges while Chinese companies will keep applying for primary and secondary listings in China and Europe. 

Maia Nikoladze is a Program Assistant with the Economic Statecraft Initiative at the Atlantic Council’s GeoEconomics Center.

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China is a global economic powerhouse, but its system remains opaque. With distress in the property sector, Beijing’s crackdown on technology companies, and the draconian zero-Covid policy being perpetuated through 2022, questions are mounting about Beijing’s economic trajectory. Both policymakers and businesses around the world are assessing how to respond and position themselves. Leaders need a shared language to describe China’s economic system that can be trusted by all sides for its accuracy and objectivity. This is the goal of the China Pathfinder Project.

Building on the framework they launched in 2021, over the past year teams from the Atlantic Council and Rhodium Group have taken a dive into China’s economy to address a fundamental question: Is China becoming more or less like other open-market economies?

To conduct this cross-country comparison, the China Pathfinder report looks at six components of the market model: financial system development, competition, innovation system, trade openness, direct investment openness, and portfolio investment openness. Our annual scorecard places China in relation to ten leading OECD economies to establish a data-centered benchmark for discussion and analysis. It finds China’s progress toward market economy norms slowed in most areas from 2020 to 2021, though not enough to undermine the market opening efforts that took place since 2010. 

China only showed considerable improvement in innovation and trade compared to 2010; the gap was further narrowed as scores for several OECD economies sagged. In other economic areas, the report finds that China is not the only country pulling back from market economy norms. Compared to 2010, we find that backsliding occurred in Australia, Italy and Spain in the areas of financial system development and market competition, while quite a few market economies turned less open to foreign direct investment.

These trends unfold as the world looks to Beijing for its twice-a-decade Party congress. While a third term could free Xi Jinping’s hand to take bolder action in the face of China’s formidable economic challenges, doing so will mean accepting greater economic disruption in the short to medium-term and some loss of control for the Communist Party. Xi’s most urgent domestic task will be to reform the financial system and promote greater market competition. On the external side, greater openness to foreign portfolio and direct investment will be critical. If China’s leadership fails to tackle the structural problems in the economy, growth could languish in the zero to two percent range for a prolonged period.

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The COVID-19 pandemic and Russia’s war against Ukraine have caused significant economic disruptions, including shortages and rising prices for energy, fertilizer, and grains. But poorly timed policies and a lack of coordination among major countries have exacerbated these problems, pushing the global economy to the precipice. 

The current economic crisis is something the IMF was designed to deal with—namely, to promote policy coordination among major countries to ensure the stability of the international monetary system. That’s why its ruling body, the International Monetary and Financial Committee (IMFC), which consists of finance ministers and central bank governors of member countries, must produce a coherent plan to help the world navigate the current dangerous situation.

This is especially urgent since the Group of Twenty (G20)—once the premier forum for policy cooperation and coordination—has descended into dysfunction thanks to geopolitical spats between China and Russia against the United States and Europe. If the IMFC fails to rise to the occasion, the IMF risks making news only by announcing downward revisions of growth estimates.

The following should be the IMFC’s three key priorities during next week’s meetings:

Promote coordination and stabilize exchange-rate movements

Among the policy failures that has aggravated stagflation, the US Federal Reserve was slow to tighten monetary policy when inflation started to accelerate, focusing on current instead of prospective inflation performance. It then tightened more aggressively than expected, sending shock waves throughout the rest of the world. 

Meanwhile, the newly formed British government has adopted a major unfunded and uncosted tax-cut package despite the fact that public debt hovers around 100 percent of gross domestic product. That has led to market turmoil, the pound sterling dropping to record lows against the dollar, and historic selloffs in the British government bond market—requiring the Bank of England to intervene and restore order. Faced with adverse market reactions and political opposition, the government abandoned the part of the package that cuts the top 45 percent income tax rate. 

For its part, the European Central Bank was among the last major central banks to raise rates as inflation in the eurozone reached 10 percent last month. Its task has been complicated by the war- and sanctions-related increases in energy prices and its desire to contain the government yield spread between Italy and Germany so as not to threaten the integrity of the euro. But that could conflict with the anti-inflation thrust of its monetary policy. The Italy-Germany spread—reflecting the credit risk of highly indebted Italy—has widened steadily recently to 240 basis points, a nearly three-year high. By contrast, the People’s Bank of China has continued to gradually ease monetary conditions to support a visibly slowing economy amid China’s strict zero-COVID policy.

Those uncoordinated, even contradictory, policies have significantly undermined consumer, business, and investor confidence, triggered sharp declines and heightened volatility in financial markets, and depressed economic activity. The Fed’s aggressive tightening has supercharged the dollar to multi-decade highs, creating serious problems for the rest of the world. In particular, the pound sterling has depreciated by more than 20 percent since the beginning of the year, falling to record lows against the dollar. The yen has also weakened by 20 percent, prompting the Bank of Japan to intervene significantly in foreign exchange markets, the first time in decades, while the euro has fallen by more than 15 percent (to below parity against the dollar). And the renminbi has also weakened by more than 11 percent against the dollar. 

Overall, the depreciation of major currencies against the dollar has exacerbated inflation problems in those countries, forcing many of them to tighten—leading to a synchronized weakening of large economies to the verge of a global recession.

The IMFC needs to fulfill its mandate to promote the stability of the international monetary system—in this case, by coordinating coherent policies and avoiding excessive exchange-rate movements. At the very least, major member countries should acknowledge the international impacts of their domestic policies aiming to curb inflation. They should find ways together with other countries to manage the spillover effects of such policies—including measures such as foreign-exchange market intervention and temporary capital control. The Fed can also clarify that the strengthening dollar could play a role in determining the necessary magnitude of rate hikes. It should also more clearly communicate its policy goals, measures, and performance benchmarks, and—possibly in a coordinated way with other central banks—reduce the huge uncertainty prevalent in financial markets at the moment.

Individually, IMF members should be encouraged to align their fiscal and monetary policies to fight inflation and to avoid having those policies working at cross purposes. Policymakers need to find ways to encourage more supply instead of just focusing on reducing demand to tame inflation. They should also reverse recently imposed restrictions on food exports to avoid exacerbating the food crisis.

Help developing and low-income countries 

Emerging-market and developing countries, especially low-income ones, have been battered the most, with the specter of famine even haunting some. Higher US interest rates and a stronger dollar have triggered net-portfolio capital outflows from emerging markets as investors have withdrawn a record seventy billion dollars from bond funds this year. Emerging-market stock and bond markets have declined more substantially—by 28 percent and 20 percent, respectively—than their mature-market counterparts. This has further tightened their financing conditions, reducing growth. Meanwhile, the slowing Chinese economy and weakness of the renminbi have made the products of those countries less competitive in Chinese markets, curtailing the growth of their exports to China.

The IMF should provide assistance to those countries in serious distress. It has about $140 billion in outstanding loans to forty-four member countries and has launched a new Food Shock Window under its emergency-lending instruments, the Rapid Credit Facility (RCF) and the Rapid Financing Instrument—both of which feature low conditionality. But while these measures are welcome, the IMF should do more to help its poor members cope with the extraordinary challenges. For example, it should increase the resources earmarked for the RCF and raise access levels to that facility beyond the normal 50 percent of quota (the share of each IMF member’s capital base reflecting its relative standing in the world economy) per year and 100 percent of quota cumulatively. In particular, the seven poor countries identified by the World Bank as suffering a combined food and debt crisis (Afghanistan, Eritrea, Mauritania, Somalia, Sudan, Tajikistan, and Yemen) should get expedited access to the Food Shock Window/RCF.

Promote a sovereign-debt restructuring framework 

The IMF has been negotiating (or has already approved) assistance programs for several countries, including Zambia ($1.3 billion), Sri Lanka ($2.9 billion), Pakistan ($1 billion), and Argentina (a $3.9 billion second-tranche disbursement under the current thirty-month, $44 billion program), among others. The IMF should use these opportunities to press the recipient countries to request their creditors to form a country-specific Official Bilateral Creditor Committee and a Private Sector Bondholder Committee as well as communications channels between the two. These committees should discuss the parameters of a sovereign-debt restructuring deal being informed by the IMF/World Bank debt sustainability analysis of the country—more or less following the Zambia debt restructuring template. The suggestion would go beyond the provisions of the G20 Common Framework for Debt Treatment, which is only available to low-income countries; it will also help provide a needed structure for sovereign-debt restructuring, encouraging full participation of all creditors in the process. This is increasingly required as 60 percent of low-income countries and 30 percent of emerging-market countries are already in debt distress or crisis.

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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