Russia and China’s Dollar Dilemma: Teaming Up for a Currency Shift

Prior to the onset of Russia’s violent invasion of Ukraine in 2022, we issued a warning regarding the collaboration between Russia and China in de-dollarization, which is the process of reducing the dependence on the US dollar for international finance and trade. We stated that this move would not be sufficient to provide Russia with economic sanctions immunity, and it proved to be accurate. Due to the unprecedented Western sanctions, Moscow was abruptly rendered incapable of conducting transactions in euros and dollars, which are the most widely used currencies globally.

Russia has since been attempting to find alternative methods for managing its reserves and trade. While gold and the Chinese yuan have emerged as prominent alternatives, both have given rise to new risks and problems. The yuan places Russia in a precarious situation of relying on China’s goodwill, while gold has not proven to be as resistant to sanctions as Moscow anticipated, and the nation has had difficulty expanding its underground gold trade.

Yuanization, in particular, has introduced fresh uncertainties. When Russia became heavily sanctioned and isolated in February 2022, it had to identify a new currency for non-dollar-denominated transactions. This currency had to possess two characteristics, namely relative stability and being produced by a non-sanctioning nation. China’s yuan, which was actively seeking a global role, was the sole option among the limited options, such as the Indian rupee and South African rand, that satisfied these conditions.

Moscow has rapidly accelerated its utilization of the yuan in two primary ways: augmenting the yuan’s portion in Russia’s reserves and moving towards direct ruble-yuan trade instead of using the dollar as an intermediary. The Russian Finance Ministry raised the authorized proportion of yuan reserves in the National Wealth Fund to 60% by the end of last year. Moreover, from February to October 2022, the ruble-yuan trade increased by eighty times. Through these actions, Russia not only created new vulnerabilities but also cemented itself as the junior partner in the relationship.

Ruble-yuan exchange rate susceptibility. China, Russia’s main trade partner, has a tight grip on the yuan-ruble exchange rate, making it risky for Russia’s trade balance. Although a strictly regulated yuan may seem more secure than a fluctuating dollar, the Chinese authorities have taken advantage of the ruble-yuan exchange rate in the past. Notably, after the invasion, the Chinese government loosened its yuan control, allowing the quickly depreciating ruble to decline at a faster rate to avoid subsidizing Chinese goods for Russians by providing them with more yuan than their rubles were worth. Consequently, it became considerably more expensive for Russia to buy Chinese goods, and China could make its imports pricey and Russian exports to China cheap at any time, for political reasons or otherwise.

Risk of Chinese bond liquidation. If Beijing imposes restrictions on yuan outflows, the Russian Central Bank may be unable to sell Chinese bonds and convert the proceeds to rubles. Liquidity risk is one of the primary reasons central banks around the world avoid purchasing Chinese bonds. As of March 2022, the Russian Central Bank and National Wealth Fund owned yuan-denominated assets valued at 140 billion dollars, which Moscow could not obtain if China imposed capital controls.

Risk of elimination of currency swap lines. When it comes to currency swap lines, Russia is subject to Beijing’s political will. Moscow utilized bilateral swap lines with the Chinese Central Bank to increase its yuan reserves. In 2014, Russia inked a three-year currency swap deal worth 150 billion yuan, which was extended for another three years in 2017. In January, the Russian and Chinese central banks agreed to establish a new yuan currency swap mechanism. However, such agreements expose Chinese financial institutions to US secondary sanctions for assisting Russia in circumventing sanctions. If Beijing determines that the risk of secondary sanctions is escalating, it will soon terminate the swap lines with Russia.

Last year, Russia took the first significant strides towards humanizing its economy, a prerequisite for Moscow, which is in turn bolstering Beijing’s influence in international finance. Although the yuan assisted Russia in weathering the effects of sanctions in the short term, it also opened Pandora’s box of new vulnerabilities for Moscow. As long as sanctions are in place, Russia will have to remain on the right side of Beijing.

News source: Atlantic Council