20.12.23 Review

Anomalous dependence: The rapid yuanisation of the Russian economy highlights its vulnerability and does not shield it from risks

Since the full-scale invasion of Ukraine, the yuanisation of theRussian economy has been proceeding at a rapid pace. A significant portion of Russia's foreign trade (not just that involving China) now involves the yuan. This has been one of the factors behind the growing share of the yuan in international settlements. Assets in yuan now form the basis of Russia's gold and foreign exchange reserves and the National Wealth Fund. In fact, the yuan has become the main reserve currency for Russia, even though in reality, the yuan is not a full-fledged reserve currency, and also does not aspire to become one. This would require Beijing to lift restrictions on capital flows and abandon its export-oriented growth policies. As a result, China's share of global foreign exchange reserves is 2.5%. Even in the BRICS countries, which support the idea of dedollarisation, the role of the yuan is barely increasing. While the yuanisation of Russia's foreign trade can be explained by a sharp increase in mutual trade (although it also has a political background), the dominant position of the yuan in Russian reserves is an anomaly without economic justification, increasing certain economic risks that would manifest in the event of a sharp deterioration in the trade balance.

The Russian economy is rapidly yuanising. According to the Central Bank's latest ‘Financial Markets Risk Review’, the yuan's share of Russian exports reached 33% by the end of the first ten months of 2023, and was 37% of imports. The Central Bank notes that 75% of Russian-Chinese trade turnover and 25% of Russian trade turnover with other countries are settled in yuan. In particular, India and a number of other consumers of Russian raw materials have largely switched to yuan payments for oil supplies. In December, the share of yuan in the total volume of trading on the Russian exchange and OTC markets reached 46% and 32% respectively, while it was almost zero at the beginning of 2022. Finally, at the end of last year, the Ministry of Finance approved a new structure for the National Welfare Fund (NWF). Until the end of 2020 it consisted mainly of dollars, euros (collectively more than 90%) and pounds. In 2021 the dollar was replaced by the yuan, yen and gold, and from 2023 the yuan increased to 60% of the NWF, with non-cash gold reaching 40%.

Following the imposition of sanctions, which froze the Central Bank's assets worth several hundred billion dollars, it no longer discloses the detailed structure of its reserves. However, it admits that the share of yuan and gold in its reserves is significant. It is worth noting that dedollarisation and, consequently, the yuanisation of the Russian economy began before the war. According to the Central Bank's annual report for 2021, the last year in which the structure of reserves was disclosed, it looked like this: 33.9% euros, 21.5% gold, 17.1% yuan, 10.9% US dollars, 6.2% pounds, 5.9% yen, 3.2% Canadian dollars, 1.3% other currencies. Thus, the yuan's share in the Central Bank's reserves even before the war was significantly higher than its share in global reserves, which stands at 2.45%. 

Structure of Russian and global international currency reserves in the fourth quarter of 2021, excluding gold, %

The yuan has been officially included in the basket of Special Drawing Rights (SDRs) by the IMF since 2016. However, it is not a fully convertible currency. The initial impetus for the internationalisation of the yuan came from the global crisis of 2008. Experts from the Belgian think tank Bruegel highlight two main reasons: first, trust in the dollar was undermined by the radical easing of monetary policy in the United States at that time, causing the currencies of many other countries, including the yuan, to significantly depreciate; second, dollar liquidity temporarily contracted and none of the swap lines that the US Federal Reserve opened in 2008 were provided to China, Hong Kong or Southeast Asian countries, with the exception of Singapore.

Nonetheless, despite a number of measures aimed at the internationalisation of the yuan (particularly within the framework of BRICS and the One Belt, One Road initiative), China's success on this path was very limited before the war in Ukraine. The yuan's share in world trade remained just below 2% at the beginning of the year. However, by the end of October it rose to 3.6%, according to data from SWIFT, cited by Bloomberg. The volume of Russia-China trade over the course of the two years since the invasion of Ukraine has grown at an extremely rapid pace, exceeding $218 billion in the first 11 months of 2023 (while Russia's share in Chinese foreign trade remained modest at about 2%). Likely, this and settlements in yuan for Russian oil became the main factor in the growth of the yuan's share in global trade. 

Experts identify six criteria for a reserve currency's solvency. China meets two of them: the size of its economy (17.8% of global GDP compared to 25.4% for the US) and its role in global trade (11.2% compared to 10.8% for the US). China also comes close to other reserve currency economies in terms of macroeconomic stability and the size and quality of its financial market. However, it does not meet two other criteria: convertibility of the national currency and the presence of countries that use it as an 'anchor'.

Indeed, the daily exchange rate of the yuan is set by the People's Bank of China. During the trading day, fluctuations of the yuan/dollar pair are allowed within a 2% range. However, the mechanism used by monetary authorities to determine the exchange rate is not entirely transparent. Additionally, there are restrictions on capital outflows in China, including for foreign companies.

The issue is that the Chinese leadership is still ambivalent about the internationalisation of the yuan. The liberalisation of the financial system by lifting capital movement restrictions carries significant risks, as explained by Deutsche Bank's Chief Economist Michael Spencer. If foreign investors can freely enter and exit assets denominated in yuan, it would make the country more vulnerable to capital outflows. The Chinese financial system is not prepared for this, confirmed Todd Lee, Chief Economist for China at S&P Global. It is largely controlled by state banks, which do not always operate based on commercial logic.

In addition, there are suspicions, which, in particular, are periodically expressed cautiously by the US Treasury, that the Chinese authorities intentionally devalue the yuan at times to benefit their industry (despite economists already considering it undervalued in terms of purchasing power parity) to support export-oriented growth.

Thus, in essence, the yuan is not only not a full-fledged reserve currency, it does not want to be. For a number of economic and political reasons, the Chinese authorities do not seek either greater openness of financial markets or greater stability of the national currency. If the yuanisation of Russia's foreign trade can be explained, the place of the yuan in Russian reserves appears economically irrational.

However, the Russian authorities began to discuss dedollarisation and wider use of the yuan as an alternative to the dollar after sanctions were imposed in response to the annexation of Crimea and the war in eastern Ukraine. The first step on this path in 2014 was a 2014 agreement between the Central Bank and the People's Bank of China to establish a 150 billion yuan swap line. In 2019, an intergovernmental agreement was reached to increase the use of national currencies in bilateral trade. Despite dedollarisation being named one of the priority goals of Russian-Chinese cooperation during these years, Russia, in reality, increased the share of the euro and yen more actively in its reserves than the yuan, according to experts from the German Institute for Security Affairs and International Relations (Stiftung Wissenschaft und Politik, SWP). Until 2022, the yuan's share remained modest in both Russian reserves and bilateral trade. However, according to experts from the Dollar Dominance Monitor project, the central banks of the two countries can now exchange rubles and yuan up to a value of $1.4 billion daily.

At the political level, the desire for dedolarisation is characteristic of all BRICS countries, according to experts from the Dollar Dominance Monitor. However, their actual achievements in this regard are still modest. All countries, with the exception of Russia, predominantly use dollars in international settlements. China has opened the largest swap line to Brazil, but it is limited to $30 billion, with the dollar firmly dominating both in reserves and in the country's export settlements. India does not seek to trade in yuan at all and does not support steps to internationalise the yuan. According to media reports, the requirement to settle in yuan for Russian oil has caused dissatisfaction among Indian authorities.

Thus, Russia is the only economically significant country that is being compelled to rapidly yuanise its economy. The increasing role of the yuan in bilateral trade and in the Russian currency market seems to be a direct consequence of the growing trade turnover between the two countries. However, as Re:Russia has previously discussed, China's high share in Russian trade poses risks to the economy and lacks economic justification. Likewise, there is no economic rationale for using the yuan as the main currency for storing reserves. In fact, Russia uses the yuan as a full-fledged and primary reserve currency, even though it neither is nor aspires to be one. This situation creates a number of economic and political risks, according to the experts at SWP. As the Chinese authorities control the yuan exchange rate, the value of Russian reserves will depend on their decisions, which, in turn, depend on the dynamics of China's trade with its largest trading partners, which does not include Russia. In addition, over 40% of Russian imports are still paid in dollars and euros. In the event of a sharp deterioration in the balance of payments, such as a drop in oil prices, these circumstances could significantly complicate the situation for Russian authorities.

The one-sided nature of the yuanisation process is also illustrated by the difficulties faced by Russian banks when integrating into the Chinese financial system. Vedomosti has reported that due to the risk of secondary sanctions from the US, not everyone who wants to join the national Chinese bank transfer system CIPS (Cross-Border Interbank Payment System) can do so. Moreover, even those fortunate enough to be connected can only become indirect participants in the system as they need local partners to operate. Only Russian subsidiaries of Chinese banks are directly connected to CIPS, and these in turn gain competitive advantages on the Russian market. At the same time, Russian banks, which are subject to sanctions, have been banned from even issuing cards for the Chinese UnionPay payment system. In other words, while Russia is gambling on the yuan, China is actually practising a regime of partial compliance with international sanctions against Russia, which further strengthens the dependence of the Russian economy on the Chinese economy.