China and its exposure to the war in Ukraine

The direct impact of the war in Ukraine on the economy of China is minor due to the relative sizes of these economies. However, the indirect impact of global consumer and investor confidence can be profound and complicated. The International Institute of Finance says it expects the war to reduce China’s GDP growth by 0.2 points.

Moderate exposure through trade

China’s trades with Russia and Ukraine are relatively small, with the two countries accounting for only 2.3% and 3.3% of China’s total exports and imports. As a key energy provider, Russia accounted for 16% and 10% of China’s total oil and natural gas imports last year.

“We expect Beijing to maintain its trade with Russia, especially Russian energy and grains imports. China’s exports to Russia can be paid in RMB, which is over 1/6 of Russia’s foreign exchange reserves. Ap- proximately 17% of the China-Russia trades were already settled in RMB in 2020. China’s exports to Russia surged by 41% y/y in Jan-Feb.

As the world’s largest oil importer, 72% and 45% of China’s oil and natural gas consumption are imported. Oil and gas (10% of China’s imports bill, 15% if including coal) and other commodities such as copper, nickel, and zinc, all experiencing rising prices, collectively accounted for around 1/4 of China’s total imports bill last year (Chart 1),” says the IIF.

China and grain supply

China’s exposure to the global grain supply is small, as China’s rice and wheat supplies are mostly self-sufficient. China’s main agricultural imports, such as soybean, oilseeds, and animal feeds, are mainly sourced from the Americas. On the export side, the damaged world economy, especially Europe, will hurt China’s exports.

The current account surplus, which is in the nominal term, will narrow due to higher imports bills and weaker export growth (Chart 2). However, the war will likely raise the net export (NX) in real-term GDP. This is because the higher commodity prices will lift imports values but depress them in real volumes.

“Thus, we expect NX’s contribution to 2022 GDP to be 0.2 pts, lower than the 1.7 pts in last year but higher than the pre-war estimate. The rising commodity prices and worsening global economic outlook will hurt China’s business confidence and investment. We expect capital formation’s contribution to be 2.0 pts, weaker than the pre- war forecast but still improved from last year (Table 1 and Chart 3).

“In terms of GDP by production, we expect agriculture to benefit from subsidies, manufacturing to be hurt by weaker ex- ports and rising input prices, and the domestic service to be little affected by the war. (Table 2 and Chart 4),” says the institute says.

A delicate situation for investment

Thanks to strong exports and profits, the inbound FDI increased by 20% in 2021 (Chart 5). The outbound direct investments (ODI), including those under the Belt & Road Initiative (BRI), remained flat in the past five years. We don’t expect much change in 2022.

China remains an attractive place for manufacturing due to its sophisticated supply chain. Joining RCEP (Regional Comprehensive Partnership) further opened China’s service sectors. Though Russia and East Europe are strategically important, investments in these regions account for just 0.6% of China’s total ODI stock (1.5% if excluding HK). China’s outbound FDIs are still mostly in emerging Asia, the EU, and the US.

China’s portfolio inflow peaked in 4Q2020 (Chart 6). The aggressive policies on real estate, internet platforms, and energy consumption last year damaged investor confidence. The war, Omicron outbreak, and Fed interest rate hike further hurt China-bound capital flows in 1Q2022.

“The IIF daily capital flow tracker noted sizable portfolio outflow in Feb-March. Thankfully, the unequivocally pro-growth and pro-market message from the Financial Stability Committee on March 16 calmed the market. We expect a smaller net non- resident portfolio inflow at around $50 bln in 2022, down from last year’s $177 bln.

“Although RMB depreciated by 0.6% against USD since the invasion on February 24, it appreciated against EUR, JPY, GBP, and many EM currencies (Chart 7). We expect RMB to only depreciate against USD by about 2% in 2022 due to the narrower trade surplus and the divergent monetary policies of the Fed and PBoC. We expect little change in China’s foreign exchange reserve (FXR) this year after the $189 bln accumulation in 2021 (Chart 8).”

Sanctions against Russia

The sanction against Russian official reserves would prompt Beijing to rethink the safety of its own $3.2 tln FX reserves. Beijing may choose to leave more foreign assets in the hands of Chinese corporate, banks, and even households.

Currently, 37% of China’s $9 tln foreign assets are held as official reserves, much higher than the 13% for Japan and only 2% for Germany. “Therefore, we may see a growing capital out- flow by residents in the future,” it says.

The institute also believes Chinese banks will be careful not to trigger the secondary sanction against themselves. Several large state banks stopped the Russian services soon after the war broke out.

“However, Beijing could still potentially set up single- purpose banks to just serve Russian trade and finance. Kunlun Bank, owned by PetroChina, provided financial services to Iranian banks sanctioned by the US. Though a secondary sanction was triggered in 2012, the enforcement was difficult as Kunlun Bank had no financial exposure in the US.

“The roles of UnionPay and China’s RMB payment system, CIPS (Cross-border Interbank Payment System), also deserve close attention. We expect Beijing to maintain most of its goods and services trade with Russia, provided that they do not expose Chinese institutions to secondary sanctions,” it adds.

China’s growth outlook

China’s 2022 growth outlook is highly uncertain. Foreign trades and investments are affected by the war, alongside global consumer and investor confidence. It remains to be seen whether the recent policy reversal can turn around China’s housing market confidence.

“We estimate that the large fiscal resources available for 2022 could mean a consolidated fiscal deficit of 8.1% GDP, much greater than the 2.8% announced for the narrow-gauged general fiscal account and the 5.2% realized consolidated deficit in 2021.

“However, the deployment of these fiscal resources depends on the confidence of local governments. Finally, the recent Omicron outbreak and lockdowns could mean zero economic growth in March and a dimmer outlook for 2022. It will be another eventful year.”