In the ongoing U.S.-Chinese financial war, Beijing has focused on insulating China’s strategic trade from dollar-based financial sanctions. This objective has animated the growing push for China-Saudi renminbi settlement. It has also accelerated Chinese efforts to deepen ties with crude oil suppliers inclined to buck the West.
One of the most effective and longstanding means of financial “de-risking,” however, has been the Chinese central bank’s steady shedding of its official U.S. dollar reserve holdings. This development is important because it will impact Washington’s ability to impose financial sanctions on China in the event of an invasion or blockade of Taiwan.
In recent years, despite escalating financial competition with the United States, Beijing has not been abandoning dollars entirely. Still, only about a third of China’s goods trade is settled in renminbi. Instead, Beijing has created a new layer of protection for the dollars it needs to sustain the Chinese economy in times of extreme geoeconomic stress. These dollars have been sloughed off the central bank’s balance sheet and pushed down into the country’s sprawling banking system. Here, they are hard for U.S. sanctioneers to find, and more painful for the United States to freeze.
These unofficial reserve dollars have a name — “shadow reserves” — and they offer a strong defense against all but the most aggressive program of anti-China financial sanctions. Beijing’s patient, nearly decade-long expansion of shadow reserves poses a major obstacle to financial sanctions aimed at China. The diversification of Beijing’s dollar holdings means that countermeasures designed to target these dollars must strike at a wider swath of China’s economy than would otherwise have been the case. To get at these dollars in any comprehensive way, U.S. officials would have to freeze the dollar balances of China’s two major sovereign wealth funds, as well as those of marquee Chinese international state-owned enterprises and policy banks. This is a difficult task in itself. What’s more, though, since banks and investment firms on Wall Street are deeply entangled with Chinese entities of this size, the pain imposed by such sanctions cannot be reliably contained.
In short, these shadow reserves should lead American policymakers to temper expectations about their ability to implement financial sanctions on China’s banking system, even in a world where the dollar remains dominant globally.
The Rise of Shadow Reserves
Since about 2015, China’s official holdings of dollar reserves have been shrinking even as China is conducting more trade today in dollars, in absolute terms, than back then:
The mystery is where all the dollars have gone. The People’s Bank of China continues to require dollars to intervene in the currency markets to keep the renminbi exchange rate stable against the dollar at about 7.2. Equally importantly, Chinese firms still require access to the U.S. dollar derivatives market — financial contracts like futures, options, and swaps used for hedging large-scale physical trading operations — to conduct the kinds of risk management and credit operations that China’s overwhelming dominance of global trade necessitates.
The term shadow reserves was first used by analyst Brad Setser to describe Beijing’s systematic effort to push dollars down into its banking system. They’ve ended up on the balance sheets of its sovereign wealth funds, state commercial banks, and policy banks — and off the books of the People’s Bank of China’s official reserve holdings. In practice, all these entities report to the Party the same way the central bank does. China’s shadow reserves are one reason efficient balance sheet management can still occur under conditions of shrinking official dollar reserves.
One way to appreciate the growth of the shadow reserve system might be to observe the wider availability of dollars circulating in the Chinese state-owned commercial banking system after the central bank’s official dollar reserves began shrinking in 2015. Mirroring the decline in official holdings has been an increase in dollars on the balance sheets of firms like Bank of China. This development is one reason it has become steadily cheaper for Chinese borrowers to obtain dollar-denominated loans. In bankers’ jargon, the “spread” between Bank of China’s short-term dollar lending rate and the U.S. Treasury’s short-term rate has “compressed”:
The “Marginal Propensity to Sanction” Principle
Typically, several reasons are given for the emergence of China’s shadow reserves. These include Chinese financial elites’ pursuit of higher yielding assets, the repurposing of dollars toward Belt and Road Initiative loans, and Chinese responsiveness to U.S. criticism about currency manipulation.
What these reasons do not account for is President Xi Jinping’s elevation of the concept of “financial security” since the summer of 2015 when China experienced a capital flight crisis. In 2017, Xi equated financial security with national security in remarks to a study session of China’s Politburo, the highest governing body. These days, he regularly cites the concept. This obsession with financial security — driven by Beijing’s keen understanding of how Washington historically conducts financial warfare, and its recognition that Chinese trade might someday be a target — has shaped the formation of China’s shadow reserves.
Since the Cold War, Washington has reliably adhered to what I would call a “marginal propensity to sanction” principle in its exercise of financial war: Whether Washington imposes sanctions on a certain entity is linked to its perception of that entity’s systemic importance to global macroeconomic stability. If the entity is too central, sanctions are less forthcoming.
While every dollar is de jure subject to Washington’s jurisdiction, some dollars are more vulnerable than others. In 2022, in a move Moscow anticipated, Washington and its allies froze Russia’s central bank reserves; at that time, they did not freeze the dollar balances of Russia’s largest energy giant, Gazprom, or its largest bank, Sberbank.
China can expect its shadow reserves to afford a similar measure of security, if confronted with Russia-style financial sanctions.
During the Cold War, it was precisely the communist bloc’s understanding of Washington’s marginal propensity to sanction that contributed to the emergence of what was known as the “eurodollar market,” where claims on offshore dollars were not subject to the same U.S. regulatory constraints. The first ever eurodollar may even have been deposited by the nascent communist government in Beijing when, at the outbreak of the Korean war, Beijing quietly transferred a portion of its dollar-denominated reserves to a neutral European bank on the continent. At the time, dollars could not be discarded entirely; they were needed to finance Chinese trade with some of its Asian neighbors. The Central Intelligence Agency later assessed that the leaders of communist states generally elected not to “hold more than working balances” of U.S. dollars in U.S. banks. Instead, they parked the dollars necessary for trade in European banks, where they “would be safer (that is, less likely to be blocked by government authorities) than balances held in the United States.”
By dispersing dollars across the Cold War–era international banking system, Beijing successfully secured its dollar assets from the long arm of U.S. financial warfare during the Korean war and throughout decades of embargo, without eschewing dollars altogether. Their dollars found security in obscurity.
Sanctions a Painful Prospect
To the central bankers of today’s China, the beauty of the shadow reserve system lies in its unpredictability. Shadow reserve dollars are not just harder to locate across the Chinese banking system than the People’s Bank of China’s official reserve holdings. Once found, they are also bound to provoke agonizing in Washington over the escalatory implications of targeting them.
Beijing readily exploits the unpredictability of the shadow reserve system. A portion of Beijing’s shadow reserves are held in accounts with influential international banking entities — a move that effectively raises the stakes of financial confrontation. Should Washington strike at the dollar balances of Baowu Steel, one of China’s largest state-owned enterprises, if they are held by London-based bank HSBC? What about HSBC’s dollar holdings on behalf of the China Investment Corporation, one of the world’s largest sovereign wealth funds? The China Investment Corporation holds 60 percent of its public equity portfolio in U.S. stocks and about 50 percent of its total assets in alternatives funds, many of which are dollar-based or U.S.-domiciled.
Washington could always opt to expand the aperture of its financial sanctions beyond those it has levied on Moscow. But freezing the balances of China’s state-aligned firms or striking at the dollar holdings of Chinese mammoth sovereign wealth funds, where these reserves hide, would amount to waging unrestricted financial warfare. And it would risk unleashing “financial Armageddon.” When faced with a similar prospect, the leaders of Edwardian Britain called off well-laid plans of punishing embargo against Imperial Germany in the early days of World War I.
Any effort to target China’s unofficial reserves would increase the unpredictability of Chinese countermeasures accordingly. Chinese leaders appear confident that real geoeconomic power is derived from dominance over world trade. As such, Beijing might elect to respond asymmetrically by leveraging its dominance in the mining, refining, and processing of at least twelve critical materials across industries like new energy, advanced electronics, and healthcare.
Slowly and deliberately, shadow reserves are helping China achieve a perceptible degree of diversification within the dollar system even as Beijing works toward the internationalization of its own currency. The de-dollarization of China’s official reserves via shadow reserves goes some way toward addressing Xi’s concerns about financial security. Xi’s confidence in China’s financial security is one of many factors governing his tolerance for risk-taking in the Taiwan Strait. The marginal degree of safety already provided by China’s shadow reserves might leave Beijing more confident in its insulation from American sanctions than traditional metrics like the overall volume of China’s trade conducted in dollars would otherwise imply.
What’s certain is that China’s patient efforts to insulate its banking system against the threat of U.S. financial sanctions must cast serious doubt on the prospect of successfully coercing Beijing with financial power. A combination of financial, suasive, and diplomatic power alone cannot guarantee peace in the Western Pacific. Rather, the unreliability of financial sanctions should reinforce the principle that military force, not financial power, will be dispositive in a material escalation of confrontation by Beijing.
Christopher Vassallo is a doctoral candidate in economic history at the University of Cambridge. He was formerly an associate at Blackstone, the world’s largest alternative asset manager.
Image: Elekes Andor via Wikimedia Commons
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