t has been more than two months since Russia launched its “special military operation” in Ukraine. As the war rages on, the West and Russia have been engaged in an economic and financial war following the West’s sweeping economic and financial sanctions against Russia, which were met with countermeasures from Moscow.
The war has caused serious economic implications around the globe. First, the conflict triggered price hikes in commodities of the most strategic importance, including oil and gas, key minerals and foods, which have driven up inflation everywhere. In the US, rising inflation was already a major concern for policymakers, which is now exacerbated. The US Federal Reserve said recently that if inflation keeps rising, it will increase interest rates by another 0.5 percent in the summer, which economists believe could lead to stagnation.
Policymakers in the European Union face a similar dilemma. As energy supplies are disrupted, inflation has spiked, and millions of Ukrainian refugees have fled to other European countries, with more expected as the conflict continues. Economic prospects for Europe in 2022 are gloomy.
Comparatively, the economic impact of the conflict in Ukraine on China is small. For China, the biggest impact of the conflict will be rising oil and gas prices on the international market, and the change in China’s foreign trade environment due to changing economic situations in other countries. But the most serious economic challenges are domestic. The primary concern is still the spread of the Omicron variant, which has caused outbreaks in several major cities.
Economists believe the pandemic will cause a decline in demand and supply, which poses a great challenge for China to achieve the 5.5 GDP percent growth garget for 2022.
It is unclear how the dynamics of fluctuations in demand and supply will play out. If the pandemic and the resulting lockdowns have greater impact on the supply side than demand side, it will drive up inflation further, potentially leading to stagnation. But if the impact on demand is greater than on supply, it is possible to see deflation.
To deal with these problems, China should adopt expansive fiscal and monetary policies. While tight fiscal and monetary policies are useful to battle rising inflation, under the current economic situation, China should prioritize maintaining economic growth, which means the country may have to tolerate a certain level of inflation.
Despite the short-term impact of the Russia-Ukraine conflict, China should be cautious about its long-term impact on the global financial system. The financial sanctions the US and its allies imposed on Russia, especially freezing Russia’s central bank assets, has shaken the foundations of the global financial system in the post-Bretton Woods era. For many countries, the sanctions pose serious questions on the security of their financial assets in foreign banks. The traditional method of diversifying one’s foreign exchange is no longer adequate to ensure the security of foreign reserves, especially in times of crises.
In an article published by Project Syndicate on March 17, Raghuram Rajan, former governor of India’s central bank, warned that “China, India, and many other countries will worry that their own foreign-exchange holdings [of advanced-economy debt] may prove unusable if a few countries decide to freeze their assets.” Rajan said that as few other assets possess the liquidity of dollar or euro reserves, many countries may start limiting activities that necessitate reserve holdings, such as cross-border corporate borrowing, and they might also start exploring collective alternatives to the SWIFT financial messaging network, potentially leading to fragmentation of the global payments system.
For China, the lesson is that there is no guarantee that its foreign reserves and foreign assets will be 100 percent secure. One solution is to minimize the foreign reserves and assets it holds by trying to reach a balance between foreign assets and liabilities. As more countries change perspective on the safety of foreign reserves, it may lead to a reshuffle of the global trade landscape. China must be prepared for such a transformation and find its own solutions.