(How Much) Would Economic Sanctions Hurt China?

To avoid misunderstandings and make things perfectly clear right from the beginning, this article pertains exclusively to Russia-style sanctions aimed at potentially isolating the Chinese economy. It does not refer to more or less “tit for tat” trade war measures, such as those initiated by trading partners such as the United States and covered extensively through dedicated articles such as this one.

We have already had those.

What hasn’t yet taken place is a Russia-style situation, or more specifically a situation involving sanctions such as those imposed on Russia after the annexation of Crimea. The difference between such sanctions and let’s say the US-China back and forth is represented by the difference between sanctions aimed at isolating an economy (with Iran as a more extreme example than Russia or North Korea as an even more extreme one) and retaliatory sanctions which came as a result of something one trading partner considers to be an imbalance (in the US-China situation, this imbalance is primarily represented by the consistent trade surplus China is experiencing).

Are such scenarios likely to occur?

This is quite difficult to state, for one important to the point of being blatantly obvious reason: China is not Russia. Yes, there are experts who portray Russia as militarily mighty and they do have a valid point but from an economic perspective, Russia is hardly a force to be reckoned with in light of its GDP which isn’t that much greater than that of Spain. Compare Russia’s GDP to China’s Gross Domestic Product (the #2 one worldwide in nominal terms and the #1 one on a PPP basis) and it isn’t the least bit difficult to understand that it is next to impossible to touch China in this manner without significantly inflicting damage on your own economy.

Aren’t countries who impose sanctions on Russia inflicting damage on their own economies as well, however?

Yes, but “magnitude” is the operative word.

While Russia does have leverage in the form of let’s say energy and commodities (with certain countries such as Germany being more vulnerable, a topic covered through another article), this is nothing compared to China, the number one game in town when it comes to demand for a wide range of industries and the same principle is valid on the supply side.

To put it differently, the global economy is so dependent on the many facets of the Chinese economy (no, not just “cheap” imports) that imposing debilitating sanctions on China would most likely lead to a Mutually Assured Destruction situation, this time from an economic perspective rather than a nuclear war one.

Therefore, no, Russia-style sanctions are unlikely.

Are they impossible?

Most definitely not, which is why it’s important to give meaningful thought to such scenarios.

Think about the year 2016 for example and put yourself in the position of an observer who is analyzing the top two upcoming events of the year: the Brexit vote on the one hand and the US elections on the other. How many people could or would have predicted that UK citizens would vote for the Brexit scenario and/or that Donald Trump would have become the president of the United States? In today’s highly volatile political landscape, expecting the unexpected is a matter of self-preservation.

Here are just three examples of scenarios that would be able to bring about the highly improbable:

1. China going overboard when it comes to its attitude pertaining to geopolitical hot spots it is involved in, such as the South China Sea or, of course Hong Kong as well as Taiwan. Realistically speaking, however, this is quite unlikely in light of the calculated manner in which China tends to approach things
2. A significant economic calamity taking place that brings about consequences (unemployment, personal ruin, sovereign insolvency, etc.) that cannot be “sold” politically without a major narrative. If history is to be an indicator, it is reasonably likely that some politicians will grasp for “us vs. them” narrative out of desperation, with China being a very attractive enemy to channel public outrage toward
3. Human rights abuses degenerating over in China beyond what the West considers to be acceptable, for example situations generated by the fact that an increasingly educated Chinese population becomes less and less willing to simply accept a totalitarian form of government. As unlikely as this scenario may seem, we have explained on multiple occasions that “selling” socialism with Chinese characteristics in its current form is far trickier for Xi Jinping than it has been for leaders a few decades ago

As can be seen, while unlikely, such scenarios aren’t outside the realm of reason.

What can be done to hedge against them?

It is mostly a matter of common sense, for example:

1. Understanding the fact that China has aces up its sleeves as well, for example the enormous amount of US-denominated debt it holds. Let’s just say things could get ugly rather quickly if that debt were to be “dumped” on the market in a retaliatory fashion very quickly and that other holders of such instruments would be wiped out. If you are one of them, perhaps it makes sense to include this dimension in your risk assessment equation
2. Smart diversification, with the end goal revolving around landing on your feet. There is no such thing as a strategy that enables you to thrive no matter what and those who pitch such strategies are snake oil salesmen at best and scammers at worse. Landing on your feet should be more than enough
3. Acknowledge that diversification doesn’t have to simply involve adding other assets to your portfolio, there is also a jurisdictional angle. Owning US stocks and “diversifying” by also adding US bonds and US real estate to your portfolio isn’t what we would consider true diversification. In the absence of jurisdictional diversification (including, of course, China), your diversification strategy is sub-optimal at best

The list of examples can continue and the bottom line is this: we always advise being optimistic in life and pessimistic when planning. With that in mind, the ChinaFund.com team highly encourages accounting for improbable scenarios as well when assessing risk and, of course, is at your disposal should you be interested in our assistance with just that.