Why is CPEC required

China versus the rest - financial sector

Payment systems

These are the connections that enable China to “connect” to the global financial system. Above all, this includes the Society for Worldwide Interbank Financial Telecommunications, better known as SWIFT, which supports international financial transactions around the globe. In 2019, the SWIFT network linked a total of 111,000 institutions in 200 countries1. SWIFT functions as an independent cooperative, but is subject to state influence. The US has intervened in SWIFT transactions in the past to enforce sanctions against Iran and Cuba. In theory, they could track and / or block certain payments to and from Chinese banks, or simply force the complete separation of Chinese banks from the SWIFT network, as happened with Iran in 2018. Given China's pre-eminent role in the global economy, the consequences of such a drastic move would be hugely significant for everyone. Hence, the logic of the Cold War nuclear impasse seems to apply, at least in theory - no one can ignore the likely cost to their economy in such a scenario.

Beijing saw this threat coming and launched its own alternative international banking messaging system in 2015. It is called the Cross-border International Payment System (CIPS) and enables payments in yuan. The scope is still small, so far 1,092 institutions have registered2, but it clearly serves a purpose that remains relevant and presumably enables institutions outside of China to switch from SWIFT quickly and smoothly if necessary, as the message structure is deliberately kept the same.

There is an earlier precedent: in 2014, when Moscow was concerned about the possible escalation of sanctions, the Russian central bank launched its own version of SWIFT called SPFS3. By 2019, the system covered 15 percent of domestic transactions4. Beijing is certainly more likely to successfully introduce its CIPS abroad than Moscow with the SFPS system.

Hong Kong - the US dollar link comes into play

Within a few years, Hong Kong has evolved from a seemingly “untouchable” location to a metropolis that is treated like any other Chinese city. The most convincing evidence of his new status came with the introduction of the mainland China National Security Act in May 2020. This law gives the government extensive powers to arrest those suspected of coup, secession and terrorism. Most Western countries have sharply criticized this move, and the US Congress and Senate in particular are increasing the pressure with new laws in the pipeline such as the "Hong Kong Be Water" Act5 of October 2019, which would oblige the President to impose sanctions under the “Global Magnitsky” Act (visa ban and financial sanctions) for Chinese or Hong Kong government officials who “knowingly suppress speech, association, assembly, procession - or suppressed or facilitated freedom of demonstration for the people of Hong Kong ”.

Large Chinese banks have so far been cautious about US sanctions against people in Hong Kong, which require a higher compliance threshold when opening accounts in Hong Kong, a radical departure from the previous practice. The fact is that these big banks need ongoing access to US dollar funding, and there is a precedent in 2012 when the Bank of Kunlun, a small Chinese institution, was charged with violating sanctions against Iran by the US dollar funding was excluded6.

There is no doubt that Hong Kong's golden age is over. It is no longer the only economic gateway to China that benefits from British law and the relative transparency of its government. The city's economic weight is now 2.7 percent7 of China's GDP - with a corresponding decline in economic importance for Beijing's agenda. But for now, Hong Kong will still benefit from its direct link to the US dollar interbank market. Could it be interrupted? That would be a severe blow, but it would also “hit” US interests. So maybe this falls into the strong threat category rather than policy options for the foreseeable future.

Portfolio Flows

Portfolio flows are a preferred benchmark used to determine the relative attractiveness of a country's capital markets at any given point in time. In the short term, they are useful indicators of the direction of capital flows, but as any finance minister knows, portfolio investors are notoriously unfaithful and go from buyers to sellers in no time if it seems in their best interest.

Equity investors - even if you add the enormous volume moved by exchange-traded funds (ETFs) - stand in the shadow of bond investors when it comes to the market value of portfolio investments. Foreign institutional investors held a total of 2.8 trillion yuan (CNY) as of the end of August 2020, according to Fitch Ratings8 ($ 409 billion) in local currency Chinese onshore bonds.

Data from the Institute of International Finance (IIF), which focuses on the portfolio positioning of investors in bonds in emerging markets, calculate that the current positioning on an aggregated basis is around 30 percent9 as shown in the figure below. In comparison, the benchmark weighting is 9 percent.

According to data from the Central China Depository & Clearing Co (CCDC) and Shanghai Clearing House, the holdings of foreign (offshore) investors in Chinese interbank market bonds now amount to 3.25 trillion Renminbi (RMB)10, which corresponds to an increase of +48.8 percent over the course of 2020. Foreign holdings of Chinese government bonds (CGBs) hit a record 1.88 trillion renminbi (RMB) at the end of December 202011, which equates to a plus of +44 percent per year.

Blocking access to US capital markets

The Public Company Accounting Oversight Board (PCAOB) was unable to reach an agreement with the Chinese authorities about access to audit documents from Chinese companies, and in the current climate the nuclear option has been put forward: the US Securities and Exchange Commission (SEC) will trade shares in companies whose The auditor has not undergone a PCAOB inspection for three consecutive years. In the course of this, the companies would have to disclose whether they are owned or controlled by a state authority. With the support of both major parties, the Senate submitted legal regulations to Congress, which it must cast into law. Chinese law restricts disclosure and currently it is Chinese accounting firms (including local subsidiaries of international companies) for national security reasons12 It is forbidden to release company test documents.

The bottom line is that it alerts all Chinese companies with American Depositary Receipts (ADRs) that there is a real chance that China will be added to the US Treasury's list of countries subject to extensive economic sanctions (such as Iran and North Korea). This would significantly limit the investment universe for US-based asset owners, but it could become a condition of trade or defense pacts that the third country that concludes treaties with the US must renounce relations with China. This represents perhaps the most far-reaching implications for investors in the short term, although the investment world will quickly find parallel mechanisms to circumvent the problem.

At the time of this writing, the New York Stock Exchange is preparing to take three major Chinese telecommunications companies off the market after the US Treasury Department following an order from President Trump13 issued corresponding guidelines. The index provider MSCI dropped14 Chinese stocks from its Global Investable Market Indices (GIMI). FTSE Russell followed suit15. The best-known (and most widely used) titles in the picture are now Tencent and Alibaba. They're not on the list of 14, nor were they removed from the China indices, but there is a clear conclusion - even after the change of government in the White House - that they could be targeted in the future. For investors in companies that have been included on the exclusion list, it would be prudent to assume that this will remain the case for some time. The onshore Chinese A-share market, which domestic Chinese investors can invest in, should benefit the most. As the Chinese population ages and the middle class expands, growing pools of domestic savings will increasingly be invested in stocks. The prospects of this growing investor base will result in the "onshoring" of many Chinese companies currently listed abroad.

Belt and Road (the New Silk Road)

The Belt and Road Initiative (BRI) is an expression of soft and hard power that now serves as an instrument to enable the beneficiary states to be recruited more quickly for the Chinese side. This means cementing access to these markets, integrating Chinese companies into those economies, establishing a secure long-term supply of raw materials, resources and agricultural products, and at the same time taking measures to promote the adoption of Chinese technical and technological standards. Given the lack of alternatives for many of these countries and the promise of radiating glory for governments that have proven investments, it would be logical to assume that most will accept this offer and become part of Beijing's sphere of influence. This list currently includes 126 countries16, but the clearest example is Pakistan, a strategically located nuclear power.

The Sino-Pakistani Economic Corridor (CPEC)17 as a showcase project for the New Silk Road

The CPEC18- Commitment extends to energy, transportation and logistics, healthcare, education and water supply. So far, 5,320 MW generation capacity (31 percent of the target value) and 2,548 km of motorway (36 percent of the target value) have been completed. The cost of this was $ 10.8 billion. A plethora of projects, including 4,122 km of railway lines and a number of industrial areas, are still in the planning stages. If implemented, they will fundamentally change the country by 2030. But one of the more interesting sidelines of the CPEC is an attempt to promote the use of the renminbi (RMB) as an international currency. This stems from Islamabad, not Beijing, and stems from IMF restrictions, dwindling US dollar reserves and persistent current account deficits. China recently doubled its RMB foreign exchange swap agreement with Pakistan to 40 billion yuan. It was reported that this arrangement was also used in 19 other BRI countries. At this point it is still unclear how successful these efforts will be, as most private companies prefer dollars or euros and the amount of goods that countries like Pakistan can purchase from China is limited.

With Pakistan and the CPEC, Beijing has shown what it can do to support countries joining the Belt and Road Initiative.


In terms of contributing to a country's industrialization process, the financial sector is just as important as the energy sector. Therefore, in a scenario of continued escalation of measures and countermeasures, it could become a target. However, the headlines were mostly about technology, trade and deficits, and very rarely about structural links in the financial sector between China and the West. Apparently the assumption is that there is no interest in causing a final rupture as the cost would be too high for everyone. In a (still) networked world, any rift in the financial ties between China and the West would have devastating consequences for global trade and, as a result, for the global economy.

In the next decade there will likely be increasing efforts to unbundle the world's two largest economies. Investors are well aware of increasing pressure on governments to take a stand. China's offering of its affordable coronavirus vaccine and infrastructure expansion within the framework of the BRI have already met with great approval in developing countries. The only questions that could possibly upset this development are sudden and appropriate financial generosity on the part of the US, an obviously inferior execution of the BRI or a particularly scandalous political misstep by Beijing. They all seem unlikely at this point, which makes it clear

that if the US-China unbundling continues, there will be many countries already under Chinese influence and relatively few will be willing to sever ties. For all of them, the prospect of severing financial ties with Beijing is an irreversible step that goes too far.

Capital flows rely on credible banks and stock exchanges, as well as secure and reliable communication services such as SWIFT. China has Hong Kong, Shanghai and arguably Singapore within its sphere of influence. Its telecommunications and technology backbone in the Belt and Road Initiative countries also provides guarantees of safe capital flows. Money flows like water and seeks the path of least resistance. It is by no means easier to block the free movement of capital than the flow of ideas and knowledge.

In the West, the demographic clock is ticking relentlessly: The existence of underfunded pension obligations requires ever higher returns - and with China and Asia promising consistently higher growth over the next 20 years, it will be even more difficult to erect barriers to investment in this part of the world.

As a result, the long-standing ties in the financial sector are likely to remain largely unmolested because of their importance to the stability of global trade and economic growth. Perhaps, in this sector, the threat of break will maximize impact, rather than severing those links. He will always be at the top of the list if a US government wants to increase its bargaining power.