Huge impact of ‘fortress economics’ in Russia and China

Russia’s defensive management of its economy protects itself against the risk of US sanctions. But China doing the same is worrying for the world economy.

Expert comment Published 2 February 2022 2 minute READ

David Lubin

Michael Klein Senior Research Fellow, Global Economy and Finance Programme

The main idea behind ‘fortress economics’ is that any country with a terminally bad relationship with the US is well-advised to try to earn more than it spends. Keeping the current account of the balance of payments in surplus is preferable to a deficit which then needs an external funding requirement – because most of that funding is dollar-denominated, which gives Washington leverage.

The logic of fortress economics also argues in favour of building up a big stock of foreign exchange reserves to support a country’s ability to spend if, and when, sanctions bite – and Russia has followed this pattern assiduously. Its current account surplus averages 3.5 per cent of GDP in the past ten years, which helped finance a build-up of foreign exchange reserves worth $460 bn, or around 30 per cent of GDP – huge by international standards.

A crucial tool in building this financial fortress is a highly conservative bias in fiscal and monetary policy. Macroeconomic policy must be kept tight to restrain domestic spending, and indeed the average growth rate of Russian public spending over the past decade has been less than one per cent in real terms, way below the 3.5 per cent average in other emerging economies.

Many areas the Chinese government prioritizes for new investment now such as technology, agricultural, and green energy all share one feature – they aim to reduce China’s dependence on imports

This is how Russia has managed to keep its government debt burden at a mere 16 per cent of GDP, and geopolitics is not the only reason why its economic policy is so restrictive. Russian officials are influenced by the traumatic memory of Russia’s 1998 financial crisis, which biases them towards a conservative approach to managing public balance sheets.

A future without oil revenue

In addition, as Russia needs to think of ways of surviving a post-fossil fuel future, saving now is sensible, particularly as the government’s budget deficit stripped of oil revenues is scarily large – almost eight per cent GDP on average during the past five years.

But Russia is not alone in seeking to insulate itself in this financial fortress – it is increasingly tempting to describe China in the same way. Ever since 2018 when China’s current account fell uncomfortably into deficit, the country’s policymakers have seemed ever more interested in ensuring that never happens again.

Many areas the Chinese government prioritizes for new investment now such as technology, agricultural, and green energy all share one feature – they aim to reduce China’s dependence on imports. Its Dual Circulation Strategy is an explicit upgrading of the government’s ‘self-reliance’ agenda, and the Communist Party’s 5th Plenum in late 2020 set out a range of ambitious targets to enhance the resilience of domestic supply chains through innovation in semiconductors, AI, quantum computing, biotech, automotive, and aerospace.

The average growth rate of Russian public spending over the past decade has been less than one per cent in real terms, way below the 3.5 per cent average in other emerging economies

But as well as pursuing a more resilient current account balance, two other aspects of Chinese policy reflect the ‘fortress’ approach to economic management.

One is the effort China has made in recent years to attract capital inflows from abroad. Foreign portfolio managers now own some $630 billion-worth of Chinese bonds, allowing China to increase the amount of dollar liquidity on the balance sheets of the People’s Bank of China as well as state-owned banks and corporates. Accumulating this foreign liquidity – after having lost $1 trillion of foreign reserves in 2015-16 – remains an important objective for Beijing.

The second is China’s zero-tolerance COVID-19 strategy. Keeping China’s borders closed means Chinese households are forced to enjoy vacations at home, which removes a major threat to China’s foreign exchange liquidity – foreign travel drained a net $220 bn from China in 2019.

Fortress economics does have one major consequence, which is that economic growth ends up lower than it might otherwise be, and the defensive approach to aggregate spending which is needed to build the fortress makes this outcome inescapable. Russia’s per capita GDP growth in the decade running up to the pandemic was considerably lower than its emerging markets peers.

Ordinary Russians have paid an economic price for the government’s fortress. If China is now adopting the same strategy, Chinese households will pay a price too, and the world economy will suffer. But that is only to be expected when geopolitics gets in the way of globalization.