Bring China into the international financial system
Will China indebt the world? China has risen rapidly to become the world’s largest infrastructure creditor. Its lending is politically driven, risk-prone and opaque, and has left many borrowers with unsustainable debt. China should be encouraged to join the established, rules-based international financial system, writes Robert Wihtol, a former Director General at the Asian Development Bank.
The first signs were modest. In the early years of the new millennium, China’s large state-owned policy banks, the China Development Bank (CDB) and China Export-Import Bank (China Exim), stepped up their lending to emerging economies around the world for projects of strategic interest to China. Subsequently, the pace of lending accelerated, and by 2014 China had become the world’s single largest infrastructure financier.
China’s financing has been welcomed by many. However, it has also quickly become clear that its lending is politically driven, risk-prone and opaque. Projects are motivated mainly by China’s national interests. Many were poorly conceived and have saddled borrowers with unnecessary debt. The first widely publicised casualty was Sri Lanka, which borrowed heavily to build a port and airport in the southern city of Hambantota. The facilities remained virtually unused, and heavily indebted Sri Lanka was unable to service the loans. Eventually a Chinese state-owned company took over ownership of the strategically located port, under a 99-year lease. The list of debt casualties has subsequently expanded to include countries ranging from Colombia and Laos to Montenegro and Pakistan.
On a visit to Beijing in October 2018, Prime Minister Mahathir Mohamad of Malaysia stressed the need to avoid a new form of colonialism where “poor countries are unable to compete with rich countries”. Many saw this as a reference to China’s infrastructure investments. In January 2019, the International Monetary Fund (IMF) indicated its deepening concern over the build-up of opaque Chinese lending to developing countries, which made it difficult to gauge debt levels and the need for bailouts. Moreover, as China is not party to international debt management arrangements, there is no mechanism for it to play a part. Increasingly, countries are referring to China’s massive lending as debt-trap diplomacy.
CHINA’S EXPANDING FINANCIAL MIGHT
China’s route to becoming the world’s leading infrastructure financier is closely linked to its rapid economic rise. When leader Deng Xiaoping initiated China’s economic reforms in 1978, the country had foreign exchange reserves of a mere USD 2 billion. Mirroring China’s record-breaking growth, in 2014 its reserves peaked just shy of USD 4 trillion before pulling back to their current level of USD 3.2 trillion.
China’s unprecedented foreign reserves, by far the world’s largest, have transformed its financial capacity. When China first opened its economy, it was in dire need of foreign exchange. In 1980 it joined the IMF and the World Bank, and a few years later, the Asian Development Bank, and established special economic zones to attract foreign direct investment (FDI).
Four decades later the tables have been turned, and China has become a leading source of development finance and FDI. The shift was reflected in the rapid increase in lending by CDB and China Exim in the early 2000s. In 2007, China established its own sovereign wealth fund, the China Investment Corporation, with an initial injection of USD 200 billion from its foreign reserves. The fund is currently among the world’s largest. By 2014, China’s bilateral lending to emerging economies had outpaced that of the World Bank and other major multilateral financiers combined.
The expansion of bilateral lending was followed by the establishment of the New Development Bank or “BRICS bank” in 2014 and the China-driven Asian Infrastructure Investment Bank in 2015. While their lending volumes are still modest, the new banks mark a major shift in the financial power structure. Most significantly, in 2013, President Xi Jinping launched the Belt and Road Initiative (BRI), a massive program that is building infrastructure in over 70 countries, closely aligned with China’s interests. BRI financing comes from a variety of sources, including China’s policy banks, local governments and state-owned enterprises (SOEs). Some estimates place total planned financing at over USD 1 trillion.
In addition to supporting President Xi’s global ambitions, China is using overseas lending to upgrade its manufacturing technologies and export its excess production capacity. Having saturated the domestic market for high-speed trains, China is relying on BRI railway projects to get an edge over Japan in the international bullet-train market. During the 2008-2009 global financial crisis, China stimulated the economy with massive spending on construction. The subsequent slowdown has left China with excess capacity in cement, steel and glass production, which it is exporting through the BRI.
UPSIDES AND DOWNSIDES
China’s push to expand international lending has several upsides. Emerging economies around the world are facing a yawning infrastructure gap. There is enormous unmet demand for highways, railways, electricity and urban infrastructure. The competitive situation created by the BRI has encouraged bilateral and multilateral donors to spend more, and to streamline their procedures to make funds more accessible. Having numerous financiers increases the scope for joint financing, which can help to spread the risk inherent in large projects
However, the push to spend also has downsides. As a borrower, China has a solid track record. Its Ministry of Finance has clear policies and guidelines for external debt management, the terms of borrowing for different sectors, and project due diligence. The Ministry is meticulous in managing China’s loans from the Asian Development Bank, World Bank and others.
The same cannot be said of its role as a lender. China’s patchy track record can be attributed in part to its meteoric rise, which has not been matched by an increase in the capacity of its bankers and bureaucrats. More importantly, CDB, China Exim and other state-owned financiers are driven by the need to promote China’s geopolitical, strategic and economic interests. In this equation, borrowers’ interests take the back seat.
The conditions of China’s lending are opaque, and are not shared with other creditors. Interest rates tend to be high, and many loans are collateralized against energy or mineral resources. China is not party to international debt management arrangements such as the Paris Club, an informal group of 19 creditor nations that seek to find workable solutions to payment difficulties faced by debtor nations. As China’s lending has expanded, its lack of transparency has made it increasingly difficult for the IMF, World Bank and other creditors to assess the sustainability of borrowers’ debt.
China does not consider its concessional financing as development assistance, is not a member of the OECD Development Assistance Committee (DAC), and does not comply with DAC guidelines. Contracts under Chinese loans are not open for international tender and are almost always awarded to its own SOEs. Research by the Berlin-based Mercator Institute for China Studies notes that its loans pay scant attention to local conditions and country risk. Rather, they include strict provisions to safeguard China’s interests, as in the case of Sri Lanka, where a Chinese SOE took over ownership of the strategic port. As a result, debt sustainability is not high on the agenda.
DEBT PROBLEMS ABOUND
Controversies related to the sustainability of Chinese debt have flared up in many countries. Either the borrower could not handle the debt, or the infrastructure being financed did not justify the cost.
Pakistan is a case in point. The China-Pakistan economic corridor is by far the largest BRI venture, with financial commitments of about USD 62 billion for port, highway, railway and energy infrastructure. The corridor’s main purpose is to provide China with an alternative route for its energy imports from the Middle East. Pakistan’s extensive borrowing from China, however, has now pushed it to the brink of a balance-of-payments crisis. Bailout talks with the IMF have foundered, partly because the Fund cannot gauge the scope of Pakistan’s hidden liabilities. China has opposed a bailout, which would require Pakistan to reveal the terms of its lending. The United States, again, has indicated that it will not support a bailout that simply helps a borrower to pay off China.
The examples abound. Laos, with a population of only 6 million, has borrowed USD 6 billion, equivalent to 35 per cent of its GDP, for a Chinese high-speed railway project. The related machine imports have left the country with a massive trade deficit. Montenegro borrowed EUR 809 million, or 20 per cent of its GDP, for a highway project, and consequently had its credit rating downgraded by Moody’s. When Mahathir took over last year as Prime Minister of Malaysia, he quickly cancelled USD 22 billion in Chinese infrastructure contracts, because of what he called their “one-sided” conditions. And the former president of the Maldives has recently indicated that his country may need to follow Sri Lanka’s example and cede ownership to China of land used for unviable “vanity projects”.
HOW SHOULD COUNTRIES RESPOND?
How should the global community respond to China’s growing financial might?
First, borrowers should beware. Potential debtors should apply the same rigorous standards of due diligence to projects financed by China as they would to projects financed by the World Bank and other multilateral financiers. Projects are either well justified or not. The fact that China is offering massive supply-driven financing does not change project fundamentals. In fact, easy financing simply increases the risk of countries being enticed to borrow for unjustified projects.
Second, China should be encouraged to join well-established international debt management and aid coordination initiatives. When China was a minor creditor, this was a less pressing concern. Now that China is a major financier, the fact that it plays by a different rule book has serious implications for international debt management, multilateral lending and the aid programs of other donors. For economic surveillance to work, debt needs to be gauged correctly. In a financial crisis, it is essential that bailout mechanisms should work smoothly. Better still to avoid unsustainable debt in the first place. China should be encouraged to participate in the DAC, IMF and World Bank -led international debt-management mechanisms, and the work of the Paris Club.
Third, China’s rise as an international creditor highlights the continued importance of the rules-based multilateral financial system. The IMF, World Bank, regional development banks, OECD and DAC, supported by major donor governments, continue to set the standards for rules-based financing and provide the mechanisms to make it work. It is important that it should not be compromised. Nationalistic tendencies in several countries have recently helped to weaken the rules-based system. Now, if ever, is the time to ensure that the system remains firmly in place.
The upcoming IMF and World Bank spring meetings, in April, offer a forum to raise these concerns.