The Endangered Asian Century
America, China, and the Perils of Confrontation
Scholars and pundits in the West have become increasingly alarmed that China’s planned Belt and Road Initiative (B&R) could further shift the global strategic landscape in Beijing’s favor, with infrastructure lending as its primary lever for global influence. The planned network of infrastructure project—financed by China’s bilateral lenders, the China Development Bank (CDB) and the Export-Import Bank of China (CEXIM), along with the newly formed and multilateral Asian Infrastructure Investment Bank—is historically unprecedented in scope. But the B&R is only the natural progression of a global sea change in developing economy infrastructure finance that has already been under way for more than two decades.
The truth is that the West long ago ceded leadership in this area to China, a phenomenon that was largely driven not by foreign policy but by domestic infrastructure policy. The same factors that keep large infrastructure projects from getting off the ground in the United States and Europe make Western-sponsored projects in developing countries less viable than their Chinese counterparts.
China’s approach to infrastructure abroad mirrors its approach at home. Projects are evaluated more on their impact than on the specific viability of the project in question. The Chinese tend to overvalue the beneficial economic spillover effects of infrastructure projects, while undervaluing the potential harms, whether economic, social, or environmental. The Western approach, by contrast, is more transactional and focuses on painstaking due diligence concerning the economic, social, and environmental consequences of a given project. These safeguards are in the interests of ordinary people in developing countries. But Western institutions have become so risk averse that the cost and time to implement such projects have skyrocketed. Western governments and the multilateral institutions over which they exert influence, such as the World Bank, must consider making their safeguarding process more flexible if they are not to leave the field open to Chinese monopoly.
Over the past two decades, Chinese construction firms have risen from relative obscurity to dominance over the international infrastructure industry. As part of Beijing’s “Go Out” policy to encourage overseas investment, these companies’ projects were almost exclusively financed by Chinese state-backed bilateral lenders, which have grown from around a quarter of the development lending industry in 2002 (measured in total assets) to more than three-quarters of it by 2016. That same year, the total assets of the CDB and CEXIM had swelled to around three and a half times the combined assets of six major international and regional development banks: the International Bank for Reconstruction and Development, the European Bank for Reconstruction and Development, the Asian Development Bank, the African Development Bank, the Inter-American Development Bank, and the International Finance Corporation.
In explaining what drives this trend, Western observers have often pointed to three advantages that China has over the West in infrastructure: first, an authoritarian state that does not need to heed stakeholders; second, a Chinese foreign policy strategy to build influence through infrastructure loans; and third, a domestic industrial policy to support Chinese construction firms.
U.S. development institutions have been hamstrung by domestic political challenges from both the right and the left over the last two decades, with conservatives criticizing them as engaging in wasteful spending or corporate welfare and liberals criticizing their investment decisions as not accounting adequately for environmental or social concerns.
Though these are certainly all contributing factors, they fall short in explaining just how comprehensively China is succeeding in this realm. While the growth in China’s policy bank lending was initially concentrated in other authoritarian states such as Venezuela or Ethiopia, today Chinese institutions also finance projects in democratic countries, such as the road network they are creating in the Balkans and eastern Europe. Beijing may seek to use infrastructure to gain foreign influence, but the impact of such diplomacy is often overstated—prospective loans are enticing for borrowers, but projects, once built, provide little ongoing leverage. While elites may be swayed in the short run, many Chinese projects deeply alienate local populations, leading eventually to backlash. This has already occurred in Argentina, Myanmar, and Sri Lanka, where deals concluded with authoritarian or populist leaders have helped discredit both those leaders and the Chinese.
A better explanation of growing Chinese dominance in global infrastructure is the fact that Chinese firms and lenders simply approach infrastructure development in a fundamentally different way from their counterparts in the West, both at home and abroad.
THE INCREASINGLY RISK-AVERSE WESTERN APPROACH
Today Western development institutions suffer the burden of their past—an era in which they were literally the only banks in town for host nation borrowers. Potential projects have always been assessed to ensure that their aggregate benefits outweigh their costs in economic terms and to ensure that loans will actually be repaid. Beginning in the late 1980s, this calculus began to include the environmental, safety, social, and other costs beyond narrow financial ones—what economists call “negative externalities.”
Accounting for negative externalities through the application of rigorous safeguards is critical if an infrastructure project is to be of net benefit to society. But these costs must be weighed against the gains projects produce in terms of reliable electricity, clean water, jobs, and overall economic growth. In the West, the appropriate level of safeguards has changed over time. Led by the World Bank, Western lending institutions gradually developed ever more burdensome requirements for borrowers. Throughout the 1990s and early 2000s, the World Bank increasingly required borrowers to meet its environmental assessment standards, in effect “exporting” these standards from its donor nations to borrowers. The increasingly stringent reviews further generated an industry of Western nongovernmental organizations that lobbied to advocate for the cancellation of or changes to potential World Bank projects.
These initiatives had a measurable effect on the World Bank’s lending programs. In real terms, lending commitments from the International Bank for Reconstruction and Development arm of the World Bank declined from an annual average of more than $25 billion in the 1980s and 1990s to $16.6 billion between 2000 and 2009. This drop was driven by excessively rigorous and demanding fiduciary and social/environmental safeguards attached to World Bank projects, which slowed down bank lending and increased its effective costs to borrowers.
Thus, the world’s largest development institution began its exit from the business of infrastructure lending, and this coincided with the emergence of China’s policy banks in the industry.
Following a 2010 internal review, the World Bank worked to implement reforms to its safeguards programs and increase its lending to infrastructure projects. The environmental policy reforms, though, have become a bit of a metaphor for the institution’s difficulties in implementing new initiatives. Its new Environmental and Social Framework has spent more than six years in development, for what is effectively a review of the review policies. The framework is slated to be launched in practice sometime in 2018.
Many of the lessons from the World Bank also apply to bilateral lending programs from the United States. U.S. development institutions have been hamstrung by domestic political challenges from both the right and the left over the last two decades, with conservatives criticizing them as engaging in wasteful spending or corporate welfare and liberals criticizing their investment decisions as not accounting adequately for environmental or social concerns. The charters for both the Overseas Private Investment Corporation and the Export-Import Bank of the United States briefly expired in 2015 owing to Republican opposition in Congress, and both institutions have recently faced lawsuits from U.S. environmental groups over their financing of some fossil fuel projects internationally.
The most recent example of a more coordinated U.S. approach was the Power Africa initiative under the Obama administration in 2013. As of late 2017, it appears that much of the allocations provided were simply reprogrammed from their existing authorizations. The Congressional Budget Office concluded that the Electrify Africa Act would actually result in a net savings to the U.S. government. Thus, the president’s signature program appears to have received zero dollars of net new funding, in contrast to the $60 billion to $70 billion in new lending that China has poured into sub-Saharan Africa over the past decade.
A BETTER MODEL FROM THE EAST?
Is the newly dominant Chinese model a better approach to infrastructure development, for host nation borrowers or even China, for that matter? Here, the emerging track record of China’s policy banks is beginning to materialize. But it is falling short on virtually every possible metric.
For decades, China has invested heavily in domestic infrastructure, but it has recently become an unsustainable share of the Chinese economy. By 2016, China’s gross fixed capital formation, a measure of total investment in physical assets, was more than 45 percent of GDP. This domestic build-out coincided with a dramatic increase in local Chinese debt, and China’s national government spent much of 2014 and 2015 trying to rein in the problem, eventually requiring domestic banks to refinance local government debts at “negotiated” interest rates in return for sovereign guarantees, which, while successful in averting a crisis, effectively transferred the bad debts of China’s local governments onto the national books.
This experience informs an understanding of China’s lending abroad, with a few critical caveats. The first is that the counterparties receiving China’s investments abroad are not local provinces. They are sovereign nations. If bad debt piles up abroad, the Chinese government will have fewer tools to work out a solution. The second is that for projects abroad, China doesn’t necessarily capture all of the beneficial economic externalities created by infrastructure development, as it does for domestic projects. Instead, abroad Chinese firms must compete with their hosts to capture them.
Western observers have accused China’s policy banks of using “debt trap diplomacy” for miring, say, Venezuela with more than $60 billion in infrastructure loans or Sri Lanka with more than $8 billion for projects that proved economically unviable. But this does not account for the fact that China’s policy banks are clearly losing an incredible amount of money in both places. A cursory review indicates that the world is littered with China-financed infrastructure that cannot possibly be performing well financially. This means that the loans that financed them are either nonperforming or, in the case of sovereign guarantees by host nations, a burden for borrowers. It would seem, then, that a country such as Venezuela has exploited China rather than the other way around.
China’s policy bank lending programs are relatively young, but signs of distress are already emerging in aggregate, especially for CEXIM, which lends exclusively internationally, while the CDB targets 70 percent of its lending to projects in China. CEXIM’s reported loan impairments were negligible in 2008 but jumped to more than $5 billion per year in 2015 and 2016. In 2015, China’s Ministry of Finance made a cash infusion of more than $90 billion split roughly evenly between the CDB and CEXIM. The ministry reported that the CDB’s capital adequacy ratio, a measure of bank solvency, just prior to the injection was under 9 percent, while it was only 2.26 percent at CEXIM.
Is the newly dominant Chinese model a better approach to infrastructure development, for host nation borrowers or even China, for that matter?
Loans by China’s policy banks generally incorporate a lack of transparency as a feature; the vast majority of their projects have been implemented via a direct negotiation. Often it is unclear what the terms and requirements of the loans actually are—and, most important, whether they come with sovereign guarantees or are “nonrecourse,” which would mean the loan is secured only by the project itself, and the lender would be on the hook if it defaults. This ambiguity renders it difficult for host nations to even quantify the extent of their indebtedness and possibly for China’s policy banks to accurately assess their risk-weighted liabilities.
If the actual objective of China’s lending programs is to build influence internationally, it has arguably been largely ineffective on that front as well. Today many of the nations that are the largest recipients of Chinese lending have the poorest bilateral relations with China, not the best. High levels of Chinese investment in Sri Lanka provide the starkest example, as local agencies mired in debt have generated a substantial backlash. With the notable exception of Pakistan, nations in South Asia that are among the largest recipients of Chinese Belt and Road lending have shifted to realign strategically with India, Japan, or the United States.
A BETTER MODEL FROM THE WEST
Western lending institutions should do more than simply wait for China’s lending programs to run their course. Multilateral infrastructure lending institutions must be restructured to account for the fact that they are no longer the only viable alternative for borrowers. The next iteration of Western development lending should promote transparent, competitive procurement and nonrecourse financing without hidden sovereign guarantees, but without imposing overly onerous requirements on host nations eager to move their projects forward. The alternative to their participation may be the very same project but without the safeguards and analysis that those institutions are trying to promote. The onus of enforcing those requirements simply must be on the host nations themselves. In order to actively move projects forward abroad, Western lending institutions must be protected from politics at home.
This would not necessitate a “race to the bottom” by development institutions for infrastructure. Today Western development institutions are hamstrung to the point at which they can no longer further the goals for which they were created. China is simply filling the gap.