Source: China Investment
Undoubtedly, 2014 was a year of great energy and determination for Chinese diplomacy. The country’s economic investments attracted a lot of international attention, and Beijing is poised to continue leaving its mark. China unveiled its new outward economic strategy and a new set of complementary financial institutions that will support it. The BRICS Development Bank was officially established in July, and three months later the foundations were laid for the Asian Infrastructure Investment Bank (AIIB). Then in November, China announced that it was establishing the Silk Road Fund.
This rapid sequence of events has been overwhelming in scale for observers around the world. These new financial institutions have emerged at a critical juncture for China’s outward development strategy. They will foster greater interconnectedness in Asia. In the process, they will support the overseas ventures of Chinese enterprises by providing more investment opportunities as well as larger-scale, more diverse funding channels.
The Importance of Overseas Infrastructure Investment
A key similarity between the BRICS Development Bank, the AIIB, and the Silk Road Fund is a common focus on cross-border investment in basic infrastructure. These newly established institutions will focus investment efforts on countries along the route of China’s One Belt and One Road initiative and other developing countries where growth is restricted by the limitations of existing infrastructure. These economic institutions will encourage and assist infrastructural development in these countries’ transportation, shipping, communication, and electricity sectors. They will increase linkages between China and these countries, will enhance interconnectivity in Asia, and will also promote regional economic integration. At the same time, this investment activity will deepen cooperation among financial institutions in China and countries along the One Belt and One Road route.According to Asian Development Bank projections, Asian countries will require an average of $730 billion dollars each year in infrastructural investment over the next decade. India alone will need $1 trillion dollars over the next five years to upgrade its infrastructure. Neither local governments nor private investors can come close to meeting these astronomical costs. Moreover, overseas private investors rarely invest in overseas infrastructure projects due to their complex, risky nature, limited capacity to manage such risk, and long investment cycles. Potential pitfalls include currency hedging, policy risks involving contracts or government requisitions, and political ones such as coups, social movements, and inter- or intra-state wars.
Consequently, multilateral institutions and bilateral agreements are the primary sources of funding for overseas infrastructure. However, such development projects face a number of geographic, political, and social challenges in terms of meeting environmental standards, protecting property rights, and the manner in which the construction work itself is performed. As a result, organizations that provide infrastructure investment operate conservatively and cautiously.
International environmental standards are constantly becoming stricter. At the same time, the UN has adjusted its definition of development to focus more on broader social objectives and less on economic growth alone. Overall, infrastructural funding from bilateral and multilateral development assistance programs has been on the decline. Not only is there a growing shortage of domestic funding for infrastructure in developing countries, but international sources of finance are also falling each year. The end result is not only that developing countries face barriers to economic growth, but also that regional economic connectivity is blocked. Countries therefore miss out on the benefits and opportunities of shared development, because they are unable to fully utilize their natural resources or play to their comparative advantages.
Beijing has confidence in its commitment to Asia’s infrastructural development, and the world is watching expectantly to see how China will fare. The Chinese government’s large-scale investments in domestic infrastructure and fixed assets have been an important part of the country’s own developmental experience. Over the long term, assisting other developing countries with building infrastructure has been a distinctive feature of Chinese economic aid in practice. All of this indicates the central importance of such overseas investment, which is reflected in China’s efforts to establish the BRICS Development Bank, the AIIB, and the Silk Road Fund.
The Orientation and Structure of Emerging Financial Institutions
Before these institutions were established, the most important actors for implementing China’s overseas development assistance programs and outward economic and trade policies were the China Exim Bank (also called the Export-Import Bank of China), the China Development Bank (CDB), and funds that these two banks established.
While the China Exim Bank and the CDB are outward-focused financial institutions, they are also China’s policy-oriented banks and therefore involved in a wide range of domestic and international responsibilities. As a result, overseas infrastructure investment accounts for only a small portion of the services and loans that these banks provide.
The CDB was established in 1994 and became a publically traded company in 2008, at which point the Ministry of Finance and an investment company called Central Huijin became its primary shareholders. The CDB primarily invests in regions, industries, and economic sectors that are relevant to China’s national development strategy. This includes large-scale national construction projects, basic industries, and economic development in western China, as well as efforts to upgrade and reform old industrial bases.
The China Exim Bank, which was also established in 1994, is directly overseen by the State Council. It coordinates the implementation of China’s international trade policy and its diplomatic strategies. It also encourages and supports Chinese firms in their ventures abroad, by helping them export more products, equipment, and technology. In terms of overseas investment in infrastructure, the China Exim Bank primarily promotes and aids Chinese enterprises in their efforts to secure bids on contracted construction projects outside of China. Meanwhile, the Exim Bank is responsible for issuing preferential loans to developing countries as a bilateral component of China’s overseas development aid agenda. By contrast, the loans that will be provided by the BRICS Development Bank and the AIIB are to be multilateral arrangements that reflect the nature of these new institutions.
After all, the BRICS Development Bank, the AIIB, and the Silk Road Fund are all multilateral and international financial institutions. Apart from their focus on investment in infrastructure, these organizations are similar to existing ones in terms of their organizational and operational structure. Their loans largely will be directed toward other developing countries rather than toward China.
The BRICS Development Bank is a global institution. The relationship between the BRICS Development Bank and the BRICS organization resembles that between the World Bank and the United Nations, the latter as a specialized branch of the former, although by comparison the BRICS Bank is currently much smaller in scale. Unlike its WB counterpart, however, the BRICS Development Bank aims to dedicate itself especially to the infrastructural aspects of global development.
Meanwhile, the AIIB is a regional, multilateral institution for development assistance. It will join the ranks of similar lending organizations that already exist, such as the Asian Development Bank, the African Development Bank, the Inter-American Development Bank, the Caribbean Development Bank, etc. The AIIB’s organizational structure and operational methods will be very similar to those of other regional development banks. Like the AIIB, these other banks all provide member states with preferential loans for building infrastructure. But among them, only the AIIB will specialize in this area.
Aside from their focus on infrastructure, both the BRICS Development Bank and the AIIB will mirror existing multilateral counterparts in their institutional arrangement and operational methods. Both banks will employ people from around the world. The institutions’ highest bodies of authority will be their boards of governors, and their executive governors will be their highest-level decisionmakers. These bodies will include one person—typically incumbent finance ministers—that are appointed by each member state. The councils of executive directors at both banks are authorized to oversee everyday policy decisions.
In general, multilateral financial institutions determine member states’ voting rights based on the amount of capital that each country has pledged to contribute. Some regional banks, however, have stipulated that member states within the respective region must collectively hold over half of the voting seats. The African Development Bank and the AIIB both operate in this way.
Such multilateral banks provide developing countries with financial assistance through loans, grants, and debt relief. Project loans are issued for infrastructure construction and social programs designed to improve sanitation, health, education, and so on. Policy loans, by contrast, are designed to provide budgetary support to borrowing countries or to encourage them to carry out policy reforms, in areas such as agriculture. It is becoming increasingly common for development banks to provide policy loans, breaking the traditional practice of leaving this type of financing for the International Monetary Fund to handle.
These multilateral institutions generally issue loans through one of two funds—also called lending windows. The first one consists of non-preferential loans at market interest rates. It also provides member states with fiscal support in the form of equity shares and loan guarantees. This type of loan is mostly provided to private enterprises in both developing countries and middle-income countries. The second lending window gives low-income countries loans or grants on preferential lending terms.
Profits generated by the first lending window are used to pay the bank’s daily operation costs, while any surplus funds are employed to finance loans through the second lending window
The loans offered by development banks are funded by equity investments and bonds that they issue in international capital markets as well as the capital contributed by their member states. Such multilateral financial institutions can borrow funds from international capital markets at comparatively low interest rates because their credit ratings are higher than those of any individual member state. The fact that multiple countries are involved acts as a collective guarantee of sorts for the loan.
In fact, the amount of capital that member countries actually give to the banks is only a small portion of what they pledge to contribute. (The AIIB, for example, will hold 20 percent of the funds that its members pledge, while the comparable rate for some development banks is as low as 5 percent). Pledged contributions that member countries have not yet been turned over to the banks are known as callable capital. Members only deliver these funds if the bank faces bankruptcy or if issues of liquidity rise. Callable capital is not put toward the loans or grants that banks issue.
The Silk Road Fund is an inclusive governmental multilateral cooperation fund, which was initially financed by China’s foreign currency reserves. It is not controlled by the BRICS Development Bank or the AIIB. The Silk Road Fund essentially could be characterized as a sovereign wealth fund, but such entities rarely make large policy-oriented investments in infrastructure. Yet the Silk Road Fund was established for the purpose of making China’s One Belt and One Road strategy a reality by fostering regional interconnectedness.
Because the Silk Road Fund’s resources will be directed toward overseas infrastructure investment, some people assert that it is more like an industrial fund and cannot be considered a sovereign wealth fund. However, regardless of which model it resembles more closely, the Silk Road Fund differs from the BRICS Development Bank, the AIIB, and other international development banks. More so than similar institutions, the Silk Road Fund must stress the rate of return on its investments, while also being more commercial, corporate, and market-focused in its outlook. And yet it has been determined that the Silk Road Fund will be directed toward investment in basic infrastructure. At this point, it remains unclear how the fund will balance its political, social, and economic interests.
Future Investments: Risks and Institutional Safeguards
During its eighth meeting, the Chinese Community Party’s Leading Group for Financial and Economic Affairs decided that the One Belt and One Road initiative should help connect the transportation, electricity, and communications networks of countries along its route. According to analysts familiar with its planning, One Belt and One Road will involve prioritizing infrastructure investment for land routes over maritime routes, railways over ports, and geographic locations closer to China over those that are farther away.
The first projects to be launched will probably be high-speed railways between China and countries in South Asia, Southeast Asia, and Central Asia. The plan also gives priority to railway and road construction projects to connect China with countries such as Pakistan, Bangladesh, Myanmar, Cambodia, Mongolia, and Tajikistan. As a result, the domestic transportation and shipping industries in these countries will be the first ones to benefit from One Belt and One Road. By the same token, domestic firms in the transportation, shipping, and construction materials sectors are expected to perform well in the stock market.
Because the AIIB and the Silk Road Fund have adopted open financing policies, enterprises investing in overseas infrastructure projects will enjoy preferential terms and other incentives. As construction progresses on the One Belt and One Road’s building projects and regional infrastructure gradually improves, these two institutions will begin to shift their investments toward overseas shipping and logistics, energy development, and the production and processing of primary agricultural goods.
On the whole, China’s strategy to establish these multilateral financial institutions is a bold move to tackle Asia’s development challenges by providing infrastructure investment for countries throughout the region. This type of high-risk overseas venture requires institutions that are capable of reducing uncertainty and safeguarding investments. Sovereign wealth funds and private investors will only join these efforts if these favorable conditions are established first.
Aided by China’s leadership and regional cooperation, the BRICS Development Bank, the AIIB, and the Silk Road Fund have important tasks ahead: lowering investment risks, encouraging and safeguarding diverse channels of capital for infrastructure, and achieving regional interconnectedness. Speaking strictly in terms of their modest capital assets, these new models for international finance may be limited in what they can accomplish. Whether these institutions can meet expectations will depend on their ability to mitigate investment risk, reduce uncertainty, and attract more diversified funding for overseas infrastructure projects.
This article was originally published in Chinese by China Investment.