REASSESSING CHINA’S RISE

Debt-Trap Diplomacy?

Understanding the nature of China’s development finance sheds light on the intensely debated question of whether China has been practicing debt-trap diplomacy and intentionally lending to financially nonviable projects, thereby gaining political leverage over the borrower countries and increasing China’s global influence. It also sheds light on China’s commodity-backed loans, which are often seen as evidence of debt trapping. In such cases, policy banks would allow borrower countries to pay back loans with future revenues collected from the export of resources, such as oil, to Chinese importers; the importers would then make payments to an escrow account opened up at the policy banks.

This book has offered an analysis on the pros and cons of such a controversial financial practice. Some policy-bank loans have indeed generated debts that are difficult to repay, but debt-generated development finance has been the very means of finance by which China has funded its own growth over the past decades. In the 1990s, the China Development Bank (CDB) began to assist Chinese subnational governments in creating financial vehicles, transforming government organs into market borrowers that could hold debts. By collateralizing subnational governments’ future land and fiscal revenues, these financial vehicles borrowed from the policy banks, commercial banks, and various other Chinese financial agencies in order to capitalize infrastructure and industrial projects in their regions, speeding up urbanization and industrialization across China. The same financing mechanism has been replicated overseas. When lending to projects that cannot generate sufficient cash flow for repayment, policy banks would request that the host government offer sovereign guarantees or collateral such as export revenues. From the lenders’ perspective, the host government increased the creditworthiness of the projects and made them “bankable” by financializing state-owned or state-coordinated revenues. The CDB referred to this practice as zeng xin, or “credit enhancement.”

In fact, collateralized lending was not a financial instrument created by China. In the late 1970s, China received official development assistance from Japan to develop oil fields and in turn exported oil to Japan. In the 1980s and 1990s, Western private banks offered collateralized lending to oil-rich countries in Africa and Latin America before China entered these markets in the 2000s (see chapter 3 for more details). China adopted the financial practice from its industrial precursors and used it to fund its own projects. Yet the “stateness” of the Chinese political economy made China’s practice of collateralized lending controversial. Given that the banks and firms engaged in China’s overseas development finance are mostly state-owned, it is unclear whether collateralized lending is employed for a purely commercial purpose or somewhat associated with the state’s policy incentives.

While prevailing policy analyses and academic discussion perceive such lending as driven by the Chinese government’s geopolitical and foreign-policy agendas, this book has provided an alternative development rationale for China’s commodity-backed lending. As chapter 3 has illustrated, the process of implementing infrastructure and industrial projects is primarily undertaken by banks and firms and regulated by government ministries in charge of China’s trade and economic development. State organs such as the Ministry of Foreign Affairs play a relatively minor role because they do not have the resources and authority to affect the behaviors of banks and firms. As chapter 5 has demonstrated, infrastructure projects that are profit-generating or financially sustainable tend to be appealing to other financiers, namely multilateral financial institutions, export-import banks, and sometimes even commercial banks. Most governments that seek commodity-backed loans from China have failed to obtain an alternative. Like China in the 1980s, many developing countries today do not have strong fiscal capacity or full-fledged market institutions to fund projects essential for economic growth. Nor can they receive sufficient aid from Western donors or effectively appeal to private investors from the international capital market. China’s state-supported and market-based means of development finance offers an alternative option.

However, in practicing this peculiar means of development finance, policy banks are essentially allowing the public borrowers to go beyond their fiscal capacity to overspend. If not regulated cautiously, such a practice may drive up debts. In fact, this has happened to China’s municipal and provincial governments. Since the 2000s, China’s central government has conducted multiple rounds of regulation on local government financial vehicles (LGFVs), aiming to curb the subnational governments’ excessive borrowing from the market as well as the Chinese financial agencies’ excessive lending to LGFV projects without prudent assessment.

When resolving domestic debt issues, China has adopted a market-based approach: rescheduling, restructuring, and refinancing LGFV debts instead of bailing out LGFVs with tax revenue. The same approach has been applied to resolving overseas debt issues: policy banks have been quite hesitant to directly cancel debts owed by developing countries; instead, they have offered to suspend repayment and restructure debts. This approach to debt relief is a reflection of a market-based rationale that emerged and persisted since China’s Reform and Opening Up. As chapter 2 has demonstrated, one of the purposes of creating the policy banks was to have them resolve the nonperforming loan issue caused by imprudent state financing during China’s economic transition. Throughout their course of development, the policy banks have endeavored to decrease the nonperforming loan rate and maintain a financial balance without the state’s fiscal subsidization. To ask the policy banks to offer debt reduction or the Chinese government to bail out the defaulting loans would require China to reverse its efforts toward marketization.

China’s aversion to debt reduction is nothing peculiar, but it is quite reminiscent of the early postwar decades, when advanced industrial economies favored restructuring over forgiveness when dealing with developing-country sovereign debts. It was not until the late 1980s that the Paris Club creditors began to accept using “haircuts” as a major means of debt treatment, and since then they have offered limited bilateral export finance loans to low-income regions and instead provided official development assistance primarily. During the COVID-19 pandemic, China offered debt suspension under the Group of 20’s Debt Service Suspension Initiative (DSSI), but it has been reluctant to reduce principals of Chinese bank loans. While most Western-led official bilateral finance in the poorest countries consists of foreign assistance, most Chinese finance in those countries consists of policy-bank loans. Therefore, reducing debts would involve increasing the nonperforming loan rates of the policy banks, something they have tried to avoid since their establishment. China’s aversion to debt forgiveness has challenged the underlying rationale of the existing Western-led international sovereign debt regime, which has become receptive to debt forgiveness since the late 1980s. Yet it took Western creditors several decades to transition from restructuring to reduction. Despite China’s willingness to address global debt challenges collectively—through collaborative efforts such as cochairing Paris Club meetings and offering the largest amount of debt suspension under the DSSI—the point at which it will make a similar transition has not yet arrived.

“Belt and Road” versus “Build Back Better World”

Regardless of how China deals with debts, the country has become a major bilateral creditor to many developing countries, significantly challenging existing international orders led by the United States and other advanced industrial economies. In response to China’s state-led Belt and Road Initiative (BRI), the United States has launched the Build Back Better World (B3W) initiative, calling on Group of Seven countries and like-minded partners to collectively offer a market-based development prescription—the Partnership for Global Infrastructure and Investment—by mobilizing private investments to engage in projects in the developing world.

While emerging policy discussion highlights a competitive relationship between China and the United States in the issue area of development finance, this book has found the “rivalry” to be more rhetorical than real. First, China’s overseas development finance is not entirely state-led. The Chinese government has indeed provided support, for instance, by offering sovereign guarantees for policy banks’ bond issuance and incorporating certain projects into intergovernmental collaboration frameworks, thereby allowing firms to access more resources. But it has never “assigned” projects to the economic actors. The implementation of the BRI is highly contingent on the business pursuits of Chinese banks and firms.

Second, Chinese firms as well as the banks that lend to them favor projects that are quite different from those undertaken by their counterparts in advanced industrial economies. While policy banks support Chinese national champions in outbidding their international competitors for more profitable projects, they also assist Chinese firms in undertaking projects that their Western counterparts are not necessarily interested in pursuing. As chapter 4 has demonstrated, export credit agencies in countries of the Organization for Economic Cooperation and Development (OECD) finance high-income and upper-middle-income economies primarily; policy banks, on the other hand, finance the developing world mostly. This implies that Chinese firms and U.S. firms (as well as firms of other advanced industrial economies) do not have as many projects to compete for as political rhetoric may suggest, especially in low-income and lower-middle-income regions.

In fact, it has been quite difficult for advanced industrial economies to incentivize their firms to undertake projects in underdeveloped regions. In the postwar decades, Western-led development finance institutions and bilateral financial agencies have created private-sector windows in order to engage commercial investors in global development, and yet they have mobilized limited volumes of capital to fund underdeveloped regions. After all, private firms seek to maximize profits; all other conditions being equal, they will choose projects in countries with less economic and political risks. This partially explains why OECD-regulated PFAs that provide development assistance and those that provide commercially oriented export finance diverge drastically in terms of the geographical distributions of their businesses. For PFAs in advanced industrial economies, it is rather challenging to serve both the state’s development objectives and firms’ commercial interests, as the lending activities of the U.S. International Development Finance Corporation (DFC) reflect.

An American PFA established in 2019 to rival China’s growing influence in the developing world, the DFC was founded to support low-income and lower-middle-income countries by mobilizing private investments. However, it financed many projects in middle-income and even high-income countries (see chapter 4 for more details). This implies that if the United States were truly to rival China in development, competition would likely occur in the relatively better-off markets, because American private investors are less interested in competing for projects in low-income countries.

China, on the other hand, has financed development-oriented projects by supporting national firms’ overseas business. As this book has argued, this is an advantage of backwardness that Western economies do not have. Compared with firms in advanced industrial economies, firms in late-developed economies are more likely to undertake projects in developing countries and emerging markets, and they can often offer cheaper packages. Since World War II, Western economies have generally criticized the practice of mixing state-led development finance with firm-driven export finance because using government-subsidized development finance loans for a business purpose would violate laissez-faire principles. However, increasing domestic fiscal challenges and the rise of China caused the world’s leading industrial economies to make a 180-degree turn: they began to advocate for incorporating private firms and commercial investors into development cooperation and for mixing self-interest-driven business incentives with development objectives. The launch of B3W and similar initiatives led by advanced industrial economies and the (re)emergence of private-sector windows in Western-led international financial institutions reflect this shift. These “new” practices, however, have been associated with catch-up economies and Southern development partners, which need state-backed capital for implementing industrial policies. That is to say, the development finance practices of Southern and Northern development partners are converging more than distinct development recipes from China and the United States are competing.

The Future of China’s Global Development Finance

However, the policy banks’ state-supported, market-based means of development finance took shape as a prescription for late development. As China develops, it becomes unclear whether the banks can sustain this practice. I have argued in this book that it has become increasingly difficult for the policy banks to continue financing projects in their peculiar way—requesting host governments to offer state support of various forms to enhance projects’ creditworthiness, thereby making financially nonviable projects viable. This is not to say that policy banks cannot lend any more. They can still pursue lucrative commercial projects on the international market or perhaps receive more government subsidy to support the less profitable projects in underdeveloped regions. But it would be challenging for the policy banks to continue supporting financially nonviable projects without the Chinese government’s fiscal subsidy. In other words, China is losing its advantage of backwardness.

The loss of China’s backward advantage has three causes. First, to increase their profits, Chinese firms have begun to move up the industrial chain, becoming equity investors or project owners rather than sheer contractors or suppliers. Investing in equity shares requires that firms be more cautious in project selection because they need to calculate the costs and benefits of the projects and pay for the contractors and suppliers. Equity investors are therefore more likely to pursue profit-generating projects, which usually also appeal to commercial investors. When more Chinese firms start to pursue profit-generating projects, it is unclear whether policy banks should continue financing the less profitable projects in underdeveloped regions. Second and related to the first point, as Chinese firms advance, policy banks are no longer their financiers of last resort. Since the launch of the BRI, Chinese commercial banks have expanded their overseas business, competing with policy banks for promising projects. As a result, the policy banks’ business scope has been significantly squeezed. Third, a growing number of developing countries cannot repay loans owed to the policy banks, even with the collateral they promised to offer, which raises the question: Is the “Chinese pathway” truly leading to development or merely driving up debts? The COVID-19 pandemic has unquestionably exacerbated debt insolvency, but even if the pandemic has not happened, the policy banks might not have been able to successfully replicate the means of finance they practiced at home in an overseas context, as the political-economic institutions of the host countries may differ significantly from China’s.

These challenges call into question whether policy banks should continue lending to financially difficult projects backed by the host government’s credibility. It is also possible that they pursue a safer strategy and just lend to financially viable projects and have other institutions finance the difficult ones. Since around 2017, the Chinese government has increased its spending on foreign assistance, while the policy banks’ overseas lending volume has decreased drastically (see chapter 3 and 5 for more details). This implies that China can increasingly use government assistance instead of policy-bank loans to capitalize projects in low-income regions.

China’s policymakers are aware of the challenges facing policy banks. In fact, they have been discussing the issue of reregulating policy banks for over a decade. As chapters 1 and 2 illustrated, the state’s sovereign guarantee for policy banks’ bond issuance has allowed them to raise large volumes of funding from China’s interbank bond market, and the close relationship between subnational governments and the CDB has allowed the policy bank to dominate the domestic infrastructure-financing market. China’s commercial banks do not enjoy such state-granted privileges and therefore accused the policy banks, especially the CDB, of violating free-market principles. Policymakers thus have struggled between continuing to give the policy banks autonomy in practicing state-supported, market-based finance at home and abroad and withdrawing these privileges and turning them into regular commercial banks or policy-oriented institutions. The changing preferences of Chinese firms, the growing presence of Chinese commercial banks, and the increasing debt insolvency against the backdrop of the global pandemic have made reregulation more urgent than ever.

China’s policy banks are not the only PFAs facing these challenges. PFAs of advanced industrial economies have all struggled with reidentifying their roles in the national economy. Many of these semigovernmental, semicommercial banks were established at difficult times to achieve special objectives. For example, the U.S. Export-Import Bank was created in a major economic downturn to vitalize exports, and the national development banks of Germany and Japan were established in the immediate postwar years to facilitate economic recovery and industrial catch-up. Whether PFAs should continue to exist after these specific objectives were achieved remains under debate.

In the 1990s, there was a major policy discussion in Japan on the issue of “demarcation” (de-ma-ke)—that is, separating the policy-serving projects and business-serving projects of Japanese PFAs. While Japanese PFAs played significant roles in facilitating Japan’s postwar economic miracle, they found it increasingly difficult to serve the state’s development policy while supporting the business pursuits of national firms at the same time. As a result, Japan’s official aid agency and export credit agency, which used to have much business overlap in the early postwar decades, began to finance starkly different types of projects.

Meanwhile, a similar policy discussion is going on in China. Fully aware of how PFAs of advanced industrial economies operate, China’s policymakers have made plans to separate the account management of the banks’ policy-oriented projects and business-oriented projects. The central government’s fiscal revenue is likely to partially subsidize the former. Demarcation, after all, is the way most OECD countries regulate their PFAs. Though details of the most recent round of reregulation have not been released, current policy discussion has indicated that the way China manages development finance will become more akin to that of its Western counterparts.

At the same time, China’s government assistance has become less mercantilist. China established the China International Development Cooperation Agency (CIDCA) in 2018 to coordinate foreign aid, which in the past was primarily coordinated by the Ministry of Commerce and tied to the business interests of Chinese firms. During the COVID-19 pandemic, CIDCA was assigned a president from the Ministry of Foreign Affairs, and it provided humanitarian aid to a few countries suffering from the pandemic. At the Global Health Summit in May 2021, China’s president Xi Jinping pledged US$3 billion in international aid over the next three years to support COVID-19 responses and economic and social recovery in other developing countries.¹ In 2022, Xi hosted a high-level dialogue on global development with leaders of developing countries, pledging to increase CIDCA’s South–South Cooperation Fund by US$1 billion.² All of this evidence suggests that China’s development assistance may be employed to better serve the country’s foreign policy instead of its trade agenda.

These changes have both a positive and negative impact on developing countries that seek to borrow from China. On the positive side, government foreign assistance such as grants and interest-free loans are much more concessional than policy-bank loans. Substituting policy-bank loans with government assistance or subsidizing policy-bank loans with fiscal revenue would reduce borrowing countries’ pressure for repayment. Yet the amount of government revenue a country can “donate” to other countries is quite limited. The experience of traditional OECD donors in the postwar decades has already shown that simply relying on government revenue to finance development-oriented projects is a fiscal burden for donors and will not sufficiently cover the infrastructure gap in underdeveloped regions. If policy banks, China’s main financiers, slow down their lending to developing countries, the amount of loans these countries could receive from China would drastically decline, despite growing foreign assistance from the Chinese government.

In September 2021, President Xi gave a speech at the United Nations General Assembly, proposing the Global Development Initiative that would offer debt suspension and development aid to countries facing exceptional difficulties in the pandemic era.³ Since then, official statements have repeatedly highlighted the initiative. The initiative reflects China’s determination to continue contributing to global development and yet also raises the question of who would capitalize these financial offers. Since the turn of the century, the policy banks have served as the primary financiers of China’s overseas infrastructure and industrial projects, globalizing a “Chinese pathway” alongside the international expansion of national firms and capitalizing underdeveloped regions without relying much on China’s tax revenue. As this book has underscored, the banks’ peculiar means of development finance is associated with the lateness of China’s development. Even if the Chinese government intends to continue supporting global development, the ongoing changes to the policy banks imply that they are unlikely to finance as massively and rapidly as they did before the global pandemic.

Years ago, I asked a Chinese bank official what differentiates China’s development finance from that of the West. He answered with a metaphor: a first-year undergraduate student is better placed to help high school students prepare for the college entrance exam than I would be as a doctoral student. Yet China is transitioning away from the position of a “first-year undergraduate student” who just took the “development” exam and is facing increasingly greater challenges in continuing to practice its peculiar means of finance associated with its late development. This leads to a crucial question for further discussion: As China loses its backward advantage, will there be another rising latecomer to capitalize the global infrastructure gap?