China’s Silk Road Financial Diplomacy Takes Shape

By George Magnus, Independent Economist and Commentator

Controversy has raged over a bank. The bank in question is the Asian Infrastructure Investment Bank (AIIB) in which China has strong financial and political interests. In March, the UK’s decision to become a founder member was made reportedly against the advice of the country’s foreign-policy establishment, and to China’s evident surprise and America’s chagrin. Countries that had previously stood shoulder to shoulder with the US and the UK, such as Australia, South Korea, Germany, France and Italy, followed the UK’s example. Japan may join later, leaving the US as the only major country not to be an actual or potential participant. The controversy over the AIIB is not a minor or esoteric matter.

The AIIB, which is a part of China’s new global financial diplomacy, is expected to be up and running by the end of the year, and promises to open up new business opportunities for banks and private providers of capital. Yet it is also a lightning rod for fundamental questions about the nature of the institutions and rules that will govern economic and political relations in the future, and in whose interests they will be framed. More broadly, it is a sort of weathervane from which we might learn if the world’s economic and financial system, fashioned by the US after 1945, can accommodate a rising China as well as other new regional powers, or whether it will succumb to fragmentation and nationalistic competition. 

China’s growing global footprint 

There is no question that China’s growing economic mass is giving it weight and significance in the global system. In politics, tensions, especially in Asia, are never far from the surface. Maritime and territorial issues with Japan, Vietnam and other countries in the East and South China seas ebb and flow. Relations with India are cordial, and the two Asian giants cooperate commercially, but there are simmering disputes over contiguous territory, water access and the so-called “string of pearls”—that is, the network of Chinese military and commercial facilities from mainland China to the east coast of Africa. China’s naval strategy, moreover, is the subject of ever-greater scrutiny by the US and Japan. 

In trade and investment matters, both China and the US are attempting to forge agreements with Asian countries that exclude one another in an attempt to build strategic alliances. The US is trying to pursue its interests through the Trans-Pacific Strategic Economic Partnership (free-trade) Agreement, while China’s focus is partly on the more modest Free Trade Area of the Asia-Pacific but also on the more ambitious “One Belt, One Road” strategy. This is a contemporary version of the old Silk Road, comprising financial and investment initiatives to spur economic and infrastructure development in the land mass between Western China and Western Asia, as well as in countries with South China Sea and Indian Ocean coasts.

China is well known as the world’s biggest export nation, but its finance and investment activities have been rather more opaque. Until relatively recently, China’s principal objective was to secure access to foreign markets and commodity resources, based on bilateral loans and foreign direct investment (FDI) flows. It has become the biggest provider of FDI to Sub-Saharan Africa, and an important provider of finance and investment capital to other emerging and developing nations in Asia, Latin America and Europe, including Sri Lanka, Pakistan, Myanmar, Venezuela, Argentina, Ecuador and Ukraine. Some of these commercial relationships have not been successful or have not worked out as planned, and China’s own economic and political needs and aspirations are different from a decade or more ago. China’s financial relations with the world, therefore, are changing.

Capital on the move, with caveats 

For some time, China has been of two minds about the relentless accrual of foreign-exchange reserves, now totaling almost $4 trillion. Some in China see the reserves as a symbol of success that should not be touched, while others see it as something that grates, given that the bulk is invested in financial assets denominated in US dollars, and that there are other more deserving causes for investment at home or overseas. China’s capital exports to the rest of the world, therefore, are increasing through FDI, and, to the extent it is politically possible, China is endeavouring to open its capital account to more inward and outward flows.

In 2014, Chinese outward FDI exceeded inward flows for the first time. Europe and the US have figured prominently in the rising volume of overseas acquisitions undertaken by China Investment Corporation, the sovereign wealth fund, and by Chinese companies. These have focused a lot on purchases of real estate and of investments in companies and infrastructure facilities. Between 2004 and 2013, the value of Chinese FDI worldwide rose from $45 billion to more than $600 billion. Excluding Chinese investment in Asian offshore financial centres, such as Hong Kong and Singapore, Asia accounted for the largest share of FDI (31 percent), while the EU accounted for 23 percent and the US 16 percent. In 2014, the UK received about $5 billion of Chinese FDI, the largest proportion of the $18 billion invested in the EU.

Meanwhile, the government has continued to emphasise a 20-year-old commitment to capital-account liberalisation, now a key element of economic reform. Investment quotas for existing capital-transaction schemes have been increased, and new channels of inward renminbi (RMB) portfolio investment have been introduced, including the Shanghai-Hong Kong Stock Connect scheme, linking the two stock exchanges. In 2013, the Shanghai Free-Trade Zone (SFTZ) was set up, and there are plans to extend free-trade zones to Guangdong, Tianjin and Fujian. Agreements have been drawn up to expand RMB use for currency trading and trade settlement from Hong Kong to Singapore, London and Frankfurt.

Notwithstanding ambitious proposals for financial reform and liberalisation, there are three reasons we should expect progress to be slow or limited.  

First, implementing liberalisation is less difficult than it might appear in a system in which markets are seen not as mechanisms for clearing and allocation but as ways of strengthening the functional primacy and control of the state and state institutions. The SFTZ is a good example of a seemingly radical model to open China’s capital regime, but one in which political patronage and privilege have had more sway than market prices, transparent regulations and the trusted legal system that is valued by private-sector entities.

Second, it is important to distinguish expanded international usage of the RMB from its development as a global currency. The former, which is proceeding quite quickly, provides for greater use in currency trading, trade invoicing and settlement, and limited types of capital transactions. The latter is about the development of deep, transparent, freely accessible, trusted and tradable capital markets, but China has neither the capacity at present nor the will to open up to this extent. There are proposals afoot to include the RMB in the International Monetary Fund’s (IMF) accounting unit, known as SDRs or special drawing rights, but full convertibility of the RMB and open markets are not expected any time soon, and may possibly be a bridge too far politically.

Third, the goal of opening up capital-account transactions does not sit well at the moment with other policy priorities, notably that of dampening down excessive credit creation. If the government were to press ahead too quickly with the reforms of capital-account and financial policies, including greater freedom for Chinese residents to send money abroad, there could be grave consequences for China’s credit system and financial stability. It is probable that the programme of liberalisation will proceed, therefore, slowly and with caution. 

Silk Road financial diplomacy leads the way 

Even though fuller capital-account liberalisation, if embraced, might strengthen China’s global financial clout, Beijing can and will press its claims in other and more effective ways, too. This is especially so given that it is losing patience with the prospect of serious global financial reform happening any time soon. A 2010 proposal to change voting rights at the IMF in favour of China and other major emerging countries, recognising their greater weight in the world, stalled in the US Congress, and it is still there. The BRICS countries account for about a fifth to a quarter of global GDP but only about 11 percent of voting rights at the IMF. Belgium’s vote carries more weight than Brazil’s, while Switzerland’s is bigger than South Korea’s. The issue of IMF voting rights, though, is just the tip of the iceberg. For China, the world’s financial system was shaped by the interests of the US and the West—and it is time to change it, or move on.

Some see China’s current financial diplomacy initiatives, therefore, as the moment when China, tiring of a Western-dominated system, has the financial resources, economic mass and power to press ahead in building a modern version of the old Silk Road trading routes that once linked Western China via Central Asia to the Middle East and eventually to Venice. China is already a member of the Shanghai Cooperation Organisation, which also comprises Kazakhstan, Kyrgyzstan, Russia, Tajikistan and Uzbekistan and includes India, Iran, Pakistan and Afghanistan as observers. The logic for bolting on to this comprehensive economic-development strategy, therefore, seems compelling. The basic idea is to link China’s poorer western provinces with Central Asia and then on to the Mediterranean, but also to incorporate key Asian corridors such as the Mekong River, the China-Pakistan border and the territory around the borders of China, India, Bangladesh and Myanmar.

There are three components to China’s Silk Road financial diplomacy.

First, in a challenge to the World Bank and IMF, it backed the Indian proposal to create the New Development Bank, known originally as the BRICS Development Bank, and the Contingency Reserve Arrangement, a facility to pool liquidity and make it available to member countries, and possibly others, in an emergency. The BRICS countries are equal shareholders. Quite what this new bank will accomplish remains to be seen. BRICS is an acronym rather than a coherent group of countries with a purpose. The bank will probably raise capital and distribute loans in US dollars, and, like the IMF, it will doubtless impose conditions on loans. These arrangements certainly have symbolic value, but the bigger efforts China is sponsoring lie elsewhere.

Second, in a challenge to the Asian Development Bank, a Bretton Woods-type financial institution founded in 1966, China has proposed to provide half the AIIB’s probable $100 billion of capital. In the ADB, the US and Japan hold over 30 percent of the voting rights, compared to about 6.4 percent each for China and India. As of the end of March, the AIIB had 31 emerging and developing Asian and 13 non-Asian members, and it is envisaged that the bank could be up and running by the end of 2015. The AIIB may even herald something of a breakthrough in lending denominated in SDRs if the RMB becomes part of the unit later this year. This would certainly fit in with China’s demand for finance to become less US-dollar-centric. In any event, new commercial opportunities, for example, in exports, construction, business and professional services are set to flow from an institution that looks poised to shape the Asian financial system and the region’s infrastructure.

The reason can be found in a much-quoted 2010 report by the Asian Development Bank that concluded that Asia’s infrastructure deficiency between 2010 and 2020 will amount to $8.2 trillion, equivalent to about 4 percent of Asia’s GDP. Little progress has been made since its publication, and there is little question that Asian countries need to take up the infrastructure challenge quickly. According to the World Economic Forum’s 2014 Global Competitiveness Report, Asia’s global infrastructure rankings are generally low, save only for the world-class characteristics of facilities in Singapore and Hong Kong. Although large Asian cities have boosted their infrastructure in recent years, substantial numbers of people remain without proper or adequate employment, education, access to acceptable sanitation, drinking water or electricity. Without a major rise in infrastructure spending, aspirations for Asia to become an economic-growth powerhouse are likely to be disappointed, especially given the relentless pace of urbanisation, working-age population expansion and, in some countries, rapid population ageing.

Third, in one of its most ambitious economic and political initiatives, it will be the principal architect and financier of the so-called Silk Road Economic Belt and Maritime Silk Road, now known by the official slogan “One Belt, One Road”. One of the project’s principal ideas is a $40-billion infrastructure development fund to fund roads, railways, ports, oil and natural-gas pipelines, fibre-optic networks, information technology and water projects. This, along with the AIIB, has already been labeled China’s “Marshall Plan”. The project is clearly designed to expand Chinese influence abroad and enhance China’s image as a benefactor.  

And so…

The launch of the AIIB, the One Belt, One Road strategy, and the arrangements being pursued with the other BRICS nations map China’s Silk Road financial diplomacy. There is little question that under China’s control or influence, these institutions have the financial clout to perform similar economic functions to those performed by British and American financiers in the past. The Silk Road vision spans 65 countries and 4.4 billion people, and so it is not surprising that many Western countries see potentially profitable banking and commercial opportunities arising from the activities of the AIIB and of China’s development banks. 

At the same time, however, these new institutions throw down the gauntlet to the existing political order of global finance that was created and fashioned by the US and Western countries in a different era. Whether US- and China-led financial institutions learn to co-operate politically, complement one another technically and adopt best-practice governance and transparency is a moot point. The US is being challenged by China, but it still has robust economic, political and commercial attributes that should enable it to accommodate China from a position of strength. China is or soon will be the world’s biggest economy and is already the world’s largest exporter and a financial behemoth, and it, too, can choose to try to accommodate the US. Private providers of capital will hope they both succeed for fear that otherwise capital would succumb to greater financial and political risk. We should be prepared, though, for less than ideal outcomes in which global finance becomes more competitive, fragmented and edgy. China’s Silk Road financial diplomacy offers considerable business potential for the global economy, but it also represents a new phase in the tussle over foreign policy, diplomatic kudos, and economic and military security.

India’s Newfound Spine in Dealing with China

In China, Narendra Modi broke a longstanding trend of Indian leaders telling the Chinese what they want to hear.

By Harsh V. Pant

For all the pomp and circumstance, Prime Minister Narendra Modi’s recent visit to China will likely only be remembered for his plain-speaking. And it is by no means a small achievement. For years, Indian political leaders have gone to China and said what the Chinese wanted to hear. Modi changed all that when he openly “stressed the need for China to reconsider its approach on some of the issues that hold us back from realizing full potential of our partnership” and “suggested that China should take a strategic and long-term view of our relations.” In his speech at Tsinghua University too, Modi went beyond the rhetorical flourishes of Sino-Indian cooperation and pointed out the need to resolve the border dispute and in the interim, clarify the Line of Actual Control to “ensure that our relationships with other countries do not become a source of concern for each other.” This is a significant shift in Indian traditional defensiveness vis-à-vis China and should put the relationship on a firmer footing.

The Chinese are masters at beguiling their interlocutors. So even as Modi was being given a red-carpet welcome on his high-profile visit to China and Chinese leaders were expressing hopes that Sino-Indian ties can be taken to a new level, China’s state-owned television network CCTV was showing a map of India that did not include Jammu and Kashmir and Arunachal Pradesh — the two territories disputed between the two countries — while reporting on the prime minister’s visit. There is a method to this Chinese madness, of course.

Chinese President Xi Jinping became the first Chinese head of state to visit India in eight years in September 2014 and was warmly welcomed in India by Modi. But the visit was overshadowed by a border crisis when PLA troops entered Indian territory in Chumar, Ladakh. Given this reality, it is vital for Indian leadership to move beyond rhetoric and insist on tackling the really thorny issues that have been bedeviling this relationship for years now, making it difficult for the bilateral relationship to achieve its full potential.

The border issue remains the biggest stumbling block. This military restiveness on the Sino-Indian border does not bode well for regional stability as the military balance along the long and contested border is rapidly altering in Beijing’s favor with the modernization of Chinese military and civilian infrastructure in Xinjiang and Tibet. Chinese military modernization has far outpaced Indian defense modernization, raising concerns about New Delhi’s ability to deter a limited conflict with China.

Trade ties too haven’t grown to an extent where they can ameliorate political tensions. China’s annual trade with India is only a fraction of its trade with Europe, Japan, and the United States. Indian exports to China are primarily dominated by raw materials and iron ore. The challenge confronting New Delhi is thus to match the level of Chinese exports to India and diversify the country’s export basket. Even as bilateral trade between China and India is moving towards the $70 billion mark, India’s trade deficit with China has soared from $1 billion in 2001-02 to over $40 billion. This rising trade deficit in China’s favor is problematic for India, as is the Indian failure to use its core competencies to enter the Chinese market.

Modi’s focus has been on engaging China economically to further India’s developmental needs. Underscoring Indian openness for business, Modi encouraged Chinese business to invest in India as firms signed deals worth more than $22 billion. Many of the contracts were for Chinese banks to finance Indian firms, and also included deals in the telecom, steel, solar energy, and film sectors. Other agreements included an agreement for the China Development Bank to fund a power plant for Adani Power, as well as a steel project between Indian conglomerate Welspun and two Chinese firms. Modi welcomed potential Chinese investment in sectors including housing, renewable energy, high-speed rail, metro, ports, and airports, adding that India is eager to draw on China’s expertise in mass manufacturing.

The PRC is entering markets in South Asia more aggressively through both trade and investment, as well as improving linkages with South Asian states through treaties and bilateral cooperation. Following this up by building a ring network of roads and ports connections in India’s neighborhood and deepening military engagements with states on India’s periphery, China has firmly entrenched itself in New Delhi’s backyard. China’s plans for a maritime silk road connected by cross-border infrastructure will further cement Beijing’s role in the region as regional states have lapped up China’s invitation to join this initiative. India too has been invited but it remains ambivalent about the project and is yet to make up its mind.

There are clearly new opportunities to significantly expand India’s economic cooperation with China for mutual benefit. The Modi government, with its decisive mandate, is better positioned than its predecessors to give a new direction to India’s China policy. Beijing should have used the Indian prime minister’s visit to reach out to India more substantively than before. But once again China has shown that it willing to muddle along when it comes to India, if only to keep India perpetually on the defensive. Modi has broken the mold during his visit and it should be an interesting ride for India-China relations from here onward.

INDIAN, CHINESE FIRMS SIGN DEALS WORTH $22B

MOST CONTRACTS ARE FOR CHINESE BANKS TO FINANCE INDIAN FIRMS, INCLUDING IN TELECOM, STEEL, SOLAR ENERGY AND FILM SECTORS.

Indian and Chinese firms signed 21 agreements officials said were worth a total of more than $22 billion in Shanghai on Saturday, witnessed by visiting Prime Minister Narendra Modi.

“Let us work together in mutual interests,” Modi told executives from 200 Chinese and Indian companies at the signing ceremony. “Now India is ready for business.”

The nationalist leader was on the final day of a three-day trip to his fellow Asian giant, as the two jockey for regional influence and India’s trade deficit with China balloons. Despite his hardline reputation Modi has moved to engage with Beijing since his election last year, and he was looking for an economic boost from the visit, seeking to deliver on election promises for foreign investment.

China is India’s biggest trading partner with two-way commerce totaling $71 billion in 2014. But India’s trade deficit with China has soared from just $1 billion in 2001-02 to more than $38 billion last year, Indian figures show.

Indian embassy trade counselor Namgya Khanpa said the agreements signed at the Shanghai event were “worth over $22 billion,” with another five exchanged earlier. A list circulated by Indian officials showed many of the contracts were for Chinese banks to finance Indian firms, and also included deals in the telecom, steel, solar energy and film sectors.

The two countries have followed significantly different economic paths in recent decades, with China rising to become the world’s second-largest economy while India has lagged behind, although Modi’s election raised hopes for reform among investors. “I strongly believe that this century belongs to Asia,” he told a business forum ahead of the signing, as he sought to stress historical links between the two countries. He welcomed Chinese investment in sectors including housing, renewable energy, high-speed rail, metro, ports and airports, adding that India was eager to draw on China’s expertise in mass manufacturing. “We are keen to develop areas in which China is strong,” he said. “We need your involvement.”

Earlier during Modi’s visit, Chinese President Xi Jinping welcomed him in Xian, the capital of his ancestral home province Shaanxi, in what his host said was an unprecedented gesture. But relations between the world’s two most populous nations are soured by a long-running border dispute that saw them fight a brief war in 1962, and on Friday Modi told Chinese Premier Li Keqiang that Beijing needs to “reconsider its approach” to their ties.

“Our relationship has been complex in recent decades,” Modi said, adding there were issues that “trouble smooth development of our relations.” His comments stood out from the usual public declarations by diplomatic visitors to Beijing, who normally stick to uninterrupted pledges of friendship and good relations.

Both countries are members of the BRICS grouping of major emerging economies, but Beijing has vowed to pour investment into India’s rival Pakistan, as it rolls out infrastructure development plans across Asia, much of which bypass India. Chinese contracts to build or manage Indian Ocean ports have raised concerns it is seeking to establish a “string of pearls” in the region.

Li acknowledged on Friday that “we do not deny that there are some disagreements between us,” but added: “We have far more common interests than differences.”