Free Zone Watch talks with Dr Paul Armstrong-Taylor about key questions facing China’s economy as the country embarks upon on major infrastructure projects, including the Belt & Road Initiative (BRI), and financial system liberalisation.

How might the Chinese government avoid inappropriate levels of political influence in loans and financing of major infrastructure projects?

Inappropriate political influence could come from the Chinese government or from the government of the recipient country. Each of these poses different challenges, so I will deal with them separately.

While China is clearly the major power within the AIIB, it will face some restrictions on using the AIIB for political purposes. China’s ability to attract so many countries to join the AIIB was a political success, but it also makes it harder for China to control the AIIB as many of those countries have quite different political systems and political priorities to China. The United Kingdom, Australia, India, South Korea (among other members) disagree with China on key political issues and would probably oppose China if it attempted to use the AIIB to pursue political goals. China only has 26% of the vote in the AIIB, so it would be difficult for it to use the AIIB to pursue narrow national interests.

While China may have some political control over AIIB investment, it has far more control over its foreign investment that does not go through the AIIB. To the extent that Chinese outward foreign direct investment (FDI) is channeled through the AIIB rather than bilateral deals, this might reduce its ability to use such investment for political influence.

In short, the AIIB does not increase China’s ability to use its foreign investment for political influence and may even reduce it. China hopes that the AIIB will rival the ADB and World Bank and so provide it with intangible global influence. For it to achieve this, the AIIB cannot be seen as a political tool of the Chinese government.

Political influence can also come from within the recipient country. Corruption within recipient countries often undermines foreign aid and investment projects in developing countries, particularly when the recipient governments are involved in distributing cash and managing the contracts. Often much of the money ends up in officials’ bank accounts rather than being used to fund investment. China’s investment in Africa addressed these problems by providing investment in the form of completed projects rather than in cash. A Chinese firm would build a port, road or other infrastructure project using Chinese funding. This largely bypassed the domestic officials and so reduced corruption. While it is too early to say, it is possible that China would envisage the AIIB using a similar approach.

While this approach does reduce corruption by local officials, it can be politically controversial. Limiting the role of the domestic government may reduce corruption, but also raises questions of sovereignty. Furthermore, Chinese firms would often bring in Chinese workers, which angered local workers who were excluded. This could be an issue with AIIB projects if such an approach is used.

Voices in opposition to major BRI developments in partnering countries have focused on potential trade deficits and local markets unable to compete with Chinese goods. How can China and partnering governments address these concerns?

Traditionally economists have defended free trade. If every country pursues its comparative advantage, all countries should be better off with free trade overall. While this may be true, it does not mean that everyone within every country will be better off. Free trade tends to lead to changes in industrial structure: some industries (in which the country has a comparative advantage) grow; others shrink. Workers in the latter industries could lose their jobs. In a perfect world, they could retrain and start working in the growing industries, but changing careers is often hard in the real world. Furthermore, trade can have geographic effects: some regions benefit at the expense of others. If people in the declining regions are reluctant or unable to move, they may suffer.

The effects of the BRI are hard to predict and would likely vary from country to country. However, it is worth pointing out that the though some industries would face severe competition from Chinese imports and may decline, others might find opportunities to export to the large and growing Chinese market. Many of the countries receiving BRI projects are currently landlocked or otherwise geographically cut off from trade networks, which harms their development. Even within China you see this – the eastern coastal provinces have grown rich through trade, while the western provinces have lagged behind. By creating transport links between central Asian countries and markets in Europe and China, the BRI could allow these countries to benefit from trade in a way that they have been unable to do so far. As trade is often a major driver of development, the potential benefits of BRI for such countries could well exceed the costs.

What macroeconomic repercussions might China face in the next five to ten years if some of its largest BRI infrastructure investments prove unprofitable?

The current scale of BRI projects are small relative to the Chinese economy. The total capital of the AIIB is $100 billion of which China has committed about $30 billion. China’s GDP is around $11 trillion, so the capital it has committed to the AIIB is about 0.3% of GDP. Even if all of this investment was lost (which is unlikely), it would have a negligible effect on China’s economy. While China’s total investment in the BRI could increase, it is unlikely to grow enough to matter.

The bigger issue is how developments within the Chinese economy might affect its ability or willingness to invest in the BRI. On the one hand, China has excess capacity in many sectors – including several connected to infrastructure construction. The BRI could provide an additional source of demand for these industries which would allow the government to avoid, or at least delay, the pain of addressing this problem. On the other hand, China’s debt to GDP ratio has increased sharply in recent years and there are concerns that it could lead to a crisis. If China faces economic problems at home, it may have less ability and willingness to invest money overseas. This could negatively affect the BRI.

How does the incremental liberalisation of China’s financial system fit into China’s long-term economic strategy?

China’s financial system grew symbiotically with its economic system. China’s growth was based on investment and the financial system was structured to support this. Interest rates were kept low so that it was cheap to borrow money for investment, but this suppressed returns to household saving which limited growth in consumption. Meanwhile, the government either explicitly or implicitly guaranteed much of the borrowing in the system. This provided strong incentives for both borrowers and lenders to increase debt. Borrowers could invest in risky projects: if the projects succeeded, they kept the profits; if they failed, the government would bail them out. Similarly, banks and other lenders could freely lend to borrowers regardless of credit quality as long as they were likely to receive government support. Finally, the government distorted various prices, including the exchange rate, to boost returns on investment. This further encouraged borrowing and investment.

These policies led to extremely high levels of borrowing and investment – the latter reaching almost 50% of GDP. Until around 2008, most of this investment earned high returns which generated high levels of economic growth. Though debt grew fast, so did the economy and so the process was sustainable. However, since 2009, investment returns have fallen, which has undermined this economic model. Low investment returns means that more investment, and more borrowing, is necessary to generate a given level of growth. Debt has continued to grow fast, but growth has slowed. As result, the debt to GDP ratio has increased sharply and the model appears unsustainable. Most observers, and the Chinese government itself, recognise the old model is unsustainable and there is an increasingly urgent need to shift to a new sustainable model. Such a model will rely less on borrowing and investment, and more on household consumption. A new economic model will require a new financial system.

Perhaps the most important financial reform is the liberalisation of interest rates and lenders. The government has ended its suppression of interest rates and allowed the rates to be set by the market (although it still exerts some influence via the state-owned banks). Higher interest rates make borrowing less attractive while increasing the income that households can receive from their saving. This has helped to begin a shift in spending from investment to consumption.

Relatedly, the government has allowed new lenders to compete with banks. So-called shadow banks have been responsible for most of the growth in lending since 2009. These institutions vary greatly, but most of them are more sensitive to market forces than the big banks. Furthermore, the development of the bond market has the potential make interest rates more sensitive market forces and credit quality. By competing for deposits and borrowers with banks, these institutions have also forced banks to become more market-focused. While the transition is far from complete, the changes should lead to lower levels of higher quality borrowing.

The government has also indicated that it would stop guaranteeing debt and allow some borrowers to fail. If implemented, this would discourage excessive borrowing and investment. In practice, however, the government still seems reluctant to allow important borrowers to go bankrupt. While some small private firms have defaulted, many more firms have received government support, and the government intervened to support the stock market in 2015. Though it talks of allowing market forces a leading role, the government seems reluctant to accept market outcomes that is does not like. As the government is more likely to bailout a state-owned firm than a private one, it is easier for the former to borrow and invest. Unfortunately, public investment returns are much lower than private returns, so this increases inefficiency.

This answer is inevitably oversimplified and incomplete and there is much more that could be said on this topic. However, the main points still hold. China needs to change its growth model and financial liberalisation is an important part of that transition. Though liberalisation has begun, progress has been patchy and there remains a long way to go.