Rethinking the Next China
Once an adapter to globalization, China is increasingly a driver of it. The Next China is becoming a Global China, upping the ante on its connection to an increasingly integrated world – and creating a new set of risks and opportunities.
NEW HAVEN – For the past seven years, I have taught a popular class at Yale, called “The Next China.” From the start, the focus has been on the transitional imperatives of the modern Chinese economy – namely, the shift from a long-successful producer model to one driven increasingly by household consumption. Considerable attention is devoted to the risks and opportunities of this rebalancing – and to the related consequences for sustainable Chinese development and the broader global economy.
While many of the key building blocks of China’s transitional framework have fallen into place – especially rapid growth in services and accelerated urbanization – there can be no mistaking a new and important twist: China now appears to be changing from an adapter to a driver of globalization. In effect, the Next China is upping the ante on its connection to an increasingly integrated world – and creating a new set of risks and opportunities along the way.
The handwriting has been on the wall for several years. This strategic shift is very much a reflection of the leadership imprint of President Xi Jinping – in particular, his focus on the “China Dream.” Initially, the dream was something of a nationalist mantra, framed as a rejuvenation by which China would recapture its former position of global prominence, commensurate with its status as the world’s second largest economy.
But now the China Dream is taking shape as a concrete plan of action, centered on China’s One Belt, One Road (OBOR) plan. This ambitious pan-regional infrastructure initiative combines economic assistance with geostrategic power projection, supported by a new set of China-centric financial institutions – the Asian Infrastructure Investment Bank (AIIB), the New (BRICS) Development Bank, and the Silk Road Fund.
For those of us studying China’s economic transformation, this is hardly a trivial development. While the shift remains a work in progress, I would stress three tentative implications.
First, China has not made a full about-face. As an economist, I am prone to placing too much emphasis on models and on the related presumption that policymakers can flip the switch from one model to another. Yet it is not that black and white – for China or for any other country.
China’s leaders have, for all practical purposes, now conceded that a consumer-led growth strategy is tougher to pull off than originally thought. The consumption share of GDP has risen just 2.5 percentage points since 2010 – far short of the boost to personal incomes that might be expected from the 7.5-percentage-point increase in the share of services and a 7.3-percentage-point increase in the high-wage urban share of its population over the same period.
This disconnect largely reflects a porous social safety net that continues to foster high levels of fear-driven precautionary saving, which is inhibiting the growth of discretionary consumption. While still committed to urbanization and services development, China has elected to draw on a new external source of growth to compensate for a shortfall of internal demand.
Second, this global push has many of the features of the old producer model. It enables an increasingly worrisome overhang of domestic excess capacity to be directed at OBOR’s infrastructure requirements. And it relies on state-owned enterprises (SOEs) to drive that investment, forestalling long-needed reforms in this bloated segment of Chinese industry.
The flip side of this newfound support for the producer model has been a de-prioritization of consumer-led growth. In Prime Minister Li Keqiang’s annual Work Report – the official statement of economic policy – emphasis on the consumer-led structural transformation has been downgraded in each of the last two years (ranked third in both 2016 and 2017, as so-called supply-side initiatives have gained higher priority).
Third, China’s new global approach reflects a recasting of governance. Xi’s consolidation of domestic power is only part of the story. The shift in economic decision-making away from the State Council’s National Development and Reform Commission (NDRC) toward Party-based Leading Small Groups is particularly important, as are the anti-corruption campaign, heightened Internet censorship, and new regulations on non-governmental organizations (NGOs).
The irony of such power centralization is unmistakable. After all, Xi issued early promises to break up deeply entrenched power blocs, and the Third Plenum reforms of November 2013 emphasized the promotion of a more decisive role for markets.
But there is an even deeper irony for China’s new global push. It runs against the grain of a populist anti-globalization backlash that is brewing in many developed countries. As a producer-focused economy, China has long been the greatest beneficiary of globalization – both in terms of export-led growth and poverty reduction stemming from the absorption of surplus labor. That approach has now been stymied by China’s mounting internal imbalances, a post-crisis slowdown in global trade, and an increase in China-focused protectionism. As a result, China’s new attempts to gain increased leverage from globalization are not without serious challenges of their own.
A more global China also has important ramifications for Chinese foreign policy. Territorial disputes in the South China Sea loom particularly large, but China’s footprints in Africa and Latin America are also drawing heightened scrutiny. This new strategy raises perhaps the biggest issue of all – whether China fills a hegemonic void created by the isolationist “America first” approach of US President Donald Trump.
In short, the Next China is shaping up to be more outwardly focused, more assertive, and more power-centric than I envisioned when I started teaching this course in 2010. At the same time, there appears to be less commitment to a market-based reform agenda featuring private consumption and SOE restructuring. The jury is out on whether this changes the final destination of Chinese rebalancing. I hope that is not the case. But that is what makes it more interesting to teach an applied course, where the focus is always a moving target.
China’s Creditor Imperialism
Just as European imperial powers employed gunboat diplomacy, China is using sovereign debt to bend other states to its will. As Sri Lanka's handover of the strategic Hambantota port shows, states caught in debt bondage to the new imperial giant risk losing both natural assets and their very sovereignty.
BERLIN – This month, Sri Lanka, unable to pay the onerous debt to China it has accumulated, formally handed over its strategically located Hambantota port to the Asian giant. It was a major acquisition for China’s Belt and Road Initiative (BRI) – which President Xi Jinping calls the “project of the century” – and proof of just how effective China’s debt-trap diplomacy can be.
Unlike International Monetary Fund and World Bank lending, Chinese loans are collateralized by strategically important natural assets with high long-term value (even if they lack short-term commercial viability). Hambantota, for example, straddles Indian Ocean trade routes linking Europe, Africa, and the Middle East to Asia. In exchange for financing and building the infrastructure that poorer countries need, China demands favorable access to their natural assets, from mineral resources to ports.
Moreover, as Sri Lanka’s experience starkly illustrates, Chinese financing can shackle its “partner” countries. Rather than offering grants or concessionary loans, China provides huge project-related loans at market-based rates, without transparency, much less environmental- or social-impact assessments. As US Secretary of State Rex Tillerson put it recently, with the BRI, China is aiming to define “its own rules and norms.”
To strengthen its position further, China has encouraged its companies to bid for outright purchase of strategic ports, where possible. The Mediterranean port of Piraeus, which a Chinese firm acquired for $436 million from cash-strapped Greece last year, will serve as the BRI’s “dragon head” in Europe.
By wielding its financial clout in this manner, China seeks to kill two birds with one stone. First, it wants to address overcapacity at home by boosting exports. And, second, it hopes to advance its strategic interests, including expanding its diplomatic influence, securing natural resources, promoting the international use of its currency, and gaining a relative advantage over other powers.
China’s predatory approach – and its gloating over securing Hambantota – is ironic, to say the least. In its relationships with smaller countries like Sri Lanka, China is replicating the practices used against it in the European-colonial period, which began with the 1839-1860 Opium Wars and ended with the 1949 communist takeover – a period that China bitterly refers to as its “century of humiliation.”
China portrayed the 1997 restoration of its sovereignty over Hong Kong, following more than a century of British administration, as righting a historic injustice. Yet, as Hambantota shows, China is now establishing its own Hong Kong-style neocolonial arrangements. Apparently Xi’s promise of the “great rejuvenation of the Chinese nation” is inextricable from the erosion of smaller states’ sovereignty.
Just as European imperial powers employed gunboat diplomacy to open new markets and colonial outposts, China uses sovereign debt to bend other states to its will, without having to fire a single shot. Like the opium the British exported to China, the easy loans China offers are addictive. And, because China chooses its projects according to their long-term strategic value, they may yield short-term returns that are insufficient for countries to repay their debts. This gives China added leverage, which it can use, say, to force borrowers to swap debt for equity, thereby expanding China’s global footprint by trapping a growing number of countries in debt servitude.
Even the terms of the 99-year Hambantota port lease echo those used to force China to lease its own ports to Western colonial powers. Britain leased the New Territories from China for 99 years in 1898, causing Hong Kong’s landmass to expand by 90%. Yet the 99-year term was fixed merely to help China’s ethnic-Manchu Qing Dynasty save face; the reality was that all acquisitions were believed to be permanent.
Now, China is applying the imperial 99-year lease concept in distant lands. China’s lease agreement over Hambantota, concluded this summer, included a promise that China would shave $1.1 billion off Sri Lanka’s debt. In 2015, a Chinese firm took out a 99-year lease on Australia’s deep-water port of Darwin – home to more than 1,000 US Marines – for $388 million.
Similarly, after lending billions of dollars to heavily indebted Djibouti, China established its first overseas military base this year in that tiny but strategic state, just a few miles from a US naval base – the only permanent American military facility in Africa. Trapped in a debt crisis, Djibouti had no choice but to lease land to China for $20 million per year. China has also used its leverage over Turkmenistan to secure natural gas by pipeline largely on Chinese terms.
Several other countries, from Argentina to Namibia to Laos, have been ensnared in a Chinese debt trap, forcing them to confront agonizing choices in order to stave off default. Kenya’s crushing debt to China now threatens to turn its busy port of Mombasa – the gateway to East Africa – into another Hambantota.
These experiences should serve as a warning that the BRI is essentially an imperial project that aims to bring to fruition the mythical Middle Kingdom. States caught in debt bondage to China risk losing both their most valuable natural assets and their very sovereignty. The new imperial giant’s velvet glove cloaks an iron fist – one with the strength to squeeze the vitality out of smaller countries.
A New Model for Chinese Overseas Investment
Chinese outward investment is forecast to triple by 2020, to some $20 trillion, putting China behind only the US. But moving quickly to invest overseas – while appealing to many in China – will be highly risky, unless policymakers and companies alike learn from past failures.
BEIJING – Two Chinese initiatives – “One Belt, One Road” (OBOR) and “International Production Cooperation” – encapsulate President Xi Jinping’s views on overseas investment. Both slogans are supported by development approaches (the former in Eurasia, the latter globally) that signal China’s desire to forge a new model of globalization built on mutual cooperation.
Chinese enterprises are already taking these investment cues seriously. By 2020, China’s overseas assets are forecast to triple, to $20 trillion, from $6.4 trillion today. But moving quickly to invest in overseas projects, while appealing to many, carries great risks – and could mean high debt – if not managed properly. If Chinese companies, both state- and privately owned, are to benefit from the leadership’s new vision, they must learn from past failures, and adapt their priorities for the long term.
One key area where China is trying to refashion its outward investment strategy is in Latin America. In recent years, China has vigorously sought to recast its bilateral diplomatic and economic ties to the region. The publication in November 2016 of the second Sino-Latin American and Caribbean policy document (which followed Xi’s visit to Latin America the same month) has created a unique opportunity to deepen bilateral investment, by placing it in a more cooperative framework. Previous approaches, often backed by risky loans that in some cases turned bad, hurt Chinese investors.
The new policy explicitly encourages Chinese enterprises to work with local businesses in sectors like logistics, electricity, and information systems, and it promotes interaction among business, community, and government leaders. Equally important, the policy also expands the availability of Chinese funding, credits, and insurance to investors. Taken together, this holistic approach is something new for China.
Despite considerable political uncertainty in a number of countries in Latin America, governments the region appear keen to meet China’s reform efforts with changes of their own.
For example, Brazil’s government has promoted an “Investment Partnerships Program” to coordinate investments in the finance and transportation infrastructure sectors. In Argentina, President Mauricio Macri’s government has introduced investor-friendly policies to restore confidence after years of political and economic isolation for the country. And in Mexico, structural reforms to increase competition in the telecommunications and electricity sectors, alongside other policies, have curbed inflation and boosted resilience to external shocks, and are expected to help return the country to a primary budget surplus.
With so many country-specific reforms underway, Latin America can serve as a testing ground for China’s new approach to overseas investment. But policy documents and bilateral agreements are just two components of China’s new “going out” strategy. Chinese businesses must change how they think about and act upon foreign investment opportunities.
The traditional Chinese investment model – mergers and acquisitions – is no longer appropriate, because concentrated M&A activity entails tremendous risk. And, unfortunately, that risk has multiplied in recent years. China’s overseas M&As jumped from 5% of the global total in 2011 to 20% in the first half of 2016, reaching some $13 billion in value. According to data released by China’s Ministry of Commerce, non-financial outward direct investment exceeded $170 billion in 2016, a 44.1% increase from 2015.
This trend has been unprecedented for China, which overtook Japan for the first time last year to become the world’s second-largest overseas investor, behind only the United States. But it has also been poorly thought out. The biggest problem is that such concentrated acquisitions have increased leverage, and a higher debt-equity ratio carries a greater risk of downgrading. Historically, roughly 25% of all enterprises are downgraded after an M&A. Such a scenario would be particularly painful for Chinese firms, given their lack of experience with the significant integration and management challenges that M&As pose for any business.
Given these risks, the most important priority for Chinese firms as they interpret the government’s new vision for overseas investment – whether in Latin America or elsewhere – is to stick to the principle of sustainability. Indeed, “long term” must be the strategic starting point.
The OBOR and International Production Cooperation strategies have a commitment to long-term partnerships at their core, and investments that presuppose many years of engagement will complement both frameworks. Only if the financial base is solid, growth prospects sustainable, and multi-year collaboration in place will an investment support the government’s strategy.
Another priority in considering new overseas investment is to consider fully the goals of “international production cooperation.” The aim here is to encourage the transfer of production capacity to other countries, in order to strengthen the “global industrial chain” in mutually beneficial ways. It is imperative to avoid using direct Chinese investment for the short-term export of production capacity, which would not be in China’s interest – and often not in the recipient’s interest, either.
For most equity investors, the value of any project depends to a large extent on effective post-investment management. Clear rights and obligations must therefore be carefully worked out at the start of an investment, something that has been all but absent previously. After all, an M&A is only the first step on a long road.
As Chinese firms invest overseas – as mine does currently in Latin America – they have a responsibility not only to invest wisely and sustainably for the sake of their companies, but also to integrate their strategies with China’s national investment priorities. Those are not mutually exclusive goals, especially if business leaders adhere to the newly articulated principles of sustainable investment and long-term engagement.
The Economic Case for China’s Belt and Road
In recent years, many of the world’s most influential countries have turned inward, with politicians promising protectionism, immigration restrictions, and even border walls. But, to achieve stronger economic growth and development, the world needs initiatives focused on building bridges – initiatives like China's Belt and Road.
NEW YORK – Since 2013, China has been pursuing its “Belt and Road” initiative, which aims to develop physical infrastructure and policy linkages connecting more than 60 countries across Asia, Europe, and Africa. Critics worry that China may be so focused on expanding its geopolitical influence, in order to compete with the likes of the United States and Japan, that it may pursue projects that make little economic sense. But, if a few conditions are met, the economic case for the initiative is strong.
As a recent Asian Development Bank report confirms, many Belt and Road countries are in urgent need of large-scale infrastructure investment – precisely the type of investment that China has pledged. Some, such as Bangladesh and Kyrgyzstan, lack reliable electricity supplies, which is impeding the development of their manufacturing sectors and stifling their ability to export. Others, like Indonesia, do not have enough ports for internal economic integration or international trade.
The Belt and Road initiative promises to help countries overcome these constraints, by providing external funding for ports, roads, schools, hospitals, and power plants and grids. In this sense, the initiative could function much like America’s post-1945 Marshall Plan, which is universally lauded for its contribution to the reconstruction and economic recovery of war-ravaged Europe.
Of course, external funding alone is not sufficient for success. Recipient countries must also undertake key reforms that increase policy transparency and predictability, thereby reducing investment risk. Indeed, implementation of complementary reforms will be a key determinant of the economic returns on Belt and Road investments.
For China, the Belt and Road investments are economically appealing, particularly when private Chinese firms take the lead in carrying them out. In 2013, when China first proposed the Belt and Road initiative, the country was sitting on $4 trillion in foreign-exchange reserves, which were earning a very low dollar return (less than 1% a year). In terms of China’s own currency, the returns were negative, given the expected appreciation of the renminbi against the US dollar at the time.
In this sense, Belt and Road investments are not particularly costly for China, particularly when their far-reaching potential benefits are taken into account. China’s trade-to-GDP ratio exceeds 40% – substantially higher than that of the US – owing partly to underdeveloped infrastructure and inadequate economic diversification among China’s trading partners. By addressing these weaknesses, China’s Belt and Road investments can lead to a substantial increase in participant countries’ and China’s own trade volumes, benefiting firms and workers substantially.
This is not to suggest that such investments are risk-free for China. The economic returns will depend on the quality of firms’ business decisions. In particular, because efficiency is not the primary consideration, Chinese state-owned enterprises (SOEs) might purse low-return projects. That is why China’s SOE-reform process must be watched carefully. Nonetheless, while the Belt and Road initiative is clearly driven partly by strategic objectives, a cost-benefit analysis shows that the economic case is also very strong – so strong, in fact, that one might ask why China didn’t undertake it sooner.
Even the United States and other countries may reap significant economic returns. A decade after the global financial crisis erupted, recovery remains weak and tentative in much of the world. Bold, large-scale infrastructure investments can provide much-needed short-run stimulus to global aggregate demand. The US, for one, is likely to see a surge in demand for its own exports, including cars, locomotives, planes, and high-end construction equipment, and financial, accounting, educational, and legal services.
In the longer term, the new infrastructure will ease logistical bottlenecks, reducing the costs of production inputs. The result will be higher productivity and faster global growth.
If Belt and Road projects are held to high environmental and social standards, significant progress can also be made on global challenges such as climate change and inequality. The more countries choose to participate in these projects, the better the chance of achieving these standards, and the greater the global social returns will be.
In an era when some of the world’s most influential countries are turning inward, talking about erecting trade barriers and constructing border walls, the world needs initiatives focused on building bridges and roads, both literal and figurative – initiatives like the Belt and Road strategy.
Xi Jinping’s Marco Polo Strategy
Last month, Chinese President Xi Jinping presided over a highly orchestrated forum for his Belt and Road Initiative, which will involve 65 countries containing some 4.5 billion people. Xi’s plan to integrate Eurasia through a trillion dollars of infrastructure investment is impressive, but will it succeed as a grand strategy?
CAMBRIDGE – Last month, Chinese President Xi Jinping presided over a heavily orchestrated “Belt and Road” forum in Beijing. The two-day event attracted 29 heads of state, including Russia’s Vladimir Putin, and 1,200 delegates from over 100 countries. Xi called China’s Belt and Road Initiative (BRI) the “project of the century.” The 65 countries involved comprise two-thirds of the world’s land mass and include some four and a half billion people.
Originally announced in 2013, Xi’s plan to integrate Eurasia through a trillion dollars of investment in infrastructure stretching from China to Europe, with extensions to Southeast Asia and East Africa, has been termed China’s new Marshall Plan as well as its bid for a grand strategy. Some observers also saw the Forum as part of Xi’s effort to fill the vacuum left by Donald Trump’s abandonment of Barack Obama’s Trans-Pacific Partnership trade agreement.
China’s ambitious initiative would provide badly needed highways, rail lines, pipelines, ports, and power plants in poor countries. It would also encourage Chinese firms to increase their investments in European ports and railways. The “belt” would include a massive network of highways and rail links through Central Asia, and the “road” refers to a series of maritime routes and ports between Asia and Europe.
Marco Polo would be proud. And if China chooses to use its surplus financial reserves to create infrastructure that helps poor countries and enhances international trade, it will be providing what can be seen as a global public good.
Of course, China’s motives are not purely benevolent. Reallocation of China’s large foreign-exchange assets away from low-yield US Treasury bonds to higher-yield infrastructure investment makes sense, and creates alternative markets for Chinese goods. With Chinese steel and cement firms suffering from overcapacity, Chinese construction firms will profit from the new investment. And as Chinese manufacturing moves to less accessible provinces, improved infrastructure connections to international markets fits China’s development needs.
But is the BRI more public relations smoke than investment fire? According to the Financial Times, investment in Xi’s initiative declined last year, raising doubts about whether commercial enterprises are as committed as the government. Five trains full of cargo leave Chongqing for Germany every week, but only one full train returns.
Shipping goods overland from China to Europe is still twice as expensive as trade by sea. As the FT puts it, the BRI is “unfortunately less of a practical plan for investment than a broad political vision.” Moreover, there is a danger of debt and unpaid loans from projects that turn out to be economic “white elephants,” and security conflicts could bedevil projects that cross so many sovereign borders. India is not happy to see a greater Chinese presence in the Indian Ocean, and Russia, Turkey, and Iran have their own agendas in Central Asia.
Xi’s vision is impressive, but will it succeed as a grand strategy? China is betting on an old geopolitical proposition. A century ago, the British geopolitical theorist Halford Mackinder argued that whoever controlled the world island of Eurasia would control the world. American strategy, in contrast, has long favored the geopolitical insights of the nineteenth-century admiral Alfred Mahan, who emphasized sea power and the rimlands.
At World War II’s end, George F. Kennan adapted Mahan’s approach to develop his Cold War strategy of containment of the Soviet Union, arguing that if the US allied with the islands of Britain and Japan and the peninsula of Western Europe at the two ends of Eurasia, the US could create a balance of global power that would be favorable to American interests. The Pentagon and State Department are still organized along these lines, with scant attention paid to Central Asia.
Much has changed in the age of the Internet, but geography still matters, despite the alleged death of distance. In the nineteenth century, much of geopolitical rivalry revolved around the “Eastern Question” of who would control the area ruled by the crumbling Ottoman Empire. Infrastructure projects like the Berlin to Baghdad railway roused tensions among the Great Powers. Will those geopolitical struggles now be replaced by the “Eurasian Question”?
With the BRI, China is betting on Mackinder and Marco Polo. But the overland route through Central Asia will revive the nineteenth-century “Great Game” for influence that embroiled Britain and Russia, as well as former empires like Turkey and Iran. At the same time, the maritime “road” through the Indian Ocean accentuates China’s already fraught rivalry with India, with tensions building over Chinese ports and roads through Pakistan.
The US is betting more on Mahan and Kennan. Asia has its own balance of power, and neither India nor Japan nor Vietnam want Chinese domination. They see America as part of the solution. American policy is not containment of China – witness the massive flows of trade and students between the countries. But as China, enthralled by a vision of national greatness, engages in territorial disputes with its maritime neighbors, it tends to drive them into America’s arms.
Indeed, China’s real problem is “self-containment.” Even in the age of the Internet and social media, nationalism remains a most powerful force.
Overall, the United States should welcome China’s BRI. As Robert Zoellick, a former US Trade Representative and World Bank president, has argued, if a rising China contributes to the provision of global public goods, the US should encourage the Chinese to become a “responsible stakeholder.” Moreover, there can be opportunities for American companies to benefit from BRI investments.
The US and China have much to gain from cooperation on a variety of transnational issues like monetary stability, climate change, cyber rules of the road, and anti-terrorism. And while the BRI will provide China with geopolitical gains as well as costs, it is unlikely to be as much of a game changer in grand strategy, as some analysts believe. A more difficult question is whether the US can live up to its part.