Behind China’s infrastructure bank

It is a confusing time for investors but there is one place that is crying out for investment: Asian infrastructure.

The world is awash with money yet in most places economic growth is decelerating and deflation threatens.

It’s a confusing time for investors, with both global equity and bond markets looking overpriced, as all of that demand for a return overwhelms the supply of true earnings growth.

Yet there is one place that is crying out for investment: Asian infrastructure.

The Asian Development Bank pegs the demand for infrastructure investment at $730 billion a year for the next decade. India alone needs $1 trillion of investment over the next five years, McKinsey says.

These astronomical figures assume that India and the rest of developing Asia need Chinese levels of infrastructure. This may not be true but, increasingly, the rest of Asia is looking upon the Chinese economic model with envy, crediting its fixed-asset investments for the Middle Kingdom’s amazing three decades-plus boom.

“Infrastructure can fuel economic growth in a sustainable way,” said Ma Zehua, chairman of China Ocean Shipping Group, at a recent forum. “It jumpstarts an economy.”

“Without infrastructure, GDP growth suffers,” agreed V. Shankar, group executive director at Standard Chartered Bank. Comparing China to India, he reckoned India’s poor infrastructure had cost it 150-200 basis points annually of lost economic growth.

Didar Singh, head of the Federation of Indian Chamber of Commerce and Industry, said infrastructure to support manufacturing accounts for 7%-8% of a company’s cost of getting goods to market in the US and Europe. But that figure is 15% in India.

“We can’t be competitive in manufacturing [without better infrastructure], and we won’t be able to provide jobs for our massive populations,” he said.

Foreign policy goals
Asia’s new infrastructure push coincides with China’s foreign policy goals. The buzzword the Chinese throw around is ‘connectivity’, which means both infrastructure that physically links China to other Asian markets as well as related financial arrangements.

“Asia infrastructure lacks connectivity,” said Cao Honghui, head of research at China Development Bank, a policy bank. The lack of funding, of stable legal and social environments, and the inability of financial institutions to make cross-border commitments are among the barriers.

In China, the government took the lead. It is famous for uprooting hundreds of thousands of people, drowning cities, levelling mountains – anything to build the dams, canals, highways, railways, airports and whatever else the central or local governments decreed.

But as China seeks to extend its links to neighbours, its officials are downplaying Beijing’s iron hand, having accepted loans from the World Bank and sold concessions to private contractors to build toll roads.

“Government only played part of the role,” said Zheng Xiaoqiang, former head of the National Development and Reform Commission, which manages China’s state-owned enterprises.
Instead it is substituting new policy funds and banks, most notably through the Asian Infrastructure Investment Bank (AIIB). This is soft power, Chinese style.

The US State Department has said it welcomes a Chinese-led infrastructure bank for Asia – so long as it adheres to international standards of transparency and governance. It is reportedly leaning on allies such as Australia and South Korea to decline membership, however.

President Xi Jinping in November also proclaimed $40 billion in funding for a Silk Road Fund, to improve trade and transport links in Asia. Xi said China plans to build a “Silk Road Economic Belt”, a network of highways and railways connecting China to its neighbours, and a “21st Century Maritime Silk Road” of ports and industrial parks across the Pacific and Indian oceans, perhaps as far as the Mediterranean Sea.

Lofty aims
The AIIB will be seeded with $50 billion by China and, it hopes, another $50 billion from other members. Jin Liqun, who is most closely associated with starting the new bank, hails AIIB as the first multilateral institution majority owned by Asian countries.

It will invest solely in poor Asian countries and aims to improve on existing multilateral institutions’ governance standards. That includes an awareness of the potential ecological impact as well as a reduction of red tape; “lean, clean and green” is the unofficial motto.

What exactly these nice-sounding homilies will mean in practice is hard to say. China’s own record of cutting through red tape is exemplary. India and other countries envy its ability to erect infrastructure without the hassle of respecting local property rights, environmental concerns, local community rights, or indeed without really having to consult anyone.

There is however no accountability or transparency around the process, which creates countless stories of real suffering.

The AIIB represents the best chance the West has to help shape how such projects unfold because it offers a forum in which a Chinese-led initiative is subject to outside influence.

It is possible, of course, that the US and its allies view their invitation to join as a Trojan horse: their relatively minor voting position would let them rant and rage without actually impacting decisions; or, worse, provide a fig leaf for Beijing to claim that its policies to bind itself more closely to other countries is fine, regardless of how it occurs.

What is clear is that the infrastructure needs of Asia are vast, that the Chinese model of infrastructure-led development is attractive, and that the private sector by itself is simply not up to the task.

China is being clever about the AIIB. Jin notes that when the US shaped the post-WW2 order, it did so through multilateral institutions. The Bretton Woods system was tailored to American desires but it worked because other countries accepted its intellectual basis. It served their needs too.

Mitigating risk, advancing China
Financing for infrastructure across borders is a tricky business, which is why private investment hasn’t been engaged. It involves currency-hedging risks, risks of expropriation, and contract risk that are magnified by the lengthy time it takes to actually build infrastructure and earn from it.

And part of the AIIB and related drives around “connectivity” involve mitigating risk and suppressing financial volatility.

Zeng Peiyan, former vice premier of China said connectivity is not just about physical infrastructure but about coordinating financial and legal rules, norms and standards. Since this is not a meeting of equals, it probably means getting other Asian countries to conform to Chinese preferences.

For example, a key tool that Beijing is pushing with governments in the Middle East and Southeast Asia is the use of currency swaps. The idea of Abu Dhabi and Bangkok entering a dhiram/baht swap beggars belief. No, these are all about bilateral deals involving the renminbi.

A corollary that Chinese officials push is a different sort of credit evaluation process. They argue that Fitch, Moodys’ and Standard & Poor’s lost their credibility in the 2008 financial crisis. To varying degrees, they also believe them to be biased or outright mouthpieces of the US government.

While this perspective may be inaccurate, the point is that an initiative to set up a multilateral institution to facilitate much-needed infrastructure finance in Asia is the thin edge of a wedge. Private investors, even Chinese or other Asian sovereign wealth funds, are reluctant to back cross-border infrastructure schemes without some assurances.

The AIIB or the Silk Road Fund can only do so much on their own. What is needed is for governments to create certainty, which means bending finance to new arrangements other than private, free trades.

That involves putting the renminbi to greater use to reduce currency risk, promoting alternative credit rating agencies to give transactions a different gloss, and finding other ways to deepen financial connectivity. When Chinese officials talk about connectivity, think “internationalisation of the renminbi” because that is really what this is about.

Just as the US set the tone in the 1940s, China is advancing a continental – perhaps even a global – strategy that advances its primacy.

Most of all it is the global financial crisis that has led to this rivalry of duelling currency systems. The US belief in unfettered global capital flows and unregulated, unsupervised finance generated the conditions for abuses that nearly collapsed the entire system.

China is not yet in a position to displace America. Its own banking system is a mess. The neglect of accountability and transparency are manifesting themselves in China’s own wildly unbalanced and risky economy. And the US’s energy revolution makes it the only attractive growth story.

But national fortunes come and go; who can predict the price of a barrel of oil in 2016? US mismanagement of its finance industry has delegitimised its leadership for many in Asia, and even people like Timothy Geithner believe US is at risk of another financial crisis, or at least plenty of volatility.

The price of a Treasury bond and the valuations of US equities point to future heartache.
What is needed is a new financial system that can incorporate the best traditions of the open US system with an Asian understanding that finance needs to prove its social value and not just enrich insiders.

The AIIB looks like a good place to experiment. The US should join. You know the expression, if you can’t beat ’em…

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