China’s Economic Imperialism Must Go

By Leslie Fu & Jianli Yang

Sunday, August 27, 2023

 

This year marks the tenth anniversary of China’s ambitious global infrastructure-financing project, the Belt and Road Initiative (BRI), a signature project of Xi Jinping. This fall, Beijing will host the Belt and Road International Cooperation Summit Forum, although several major European countries are planning not to attend. Despite China’s significant efforts, the BRI has had limited success in developed democratic countries, excluding Italy. By the end of this year, Italy is likely to withdraw from the BRI agreement it signed with China in 2019. However, China’s BRI continues to make progress in other parts of the world.

 

For example, despite indications that war-torn Afghanistan has limited capacity to repay its financial obligations, China in May 2023 extended a BRI investment to the Taliban-controlled country, which is challenged by a fragile governance structure and weakened security apparatus. This is part of a larger trend whereby China ensnares low- and middle-income countries in a web of debt. Unfortunately, China’s irresponsible lending behavior goes unpunished, owing to the lack of formal international laws governing sovereign lending, coupled with the fact that China has no incentives to adhere to nonbinding norms.

 

Borrowing countries under the BRI have struggled to repay their loans. In more than 40 countries, the sovereign-debt exposure to China exceeds 10 percent of gross domestic product. Eight BRI-recipient countries have debt-to-GDP ratios that exceed 50 percent, with at least 40 percent of foreign debt owed to China. Excessive financing, combined with inadequate due diligence and lack of transparency, has embroiled 35 percent of BRI projects in corruption scandals, labor abuses, and environmental hazards.

 

The reckless lending was largely caused by the moral hazards of sovereign financing, whereby lenders have incentives to take excessive risks because the costs will ultimately be borne by someone else. Sovereign countries cannot declare bankruptcy and discharge unserviceable foreign debts, and so China continues to lend to insolvent debtors. It expects them to be bailed out by future taxpayers of the host countries. Conversely, politicians who borrow on behalf of their constituents are willing to accept onerous loans, since the negative consequences usually become apparent only after they have left office.

 

China’s financial risks associated with overextended credit can be offset by other means as well. China has repeatedly pressured defaulting parties to engage in debt-equity swaps so that it can acquire majority ownership of vital infrastructure or natural resources, making the inability to receive repayments profitable in the long run. In the case of Afghanistan, if it is indeed unable to repay its debt obligations, China may seek to seize control of Afghanistan’s rare-earth deposits.

 

These issues closely parallel what happened in the consumer credit market, where the securitization of residential mortgages led to excessive lending because lenders are incentivized to obfuscate the risks to borrowers as they off-load long-term liabilities onto the capital market. Additionally, predatory lenders also deliberately lend to borrowers with weak repayment capacity and force them into foreclosure to profit from the seizure of their property, a ploy similar to China’s use of debt-equity swaps.

 

However, unlike consumer credit markets, where regulations limit the ability of lenders to exceed certain debt limits or ratios, sovereign leaders are subject to no formal laws to curb their incentives for financial abuse. Instead, they face only the nonbinding “Principles on Promoting Responsible Sovereign Lending and Borrowing” (“Principles”), published by the United Nations Conference on Trade and Development. UNCTAD has no ability to enforce them or to deter noncompliance, other than to hold out the prospect of reputational damage. China’s relative isolation from the international financial system is thereby helping to undermine the informal framework for debt sustainability that relies on self-regulation by market participants.

 

In the absence of treaty-based systems, sovereign creditors and debtors could cooperate by identifying noncompliance and upholding intragroup norms. However, the BRI’s reliance on strictly bilateral ties means that those norms have no impact on China. The financing of BRI projects by China is driven mainly by its own institutions, banks, and state-owned enterprises rather than by multilateral institutions. Such bilateral lending has reduced transparency in the financing of BRI projects and thereby reduces the risk of reputational damage. In short, by positioning itself outside the international financial community, China enjoys relative immunity to informal enforcement of norms, making the Principles an ineffective deterrent to China’s misconduct.

 

Given the serious repercussions of China’s irresponsible lending practices under the BRI, it is vital that the international community take action to implement treaty-based hard law that imposes formal legal obligations on sovereign lenders to prevent predatory behavior and ensure debt sustainability. Although the nonbinding Principles are a positive step, China’s strategic position in the global financial market diminishes their effect to that of a mere symbolic reprimand. It is time to prioritize responsible sovereign lending and hold China accountable.