Too Much Risk or Not Enough? New Development Finance Agencies in China and the United States

The past year has seen significant shake-ups to the development finance regimes of the world’s two largest economies. In April 2018, China officially established its new China International Development Cooperation Agency (CIDCA). Not to be outdone, the United States Congress in October 2018 passed the Better Utilization of Investment Leading to Development Act, better known as the BUILD Act. The BUILD Act established the United States International Development Finance Corporation (USIDFC), which will replace and expand upon the Overseas Private Investment Corporation (OPIC). At first glance, it might be easy enough to dismiss these two agencies as roughly parallel developments in a tit-for-tat competition between the United States and China. Indeed, there is an undeniable element of Sino-American competition at play here, especially given the current state of overall bilateral relations. However, CIDCA and the USIDFC actually serve very different purposes rooted in the particularities of their respective domestic political economies.

In China, state-owned firms with easy access to government money can afford to take risky bets, and as is the case in Las Vegas or Macau, these bets can result in anything from spectacular gains to large losses. The United States, on the other hand, has a private sector-led system in which corporations do not expect much support from the government and are more cautious in their overseas activities. The USIDFC’s challenge will not be to rein in American firms so much as to prod them outward. A look at these two agencies reveals quite a bit about how two very different political and economic systems can have divergent implications for development finance practices.

The China International Development Cooperation Agency (CIDCA)

China’s development finance practices are in many ways a natural outgrowth of its domestic financial system. During the Mao era, China’s banks were more akin to those in the Soviet Union: they existed to channel credit to the government’s preferred projects, but were not expected to turn a profit. Since Deng Xiaoping initiated China’s “reform and opening up” in the late 1970s, and especially since the reforms of economic czar Zhu Rongji in the 1990s, China has tried to overhaul this system to make it more similar to privately run banking systems in other countries. However, the transition has been incomplete. The banks are still predominantly state-owned and have a relatively high rate of non-performing loans (NPLs)—essentially, loans that aren’t being paid back—and the bulk of these loans are to state-owned firms.

Of course, there is a reasonable defense for losing money in this fashion. The private sector tends to underinvest in projects like public infrastructure that only generate profits after an extended period of loss, if at all. China’s willingness to use state credit toward questionably profitable projects could actually be an asset in this regard. Former World Bank Chief Economist Justin Yifu Lin and World Bank Senior Economist Wang Yan use the term “patient capital”—in other words, willingness to wait until a loss-making project turns profitable, as in a new highway or railway slowly generating traffic to an underdeveloped area. More recently, Made in Africa Initiative Chief Economist and former Renmin University researcher Jason Cheng Cheng has termed China’s approach “blood cell finance,” using the metaphor of the body’s circulatory system to describe how spending money on connectivity projects can serve to benefit the rest of the economy. After all, the heart burns a lot of energy pumping blood, but you wouldn’t exactly call it a waste, right?

The most obvious problem with this approach to development finance is that it can be fairly difficult to predict which projects are worth a period of loss-making. Even when this is possible, Chinese firms do not face much incentive to lower their operational risks. Firms know that the government will probably back them up with further loans if projects fail, and they obtain credit on cheap enough terms that there is little reason not to gamble, even in unfavorable investment climates. This issue is compounded by a variety of internal divisions. Many outsiders tend to view China as a centrally coordinated monolith, but the reality is that it is internally as fractious and chaotic as most market-based systems. Firms may gamble on dicey projects just to keep rival firms from getting them. Large state-owned firms subject to the centralized State-owned Assets Supervision and Administration Commission (SASAC) may receive a degree of oversight, but provincial and local firms often slip through the cracks. Government ministries, for their part, are not particularly unified either. The Ministry of Foreign Affairs’ emphasis on diplomatic interests frequently leads to clashes with the business-minded Ministry of Commerce, leading to a general lack of coordination, as well as increasing the odds that firms can find at least one government patron for unreliable projects. A series of bad investments has prompted the government to tighten the belt over the past few years, but there is still a distinguishable gap between Chinese practice and that of most private firms.

There exists yet another divide between China’s firms and government: the state simply lacks the capacity to effectively oversee all of its firms’ activities. During a recent trip to Beijing, I found Chinese specialists to be quite divided on to what degree China should impose greater constraints on its firms, but unanimous in their assessment that China’s government was much weaker than its firms. Most Chinese embassies abroad and agencies in Beijing have a fraction as many personnel as their developed country counterparts, despite frequently overseeing larger volumes of financial flows. This lack of oversight opens the door to bad behavior by firms abroad, as evidenced by recent corruption scandals in places like Chad, Kenya, and Malaysia.

Resentment of such cases sometimes resonates in local politics: few would have foreseen the return of the nonogenarian “Asian values” godfather Mahathir Mohamad to the Malaysian Prime Minister’s office on a platform critical of Chinese corruption, but he nonetheless took office last year. Even where corruption is not involved, many borrower country publics have become leery of their governments’ ability to repay debts involving projects that might not be as profitable as anticipated. China Merchants Group’s takeover of the management of Sri Lanka’s Hambantota Port in response to debt non-repayment has sparked a public relations backlash that appears to have exceeded Beijing’s expectations, with fears of a similar fate surfacing in a range of countries including Djibouti, Laos, Kenya, Pakistan, and Zambia.

This has led many observers to fear that China is using “debt trap” diplomacy: lending unsustainable amounts of money to poor countries knowing that when they cannot repay, China can use the overdue debt as leverage to gain influence and take control of assets. This danger is much more real in some cases than others. The large majority of projects are not as strategically significant as the Sri Lankan port, which is situated at the center of the Indian Ocean shipping route linking China to African and Middle Eastern commodities, as well as to European consumers. Beijing faces little incentive to take over, say, a semi-profitable plastics factory. However, the speed-of-light rumor mill that is the modern media environment can easily turn a deal gone bad due to poor planning and ineffective oversight into a sinister plot, with actual and perceived negative developments alike contributing to the “debt trap” narrative. This narrative is currently in vogue in many Western outlets, but the bigger problem for Beijing is that many people in developing countries are beginning to believe it as well. Unlike third-party Westerners, developing country leaders and voters actually have the ability to delay or cancel deals.

China’s so-called “governance deficit” requires attention, lest the benefits of infrastructure construction fall victim to weak risk management practices. Chinese experts and official documents both convey that CIDCA is intended to address these shortcomings. Jason Cheng Cheng’s book, for example, devotes much of its last section to how the new agency can address the “ethics trap,” or the danger that unscrupulous corporate bosses could derail investment projects and damage China’s reputation by committing legal or ethical violations.

Analysis of primary source materials backs this argument. Marina Rudyak of Heidelberg University has helpfully published a side-by-side comparison of CIDCA’s 2018 guidelines for foreign aid with the Ministry of Commerce’s 2014 predecessor document. The majority of the language in the new document is copied and pasted from the old, but the new parts are telling. A number of clauses discuss planning and coordination. “CIDCA shall, in conjunction with relevant departments, establish an interdepartmental aid coordination mechanism in order to plan and coordinate major foreign aid issues,” states one new paragraph; “CIDCA shall be responsible for the top-level design of foreign aid, drafting of foreign aid strategies, and implement[ing] them upon approval,” states another. Keeping in mind that enforcement and oversight are historically issues for China, the new document promises that “CIDCA shall […] establish supervision and inspection mechanisms for major projects” and provides for “on the ground” inspections of embassies and project sites. It certainly seems that Beijing is becoming aware of the “governance deficit” in its development finance activities and is trying to reduce the presence of white elephants and black markets among its projects. Also of note is CIDCA’s situation within the Chinese bureaucracy. Like the Ministries of Foreign Affairs and Commerce, CIDCA is directly under the purview of the State Council, China’s top level of governmental (as opposed to Party) authority. This should grant it a degree of independence from either.

More intriguing is the appointment of Wang Xiaotao as CIDCA’s inaugural chairman. A career civil servant in the National Development and Reform Commission (NDRC), China’s powerful economic planning agency, Wang’s appointment serves as a means of bypassing the headaches that would come from selecting someone from one of the feuding Ministries of Foreign Affairs or Commerce. One can understand Xi’s desire not to take sides in a spat between agencies, but the choice of someone from NDRC cuts against recent political trends. Xi sees China’s bureaucracies as excessively rigid and unwieldy. So, he has attempted to centralize power above them through the use of Leading Small Groups (领导小组), in which highly placed people oversee much larger bureaucracies from perches in the State Council. Given the NDRC’s strength and the sheer scope of its activities regarding the economy, energy, and the environment, it could easily be considered a poster child for China’s powerful bureaucracy. A recent reshuffling of China’s bureaucratic flowchart transferred responsibility for certain issues involving agriculture, energy, and the environment from NDRC to other agencies, and CIDCA itself has been interpreted as part of a secular trend of transferring power away from entrenched bureaucracies. Appointing Wang Xiaotao, a thirty-year NDRC veteran, might thus be considered one step forward and two steps back, depending on to what degree he maintains his NDRC linkages in his new capacity. Or, perhaps his appointment is two steps forward and one step back: Xi might be willing to augment the power of one ministry (NDRC) in order to limit that of two deadlocked rivals (Foreign Affairs and Commerce).

The United States International Development Finance Corporation (USIDFC)

If CIDCA is a product of the need to rein in risk-tolerant, cash-flush state-owned firms and increase coordination in the context of numerous internal divisions, then the USIDFC is the product of a very different set of problems. Instead of fighting over international development contracts, American firms often avoid them altogether, especially in the most difficult markets. The reason lies in the fundamental organization of the United States’ domestic political economy. The United States government tends to take a hands-off approach to the economy, with private firms playing a leading role. In the context of international development, this means that American firms do not frequently receive “patient capital”-type support to invest in projects with long periods of loss or high degrees of political risk. What’s more, while Chinese firms rely on state-owned banks for much of their financing, American firms rely more on equity financing through the stock market. The stock market is generally short-term in outlook, with most corporate bosses judged by whether quarterly earnings reports meet analysts’ targets by margins of pennies per share. American financial analysts also tend not to look kindly on excessive corporate reliance on government funding. Such a system does not lend itself to slow-moving, high-risk projects.

The resulting numbers are sobering. As of 2014, the most recent year for which comprehensive data is available, AidData estimates that China committed approximately US $140 billion in new development finance projects worldwide. OECD figures put American commitments at $29.4 billion in the same year. The United States still maintains a lead over China in other areas, but is being badly outclassed in development finance, despite boasting a larger economic base. Developing countries are taking notice; a recent piece in Foreign Affairs titled “A Post-American Africa” captures a certain melancholy sentiment.

The passage of the BUILD Act has largely been in response to this sentiment. Even members of Congress not historically amenable to foreign aid voted in favor. Sponsoring Representative Ted Yoho (R-FL) told the New York Times after the bill’s passage that:

“[…] it is all about China […] My whole impetus in running for Congress in the first place was to get rid of foreign aid. It was my thing. But if we can reformulate and modernize it, yeah, I have no problem with that. There are people who want to do this for humanitarian aid, fine. There are people like me who want to do this for national security, like me, fine.”

The bill sailed through the House by a vote of 398-23, and through the Senate by 93-6. Such a consensus is all the more impressive given the gridlock that prevails in Congress on most other issues, not to mention the $60 billion price tag. Clearly, anxiety about China is creating that most elusive of creatures: a common sense of purpose.

As is the case in China, this sense of purpose cuts across traditional political divides. Foreign aid is historically more popular among Democrats than Republicans. Some on the right see aid as a waste of money when there are still needy people within America’s borders; others see it as “corporate welfare” distorting markets through an inappropriate use of government funds to intervene in the economy. For this reason, OPIC, the USIDFC’s predecessor, faced periodic threats of abolishment by Congress during the 2010s. It says something that Republicans such as Representative Yoho and President Trump have nevertheless turned to embrace the BUILD Act. Indeed, one of the USIDFC’s biggest proponents has been Ray Washburne, a Dallas real estate investor and longtime Republican fundraiser appointed by President Trump to lead OPIC.

Looking Forward

So what does this all mean in the future? How far will China and the United States go in reforming their development finance systems? With CIDCA less than a year old and the USIDFC not yet operational, it is still too soon to definitively say, but this author would predict only gradual change. In China’s case, the reason is fairly simple: state capacity. Even with the new agency, the government does not have enough resources and personnel to oversee all firm activities. Increasing staffing levels will take time, and even a larger CIDCA will run into the usual problems encountered whenever regulators take on powerful entrenched interests. There is every indication that the Chinese leadership is serious about CIDCA, but full implementation will not happen overnight.

The United States’ situation is much more complicated. There is an old adage that “in China, it is easy to pass a law, but difficult to enforce it. In the United States, it is difficult to pass a law, but easy to enforce it.” The adage seems appropriate here. In China, laws can be passed more or less because President Xi says they should be, but mustering the resources to enforce them against well-entrenched bureaucracies is a steeper hill to climb. In the United States, it took the major shock of being eclipsed by a developing country in the realm of development finance to jolt Congress into action, and agencies are almost certain to comply with the letter of the recently passed law. The real question, then, is what exactly is in the law?

A look at the substance of the bill reveals that it is unlikely to be quite as transformative as advertised. The first issue is the amount: the $60 billion cap on outstanding assets is quite a bit of money to most of us, but still less than the amount that China might add to its books in one year. Still, the cap is a doubling of OPIC’s. However, even if the quantity of financing provided represents a significant change, the nature of the financing does not. The opening lines of the bill are worth reading:

It is the policy of the United States to facilitate market-based private sector development and economic growth in less developed countries through the provision of credit, capital, and other financial support—

(1) to mobilize private capital in support of sustainable, broad-based economic growth, poverty reduction, and development through demand-driven partnerships with the private sector that further the foreign policy interests of the United States;

(2) to finance development that builds and strengthens civic institutions, promotes competition, and provides for public accountability and transparency;

(3) to help private sector actors overcome identifiable market gaps and inefficiencies without distorting markets […]

A consensus has emerged in Washington that the United States should counter China in development finance, but not that it should act like China in development finance. Traditional American priorities such as maximizing the role of the private sector in the economy are on full display, as are some more generally Western priorities such as clean governance and reliable institutions. As the bill later puts it, the USIDFC is intended to “ensure that support provided under this title is additional to private sector resources by mobilizing private capital that would otherwise not be deployed without such support.” This reflects a classic tradeoff in international development. On the one hand, development agencies can fund projects in countries with strong institutions and rule of law knowing that they are more likely to result in greater private sector growth and employment. On the other hand, these well-governed countries typically do not need the help as badly, simply because private investors also take note of their better business climates.

Reaching the world’s most desperate often involves dealing with unscrupulous leaders and hoping that some funds are not squandered or stolen before having any impact. China is willing to do this. David Landry’s statistical analysis of development finance in Africa finds that Western countries tend to pay attention to factors such as corruption and human rights, but China is basically agnostic. Per AidData, the top five recipients of Chinese development finance from 2009 to 2014 were Russia, Venezuela, Pakistan, Iran, and Belarus. Russia, Venezuela, and Iran have all been subject to broad-based US sanctions, while the United States’ relationships with Pakistan and Belarus could best be described as complicated. China is filling a void where the United States and many others are afraid to go, and the BUILD Act’s provisions regarding support for the private sector and good governance would indicate that this pattern is unlikely to change, at least for the US. This is not to say that the pattern should change, but simply to say that we should remain clear-eyed about to what degree the USIDFC directly competes with CIDCA.

Furthermore, the BUILD Act allows up to 35 percent of USIDFC assets to be in the form of equity investments. This is a positive in that it avoids the potential backlash from excessive debt burdens—no “debt traps” here!—but simultaneously presents some difficulties in certain markets. Namely, complex ownership contracts are difficult to adjudicate in many developing country court systems. In my own forthcoming research, I find that China tends to use more debt than equity financing in high-risk countries partially for this reason: many loan agreements amount to beefed up IOUs, leaving little room for courtroom interpretation. At least 65 percent of USIDFC assets will go toward debt, insurance, and technical cooperation arrangements, but the equity component will function better in more stable, middle-income countries. Included safeguards regarding adherence to trade agreements and labor and environmental standards may have a similar effect, as dicier markets are less likely to remain in compliance. Last, but not certainly not least, the USIDFC must be self-sustaining and revenue neutral. This is a positive for fiscal sustainability, especially given the United States’ budget deficit, but it does mean that marginally profitable projects with high risk and low interest rates are not likely to be a big part of the USIDFC’s portfolio.

Conclusion

The USIDFC, then, is not going to compete with China in high-risk markets. China’s risk appetite may be shrinking, but it is still willing to accept greater losses and longer periods of unprofitability than the USIDFC or Western private sector. This is doubly true with respect to markets either formally sanctioned by the West or simply unpopular with investors due to questionable track records of economic management. To directly compete with China, the United States would certainly have to develop a higher tolerance for financial loss, and in some cases would have to fundamentally change its foreign policy approach toward unsavory regimes. There are a whole host of reasons why Americans will not want to make these kinds of changes, beginning with concerns for human rights and budgetary mathematics, and we should not expect the USIDFC to look all that much like Chinese lenders.

Early public statements from American leaders indicate both an awareness of these differences, and a willingness to use them as an asset. A White House statement after the BUILD Act’s passage emphasized the goal to “better incentivize private sector investment in emerging economies and provide strong alternatives to state-directed initiatives that come with hidden strings attached.” The word “China” is not uttered, but “state-directed” and “hidden strings attached” are pretty clear references to the “debt trap” narrative, and the “private sector” reference is a nod to the American system. The USIDFC isn’t meant to prod Americans into investing like Chinese; it’s meant to prod them into investing like Americans.

For all this talk about the United States and China, we should end by discussing the oft-neglected other half of the equation: developing countries. The developing world encompasses over half of humanity and is no monolith. Some developing countries—think of Botswana or Chile—are historically friendly to an American-style model of private sector-led growth and strong rule of law. These are likely to embrace the USIDFC and continue to polish their pro-market reputations among international investors. Another group—think of Russia or Zimbabwe—are simply not going to want to fundamentally overhaul their domestic systems in exchange for a handful of American loans. These will continue to rely on China. A third group, perhaps the largest of all, does not particularly care about ideology and will simply go with the most favorable offers. China’s willingness to lose money on overseas deals has admittedly diminished, but barring some surprises in how the USIDFC does business, China is still likely to offer cheaper repayment terms and larger quantities. A pragmatic developing world leader would have to take this into consideration.

The USIDFC’s real impact, then, will not be to expand to higher-risk countries, but to expand to higher-risk or less profitable projects in safer countries. For example, electricity generation is often not very profitable, but it has enormous consequences for industrialization and growth. The same goes for other areas of American strength such as medicine, air travel, and telecommunications. The USIDFC will enable some of this talent to be put to use in lower-risk developing markets. However, we shouldn’t kid ourselves about how much this will allow the US to compete with China, especially in the parts of the world most in need of capital. The Chinese system is wired to support high-risk gambles on projects that could help to transform poor economies, or could completely go bust. The American system is wired to support safe short-term bets. Both sides are changing incrementally, but more via evolution than revolution.

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Scott Wingo is a doctoral candidate in political science at the University of Pennsylvania focusing on China’s economic engagement in the developing world and why its modes of doing business are different from those used by Western governments, international organizations, and multinational corporations. He has previously worked with the Woodrow Wilson Center, the World Bank, and in the private sector, and has served as a teaching assistant for five semesters at Penn. He holds both a Bachelor’s of Science in Foreign Service and a Master’s of Arts in Asian Studies from Georgetown University. You can follow him on Twitter @ScottCWingo.