Author: David Dollar, Brookings
China’s economic rise is one of the factors straining the international financial order. China is already the largest trading nation and the second-largest economy, and if current trends continue, China will become the largest net creditor around 2020.
After controlling for market size and natural resource wealth, foreign direct investment is strongly attracted to better governance environments. Chinese overseas direct investment (ODI) differs from other investment in that it is uncorrelated with the index of property rights and the rule of law. There is actually a slightly negative relationship between how much ODI a country receives and economic governance, but it is not statistically significant. Chinese ODI appears indifferent to the governance environment.
China is not seeking out poor governance environments. It is a major investor in the well-governed countries that are the largest recipients of investment globally. But it does appear to be indifferent to the governance environment to the extent that it is making major investments in weak governance environments where other investors fear to tread.
There are a number of plausible explanations for this pattern of investment. Many large investments from China are made by state-owned enterprises (SOEs). SOEs do not feel the same pressure as private firms to earn good returns on their investments. Their investments in poor governance environments are often part of state-to-state deals and they may feel insulated from the local economic environment.
It is also the case that China is a relative newcomer on the global investment scene and Chinese firms may have underestimated the risks involved in some investments. There is evidence that some natural resource investments in poor governance environments are turning out badly.
China’s pattern of global investment raises two policy issues, one for China and one for the world. First, from China’s point of view, is it getting the best return on its investments?
Chinese SOEs, by definition, are playing with the people’s money. If they waste tens of billions of dollars in poor investments, that is a real loss for China. From a global point of view, there is the question of whether China’s state-to-state financing is sustaining poor governance in some countries. The projects in the worst governance environments may not be returning economic benefits, but China’s money is going somewhere.
A second issue raised by China’s emergence as a major global investor concerns environmental and social safeguards. China is a major funder of mining and infrastructure projects. Such projects normally carry significant environmental risks and often involve the involuntary resettlement of large numbers of people.
So far, China has been reluctant to subscribe to any international standards for environmental and social safeguards. China’s position is that it follows the laws and regulations of the host country. This is a reasonable point of view, consistent with China’s general position that countries should not interfere in each other’s internal affairs. The problem is that the implementation of environmental and social regulations is often weak, especially in the countries with weak governance. Private financial institutions from Western countries have generally subscribed to international environmental and social standards, but large Chinese banks have not been willing to join.
Given this situation, the emergence of China as a major funder of mining and infrastructure projects has been welcomed by most developing countries. China is seen as more flexible and less bureaucratic. It completes infrastructure projects relatively quickly so that the benefits are seen sooner. But China’s approach of relying on the recipient country’s own laws and regulations also has its risks, particularly in regards to the environment.
China is likely to evolve in the direction of current investment norms — that is to favour better governance environments. Part of China’s motivation for investing in countries such as Venezuela and the Democratic Republic of the Congo was to access natural resources. In the 2000s, China’s growth model was very resource intensive and global prices for most commodities were rising. That made it tempting to look for resources, even in risky environments
That has all changed this decade. A lot of new supply has come online in sectors such as oil and gas, iron and copper. Meanwhile, China’s growth model is shifting away from resource-intensive investment towards greater reliance on consumption.
Concerning environmental and social safeguards for infrastructure projects, China has identified an issue that resonates with other developing countries. The World Bank and other multilateral development banks have been imposing environmental and social standards that reflect the preferences of electorates in rich countries. Developing countries have been voting with their feet and have turned away from those banks as important sources of infrastructure financing. In general, they welcome Chinese financing of infrastructure.
China has clearly tapped into an important sentiment in the developing world that infrastructure is key to growth and that private finance and existing development banks are not sufficient. Part of the problem is that the existing banks are not large enough; a second issue is that they have turned away from infrastructure as a core business. On this issue, the smart thing for the United States would be to find a way to say ‘yes’ to China’s standing offer to join the Asian Infrastructure Investment Bank.
More importantly, given the United States’ leadership role in the World Bank and regional banks, it should accelerate governance reform that would strengthen developing countries’ shares and roles in these institutions. If the next president of the World Bank were a successful reformer from the developing world, that would be a powerful statement and a real change. More developing-country voices in the existing development banks are likely to result in their getting back into infrastructure in a major way.
David Dollar is a Senior Fellow in the John L. Thornton China Center at the Brookings Institution.