Following the global financial crisis, China has arguably changed its approach towards the global financial system. China has changed from being pragmatic in its accommodation with pre-existing institutional structures, to becoming a more proactive financial power. Recently China reached two milestones: the renminbi’s (RMB) inclusion in the International Monetary Fund’s (IMF) special drawing rights basket (SDR) and the establishment of the Asian Infrastructure Investment Bank (AIIB). Below, I briefly examine the road leading to these milestones, as well as the key challenges ahead.
Chinese officials and leadership have prioritised the role of finance as reform of the financial system over the last decade has lagged behind industrial development. China’s domestic bond markets were a decade ago practically non-existent, while its stock market is still prone to speculative bubbles. Until recently, Chinese interest rates were also administratively set and not reflective of true financial risks. As a result, the available investment options for Chinese domestic investors have been severely reduced by capital controls, which have spurred bubbles in real estate and large inflows to dubious alternative financial products.
In order for the country’s economy to continue developing, finance is a key area that needs to be reformed. In late 2013, the Chinese Communist Party’s Central Committee publicised a 60-point extensive reform agenda, with domestic financial system reform given high priority, including exchange rate reform and capital account convertibility—key prerequisites for the renminbi’s increased international use.
The renminbi’s future role in the international monetary system and the currency’s internationalisation caught people’s attention when the Chinese central bank governor, Zhou Xiaochuan, penned three articles that addressed the issue in 2009. Zhou argued that the world should gradually move away from a financial system based on national currencies as reserve currencies and pondered options for giving a greater emphasis to the IMF, including strengthening the role of the IMF’s SDR in the global financial system. Since then, a long raft of government measures has been launched to promote this political aim. These range from cross-border trade settlement and direct investment in RMB, to ‘dim-sum bonds’ and bilateral swap arrangements with other central banks. The international use of the Chinese currency has leapfrogged in a short time, exceeding 2% of all global payments, based on value. However, recently progress appears to have stalled, possibly an early indication that there are clear limits to the underlying international demand for the RMB, in the absence of sufficiently deep, mature and open domestic financial markets.
China’s effort to promote its currency’s wider international use resulted in the November 2015 IMF review’s conclusion that the renminbi will be included in that most exclusive international club—the SDR currency basket. Earlier, the IMF had maintained that the currency was not yet ready to be included in the basket, because of formally still relatively tight controls on the capital account.
The eventual political goal of making the Chinese currency convertible had been set already during the third Central Committee plenary meeting of the Communist Party’s 14th Party Congress in November 1993. Yet, amid massive capital flight and a mini stock market crash in 2015, Chinese leaders’ actions have recently been sending mixed signals with regard to further liberalisation of the capital account. The fact that the IMF accepted the RMB may be taken as a sign of China’s growing financial power. It is, however, doubtful how much more space there is for further expansion of the RMB’s use, if capital controls are maintained—or even re-tightened—as now seems increasingly likely.
With the rise of large emerging economies, the old institutional set-up of the global economy has become outdated. The main pillars of this system, the so-called Bretton Woods institutions (the IMF and the World Bank Group), reflect the dominance of Western economies in the post-War period with EU member states accounting for roughly 1/3 of quotas and votes in the IMF, while the United States effectively has held the power of using a veto.
The reform of the Bretton Woods institutions came onto the G20 agenda in the October 2005 Xianghe meeting of finance ministers and central bank governors. This was at a time when the G20 issued a statement exhorting that quotas and representation should reflect changes in economic weight while the selection of senior management should be based on merit and ensure broad representation of all member countries. The BRICS (Brazil, Russia, India, China and South Africa) summits have hence often called for greater voice and representativeness.
There was cause for celebration in 2010, as the IMF Board approved a reallocation of quotas and voting rights for member states. Yet progress was stalled, with the United States Congress foot-dragging on ratification of the IMF reform package until 18 December 2015. Unsurprisingly, the Chinese response was to put more effort into promoting multilateral financial institutions initiated by itself. First, the so-called (formerly BRICS) New Development Bank (NDB) was set up in 2014. The Bank, headquartered in Shanghai, promises to pool the resources of China and the other BRICS countries. The NDB will provide capital for development projects, as the World Bank does, and will also maintain contingent reserve arrangements, similar to the IMF. A noted difference is that the NDB adopts a ‘one country, one vote, no vetoes’ decision-making system, whereas the decision-making structure in the IMF resembles more that of a corporate shareholder structure.
But it was the launch of the AIIB—with the purpose of providing financing to infrastructure projects in the Asia-Pacific region and headquartered in Beijing—that truly attracted global attention. The AIIB attracted attention because of American opposition and because it was perceived as a competitor to the Asian Development Bank (ADB), headquartered in Manila, in which the Japanese government traditionally has had a strong voice.
Some years ago, academic conversations on the BRICS theme tended to end up as discussions on China. The shift of focus from the NDB to the AIIB is therefore symbolic. With the AIIB China will be more dominant, with its current 30.34% of shares and 26.06% of votes giving a de facto veto and a position even surpassing the US position in the IMF. Beijing has been keen to stress that it won’t exercise its veto and that its votes will later be diluted as other countries join. Yet, Beijing will face an uphill struggle to convince sceptics that the AIIB will not be dominated by China and used to further China’s political and strategic objectives.
Since Premier Zhou Enlai’s famous ‘eight principles’ from 1964, Chinese leaders have emphasised that in their dealing with other developing countries, they are neither imposing any conditions, nor asking for any favours. Chinese state-linked lenders, e.g. policy banks, also contend that they do not apply ‘political conditionality’ in their lending decisions. However, this is true only in a qualified way, to the extent that conditionality is understood to mean the kinds of policy conditionality required by e.g. the IMF. Chinese aid and bank credits are given to countries with which China maintains diplomatic ties. The political condition of adhering to the One-China principle may also be enshrined in diplomatic agreements that incorporate the framework agreement for concessional loans. Recent research indicates that there may also be other kinds of conditions embedded in projects financed with Chinese lending.
Nevertheless, since Chinese state-linked lenders commonly do not have many upfront conditions for their loans, it is also harder for them to deny loans to other developing countries with which China maintains diplomatic and good political relations. Clearing the ‘One China’ hurdle is a small barrier compared to the conditionality, feasibility studies, transparency and reporting requirements typically imposed by Western or other multilateral lenders.
How Beijing deals with issues of structural dominance, policy conditionality and financing criteria in the AIIB are crucial to its success, and a test for the kind of financial power that China will be.
Ahead of the EU-China Summit in July 2016, Friends of Europe will publish articles from our vast network of Chinese and European academics, policymakers, business representatives and media on the future of the EU-China strategic partnership. These will be collected into a publication entitled “EU-China relations: new directions, new priorities”.
IMAGE CREDIT: CC / FLICKR – International Monetary Fund