The Belt and Road Trilemma: The Future of China’s Role in International Development Finance

 

nternational development finance is in crisis. Official development assistance (ODA) volumes are falling, and private financial flows have shriveled too. Trade wars add to the uncertainty.

China sits at the centre of these developments. In recent years, it has become the single largest source of bilateral ODA. Yet the dramatic reconfiguration of global trade and capital flows currently underway is creating new tensions over China’s ability to perform that role. How Chinese economic policy adapts will have a huge impact on the rest of the developing world. That is the subject of my new working paper published today.

Funding for bilateral ODA is collapsing as a transformed geopolitical situation forces high-income country governments to confront trade-offs between spending priorities. In February this year, the UK reduced its financial commitment to foreign aid from 0.5 percent to 0.3 percent of GNI. A month later, the US dissolved the world’s leading bilateral aid agency, USAID, and over 40 percent of its active contracts have since been terminated. “If you were looking for a strategy to bring the global aid sector to its knees,” as one veteran aid-watcher has put it, “you would be hard pressed to come up with a better one.”

It is not only aid that has suffered. Private capital flows to low- and middle-income countries (LMICs) have also collapsed, as a result of the economic shock of the COVID-19 pandemic, the return of inflation in the advanced economies, and the subsequent synchronised tightening of reserve currency financial conditions. Long-term portfolio debt flows to LMICs ex-China dropped by two-thirds between 2013-19 and 2020-23. For the poorest countries, the sudden stop has been even more severe. The fall was more than 85 percent for sub-Saharan Africa.

This crisis in development finance is just one part of a still more extensive disruption of the international economic order, however. The last half-decade has seen a reverse in the 25-year trend towards freer trade, disrupting international commerce, supply chains, and investment. National security has become a dominant theme in the domestic and international policies of the world’s leading economies. At the root of these shifts are chronic, large-scale global current account imbalances, which have long been understood as a major challenge to global stability, and the new US administration has now pledged to confront.

China’s pivotal role in development finance

China is a central player in these developments. Since its accession to the World Trade Organization in 2001, China has become by far the world’s leading exporter, and thus a lynchpin of global trade. As a result, it has accumulated an enormous stock of foreign savings, making it one of the world’s largest external creditor nations­—and thus one of the major poles of international finance as well. Since 2013, those external savings have been increasingly deployed to finance lending to developing countries under the Belt and Road Initiative (BRI)—making China by some distance the largest single bilateral source of official development finance globally.

The future of international development finance generally will therefore depend critically on China’s future role—and China’s future role will, in turn, depend on the global patterns of trade and finance set to emerge from the current period of disruption.

China itself has faced a number of novel policy challenges in the post-pandemic period. Several long-term, structural risks to its growth model have crystallised. On the domestic front, productivity has slowed, the decade-long real estate bubble has burst, and high indebtedness has begun to interact with very low and even negative inflation. At the same time, the international economic environment has become more fractious, with China’s largest trading partners imposing increasingly wide-ranging tariffs on its exports.

Together, these developments are imposing new and unfamiliar constraints on China’s balance of payments and its international investment position. Weak domestic demand stemming from China’s domestic economic adjustments has combined with a continued strategic emphasis on manufacturing for export to generate record foreign currency earnings on the current account. At the same time, starting in 2021, all major categories of gross capital inflows to China went into reverse for the first time in the modern era. As a result, rather than financing further additions to China’s stock of foreign assets, China’s current export earnings switched instead to funding capital outflows, bringing to a halt the expansion of the stock of foreign savings on which China’s status as the world’s premier bilateral source of development finance has been based.

The Belt and Road trilemma

This dramatic change from the pre-pandemic years implies that China now faces an effective trilemma between three different high-level policy priorities:

• the continuation of BRI lending
• China’s long-term strategy to internationalise the use of its currency, which requires the maintenance of a stable external balance sheet and the continued liberalisation of capital controls
• the current domestic policy mix to which China is currently committed in order to restructure and rebalance its economy

The reversal of gross capital inflows will almost certainly require China to prioritise more aggressively between these three objectives in future. Moreover, if the US administration succeeds in its stated objective of shrinking global trade imbalances, thereby staunching China’s current account earnings as well, the trilemma will become still more acute.

Given the retreat of traditional donors and the collapse in private capital flows to LMICs, how China’s BRI lending evolves in light of this trilemma will be critical in determining the future of international development finance more generally. The BRI has already adapted significantly, both in the scale and the composition of its lending, since its early years. The recent triennial Forum on China-Africa Cooperation indicated further strategic changes, with less emphasis on infrastructure projects and on lending to recipient-country governments, and more on directing funds to Chinese direct investment and offering tariff-free market access.

The risks—and opportunities—of the BRI trilemma

For LMIC governments, investors, and businesspeople, China’s emerging BRI trilemma carries obvious risks. It seems likely that the configuration of international capital flows which sustained the largest single bilateral development finance initiative of the past decade is over. Moreover, this change is driven by geopolitical shifts largely unrelated to development policy per se, and over which recipient countries can hope to have very limited influence. Much will depend on the success of China’s domestic economic restructuring strategy, and benign outcomes to ongoing disputes over the future shape of the international trade and monetary systems.

Yet there are also opportunities. For developing countries with capital market access, the dominance of the US as an investment destination for international investors over the past decade has been far from an unmitigated positive. A rebalancing of private capital flows away from the US, and especially a secular weakening of the US dollar, may offer powerful new incentives for private capital flows to the emerging markets—and in some cases, offset the decline in official development finance. Geopolitically, there is potentially an opportunity for developing countries to benefit from capital flows seeking strategically neutral investment destinations.

Given the current pace of change in the international economy, predicting how China will navigate its BRI trilemma—and what its future role in international development finance will therefore be—would be hazardous. One conclusion, however, is likely to remain robust under almost all scenarios: in a more competitive environment for attracting international development finance, policies designed to maximise the prospect of attracting private capital inflows are more essential than ever for developing countries themselves.