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Thinking like a creditor : risk, leverage and multilateralism in China's development finance Zhang, Linting 2019

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   THINKING LIKE A CREDITOR: RISK, LEVERAGE AND MULTILATERALISM IN CHINA’S DEVELOPMENT FINANCE  by  Linting Zhang     A THESIS SUBMITTED IN PARTIAL FULFULLMENT OF THE REQUIREMENTS FOR THE DEGREE OF   MASTER OF ARTS  in  The Faculty of Graduate and Postdoctoral Studies (Political Science)     THE UNIVERSITY OF BRITISH COLUMBIA (Vancouver)      April 2019   © Linting Zhang, 2019  ii The following individuals certify that they have read, and recommend to the Faculty of Graduate and Postdoctoral Studies for acceptance, a thesis/dissertation entitled:  Thinking Like A Creditor: Risk, Leverage and Multilateralism in China’s Development Finance  submitted by  Linting Zhang     in partial fulfillment of the requirements for  the degree of  Master of Arts                                            in     Political Science                                            Examine Committee:  Dr. Yves Tiberghien Supervisor   Dr. Brian Job Additional Examiner  iii Abstract The establishment of the Asia Infrastructure Investment Bank (AIIB) by China has raised many questions from global public. Most importantly, what are China’s motivations behind the decision of the AIIB? And why does multilateralism become a favored approach in China’s international development finance? Contrary to existing explanations which mainly focus on China’s strategic and geopolitical ambitions, this thesis provides a functionalist and pragmatic perspective: the economic rise of China has enabled the communist state to become a major sovereign creditor in international finance landscape in recent years. However, this new position in global financial system also brings China many structural challenges faced by other similar sovereign creditors, namely management of various lending risk and private fund leverage. To safeguard its valuable financial resources, China turns to multilateralism and multilateral institutions such as the AIIB, because they could be utilized as reliable and effective financial vehicles to help sovereign creditors like China in collecting information, hedging credibility problem, sharing burden and risk with others, as well as tapping private capital to supplement its financing goals. iv Lay Summary  The newly established Asian Infrastructure Investment Bank (AIIB) has been widely considered to be China’s own “World Bank” and viewed as its latest move to challenge the U.S. dominance in global political and economic affairs. This thesis, on the other hand, argues that China has moved up its position in global financial system to become a major sovereign creditor, and therefore China’s AIIB initiative was largely driven by functional and pragmatic needs associated with the country’s surged international lending and investment, which is by nature a high-risk business. Multilateral development banks like the AIIB can help sovereign creditors reduce various lending risk and leverage more capital from non-sovereign lenders in international financial market. The thesis uses the story behind the building process of the AIIB and the market performance evaluation of existing multilateral development banks as key evidence to support the argument.  v Preface  This thesis is original, unpublished, independent work by the author, Linting Zhang.     vi Table of Contents Abstract…………………………………………………………………………….......iii Lay Summary……………………………………………………………………..……iv Preface……………………………………………………………………………..……v Table of Contents…………………………………………………………………… List of Tables……………………………………………….………………..……….viii List of Figures…………………………………………………………………….……ix List of Abbreviations……………………………………………………………….....x Acknowledgements…………………………………………………………………..xi Section 1 Introduction……………………………………………………….……...1 Section 2 Overthrow the Bretton Woods?......................................................5 Section 3 The Conundrums of Sovereign Creditors…………………………..9 3.1 Three Assumptions…………………………………………….…………...9 3.2 Information Risk…………………………………………………………....11 3.3 Credibility Risk………………………………………………….………..…12 3.4 Market Risk……………………………………………………….………...13 3.5 Political Risk………………………………………………….………….….14 3.6 The Necessity to Leverage Private Fund………………………………..15 Section 4 A Functionalist Theory of Multilateral Development Banks……17 4.1 MDBs and Information Risk………………………………………………..18 4.2 MDBs and the Credibility Problem………………………...……..............18 4.3 MDBs and the Market Risk…………………………….……………….….22 4.4 MDBs as Firewall for Political Attention…………..………………………23 4.5 MDBs as Leverage Vehicles……………………….....…………………...24 Section 5 Flooding Red Back: China as A New International Creditor.......26 5.1 Rise of The Red Creditor………………………………….……………….26 vii 5.2 The Multilateral Turn of China’s Monetary Power…………….………....30 Section 6 Thinking About Risk and Leverage: The creation of  the AIIB…………………………………………………………………...37 Section 7 Market Performances of MDBs……………………………………....41 Section 8 Conclusion……………………………………………………………....47 Bibliography……………………………………………………………………….….50 viii List of Tables  Table 1   Summary of Monetary Power Patterns by A Sovereign Creditor…….31 Table 2   Credit Ratings for Selected Creditors, Long-term…………..………....42   ix List of Figures  Figure 1  China’s Outbound Foreign Direct Investment, 2002-2017…………....28 Figure 2  China’s Foreign Aid and Assistance, 2000-2014……………………....29 Figure 3  Gross Disbursement of China’s Foreign Aid……………………….…...35 Figure 4  Long-term Co-Financing Mobilized by the MDBs, 2017………….…...45  x List of Abbreviations  ADB  Asian Development Bank AIIB  Asian Infrastructure Investment Bank APEC  Asia-Pacific Economic Cooperation CCIEE  China Center for International Economic Exchanges CMIM  Chiang Mai Initiative Multilateralized CPRO   Central Policy Research Office FDI     Foreign Direct Investment IDBG   Inter-American Development Bank Group IMF    International Monetary Fund IO    International Organization MDB    Multilateral Development Bank NDB    New Development Bank PCS    Preferred Creditor Status WB    World Bank   xi Acknowledgements  There are too many people I would like to thank to during my years at UBC. But first and foremost, I want to express sincere gratitude to my supervisor Dr. Yves Tiberghien for his mentorship and unwavering support all along the way. Without his guidance, patience and encouragement this thesis would be impossible.   I thank Dr. Brian Job who serves as the second reader of this thesis for his detail-oriented comments and suggestions. I also thank Dr. Alan Jacobs, Christopher Fernandez and Josephine Calazan from UBC political science department for their continuous administrative support. Besides, I thank my colleagues and friends from political science department as well as UBC institute of Asian research for their mental and moral support.  Last but not least, I thank my family and my wife in particular for their understanding, tolerance and unconditioned love. They are the source of my courage and the reason I begin a new journey of life from now on.1 Section1 Introduction  On January 16, 2016 the Asian Infrastructure Investment Bank (AIIB) announced its official operation in Beijing with representatives from its 57 founder member states. The three-day grand opening ceremony occupied the headlines around the globe. In his welcoming remarks, Chinese President Xi Jinping highlighted that “the establishment of the AIIB was the result of sincere collaboration and strong support from member states” and he promised that the new development bank “will operate following the principle of open regionalism and will be mutually compliment to existing multilateral development banks”1. Moreover, Mr. Jin Liqun, a Chinese government international financial veteran who would serve as the inaugural president and chairman of board of directors of the AIIB, also pledged to “forge the AIIB with creative international best practices” during an interview2.  Nevertheless, the opening of the AIIB and the message with a collaboration-seeking tone sent by the Chinese leaders had not been received and interpreted positively by all others. Even though a large group of both developed and developing countries from Asia as well as from other regions endorsed the China-led new multilateral financial institution, some key global                                             1 Xi Jinping. 2016. “Remarks at The Opening Ceremony of The Asian Infrastructure Investment Bank”. Accessed Feb 2, 2019,, in Chinese 2 Jin Liqun. 2016. Interview with Caixin Weekly. Accessed Feb 4, 2019,, in Chinese 2 financial powers casted heavy doubts against the new organization instead, most notably the U.S. and Japan. Deeply concerned about China’s political and strategic motives behind the AIIB and the centrality of existing multilateral institutions like the World Bank, the U.S. government even tried every effort to publicly persuade other nations not to join the new bank. As a matter of fact, the controversies around the AIIB began and intensified as early as China first unveiled the idea in 2013.  Intrigued by China’s surprising yet remarkable entrepreneurship in the case of the AIIB, this thesis intends to focus on following questions: What motivated China to take a proactive role in founding a new multilateral financial institution like the AIIB? And why is multilateralism becoming an increasingly favored approach in China’s international development finance ambition?  Drawing on the functionalist viewpoints from neoliberal institutionalism with regard to the creation of international organizations, this thesis contends that multilateralism is particularly appealing to China in the context of its new structural position as a major international investor and creditor. Since international lending and investment is by nature a high-risk business even for sovereign creditors, it is therefore necessary to find some reliable and effective risk management 3 mechanism. For China, in comparison to its traditionally preferred bilateral approach, multilateral investment banks could be utilized as efficient financial vehicles performing a spectrum of specific functions to help new creditors like China in collecting information, hedging credibility problem, sharing burden and risk with others, as well as tapping private capital to supplement the financing goals. As a result, China’s embrace of financial multilateralism is to a great extent driven by pragmatic and functional needs associated with its new international creditor status regarding the secure repayment of its valuable financial resources.   The rest of the thesis is organized as follows: section two reviews the current debates and existing literature on the AIIB and China’s underlying motivations. After that, section three discusses the strategic environment within which sovereign creditors make decisions on their international lending and investment. Section four presents the main theory of the thesis, namely that an under-discussed but decisive factor behind China’s AIIB initiative is the country’s pragmatic needs to manage various lending risk and to leverage enough capital from global financial market. The following three sections are the empirical parts of the study. Section five focuses on China’s growing investment worldwide and the implications of its new sovereign creditor status. Then section six examines in detail the creation process of the AIIB and serves as a process-tracing test to the 4 theory. Section seven evaluates the market performances of major MDBs including the AIIB and provides further evidence to the function-based argument. The conclusion follows in the end. 5 Section 2 Overthrow the Bretton Woods?  Realism asserts that in an international system of anarchy, states are like-mined actors in the sense that they face the same external environment and thus they all view security as the only end that matters, regardless of their various domestic situations. On the other hand, because states can never be sure about the intentions or commitments from others, they are self-reliant on maintaining their own survival (Waltz 1979). Power is perceived to be the most reliable and effective mean, if not the only one, to achieve that end. Whether it is through the strategy of balancing (Waltz 1979) or that of seeking hegemony (Mearsheimer 2001), one’s security depends on its successful maneuver of power and geopolitics among states. As a result, realists argue that international cooperation and the accompanying international institutions are epiphenomenal and reflect only the hard fact of power configuration and relative gains orientation at the international level (Mearsheimer 1995). States are motivated by calculations of power-centered consequences since joining these institutions might promote their own interests or exert influence on third parties. Accordingly, international institutions are temporal and limited that once these interests disappear, cooperation dissolves (O’Neil& Van Deveer 2004).  From this point of view, the creation of the AIIB and the border trend of China’s 6 turn to financial multilateralism can be interpreted as a new sign of the geopolitical battle between the rising China and the declining U.S. hegemon. From the U.S. perspective, cooperating with China and enmeshing the country into the U.S.-dominated post-WWII multilateral institutions was once a crucial part of its engaging strategy vis-à-vis China with the hope that internally China will gradually democratize and externally it will become a status quo power and a “responsible stakeholder” under the U.S. hegemon (Friedberg 2012). Nevertheless, the development of China in the past two decades seemed to suggest such expectation was too optimistic and over-simplified. In the mean time, some in the U.S. started to argue that China has become increasingly aggressive and assertive (Swaine 2010; Christensen 2011) and therefore the U.S. as a hegemon needed to re-orient its grand strategy to “pivot” and “rebalance” to Asia (Steinberg& O’Hanlon 2014). It is against this changing strategic context that the AIIB was perceived to be a strategic reaction and soft-balancing response by China to counter and push back the pivot strategy by the U.S. (Chan 2017; Ren 2016; Tiberghien 2019). The new development bank could compete for clients and influence with existing Bretton Woods institutions, leading to a diminution of U.S. leadership in the global financial system and displacing it as the final arbiter of the rules of international trade and finance (Morris 2016; Chow 2016).  7 On the other hand, from China’s viewpoint, the old architecture of global financial governance did not keep up with the changing power dynamics in global political economy. Emerging powers like China are underrepresented in those international institutions and the developing world has been feeling frustrated for long time about the rules and conditionality imposed by the rich countries through these institutions (Liao 2015). Moreover, in the eyes of a rising power, multilateralism and international institutions could be utilized as an effective instrument for China to grow into a true global power and to reshape the rules of games without eliciting direct confrontations with its major rivals like the US, Japan or India, therefore facilitating and smoothening the power transition process (Lanteigne 2005; Hughes 2005).   Nevertheless, the realist explanation, which unsurprisingly reads the AIIB merely as a mean for power struggles, is empirically unsound. Contrary to the argument that China uses the AIIB to replace or challenge the Bretton Woods system, so far there is little evidence that China is retreating or drifting away from existing multilateral institutions. In addition, it seems that the interaction dynamics between the new and the old development banks has been cooperative rather than confrontational, and complimentary rather than competitive. For instance, the AIIB has already signed cooperation framework with both the World Bank and the 8 ADB 3 . Perhaps more importantly, after three years of operation, some international observers have concluded that “the AIIB’s structure, governance, and operating procedures closely mirror those of other MDBs” (Hameiri& Jones 2018).                                               3 See World Bank and AIIB Sign Cooperation Framework, Also ADB and AIIB Presidents Discuss Strategic and Operational Issues, Accessed March 21, 2019. 9 Section 3 The Conundrums of Sovereign Creditors  While admitting the merits of existing literature on China’s motivations behind the AIIB, this paper argues that they are at best insufficient to explain China’s underlying incentives in creating new multilateral development institutions. To reveal the full logic of China’s growing interest in international financial institutions and particularly the Multilateral Development Banks (MDBs), the starting point is to identify and examine the structural and strategic environment faced by an international sovereign creditor.   3.1 Three Assumptions The theory of this thesis will be built upon three basic assumptions. First of all, as realist perspective argues, states are in a self-help system (Waltz 1979) and there is no absolute higher authority or a world government to arbitrage disputes among sovereigns. This assumption applies not only to the security realm, but also to the financial world. When a sovereign creditor lends money to another sovereign, it must realize that the execution of the lending terms is not guaranteed by a supreme authority as for lending within a sovereign. When a default sets to occur, the creditor state would have no one to ask for enforcement but to rely on itself. The creditor state might choose to get its money back by using physical force against the debtor state, but war could be too costly itself and even if the creditor 10 conquers the debtor it still may not be able to collect the repayment in full amount.   Certainly, there is another option that the sovereign creditor might just choose to accept the financial loss and write off the debt from its book. This brings about the second assumption that capital is a valuable but scarce resource for sovereign states. For realists wealth can generate and increase power. For liberalists economic prosperity is critical for domestic political order (Moravscik 1997) and also for peace prospects among states (Kant 1795; Angell 1913). In brief, capital is a strategically vital goods that every state pursues. On the other hand, however, economic history shows that the accumulation of capital is difficult. Only a small number of states in today’s world might be recognized as “capital abundant” and even that is only in a relative sense. As a result, this thesis assumes that sovereign states care a lot about the repayment of their lending. The fact that sometimes states do write off unpaid debts does not indicate at all that capital is something dispensable or non-essential for them.  Lastly, this thesis also assumes that sovereign states care about the opportunity costs of the lending decisions they make. The concept of opportunity cost suggests that since resources are scarce relative to needs, the use of resources in one way would prevent their use in other ways (Palmer& Raftery 1999). Thus, creditor states face at least two challenging trade-offs: first, should they lend their 11 valuable capital to other states, or use it for domestic purposes? The choice here will for sure lead to important repercussions for domestic politics in the sense that policy makers have to convince and justify to the constituencies and their political opponents at home that lending money to foreigners will bring more benefits than spending it home. Furthermore, creditor states also have to decide to whom they lend and for how much. No matter the lending is driven by economic or strategic purposes, states want to maximize the efficiency of their international lending and minimize their opportunity costs at the same time.     Self-help, Scarcity and opportunity cost, these structural characteristics have made lending among states a high-risk business in nature. Compared with domestic situations, international financial transaction is usually much more complex and therefore more vulnerable to the probability of defaults. In particular, sovereign creditors need to consider four types of risk before reaching a foreign lending decision:  3.2 Information Risk.  Economic theories suggest that any wise and rational financial decision depends on accessibility to critical information. But in reality, the problem of asymmetrical information is a fundamental challenge to parties in economic transactions 12 (Akerlof 1970; Spence 1973). This problem becomes even more severe in an international context. Unlike their local counterparts, foreign creditors tend to have very limited knowledge about the institutions and rules of local market, economy, government as well as the larger society. How is financial market organized here?  What is the role of government in local market? How financial resources are priced? These are merely a few examples of a long list of questions that lenders would like to dig as much as possible before they decide to transfer their valuable funds to someone thousands of miles away.   Apart from the formal institutions, what’s more difficult for foreign lenders is to learn and understand so-called informal norms and institutions (Helmke& Levitsky 2004) in another country. Things like dynamics of personal relationship and social networking, niches of government-business interactions, and everyday business culture usually require long-term and deep immersion within local community only to have some ideas. This is obviously an information disadvantage of foreign lenders vis-à-vis their local borrowers.   3.3 Credibility Risk.  The second type of risk is the extent to which lenders can trust borrowers from another country to abide by lending agreement in full term. The credibility problem 13 is firstly the result of the asymmetrical information problem aforementioned. The fact foreign lenders have only limited information about local borrower’s capacities and motivations, and their business/credit history in particular, makes it harder for the lenders to have confidence that the borrowers will actually pay the interests and the principal on time and in full amount as agreed.   Furthermore, the credibility problem can get even worse because unlike domestic transactions which are ruled and arbitrated by a sovereign, international transactions often lack contractual and legal enforcement mechanisms as powerful and efficient as domestic ones. This is related to the self-help assumption discussed above. The fact that the current international system is still essentially anarchic has made the enforcement of contracts and laws fundamentally more difficult and of higher-cost between entities from different countries. Admittedly, the development of international commercial arbitration system has proven to be a usable and to some degree reliable legal channel for the international business community when facing a dispute. But for foreign lenders and investors it is still far away from being satisfying as a fully predictable and enforceable mechanism, especially when they face a sovereign borrower.   3.4 Market Risk 14 Financial market itself is volatile and beyond predictions. Even when foreign lenders are well informed beforehand and local borrowers have good intention to execute the contract with their greatest efforts possible, defaults might still happen due to forces and factors out of the control or anticipation by any party of an agreement. Market prices of raw materials and final products could rise or fall; accidents could occur which delay project progress; sales might be below expectation due to low popularity. In short, even the most carefully and scientifically calculated business could just end up a failure and lose money in the real world. For international lenders and investors, putting their money into projects in developing countries where market fundamentals are much weaker and volatilities are way higher could be like low-odds gambling.  3.5 Political Risk For a specific subgroup of international lenders, namely sovereign states’ official or government-linked financial entities, getting involved in international lending could also trigger political uncertainties and consequences for political leaders and the administration. On one hand, getting domestic approval for borrowers and projects overseas could be politically controversial and difficult, even when foreign borrowers are trustworthy and projects are economically promising. On the other hand, if the lending or investment turns out to be a troubled deal or a failure, which 15 is not uncommon in international financial transactions, domestic decision makers who were responsible for the initial funding could face strong criticism from the public and serious challenges from their political opponents.     3.6 The Necessity to Leverage Private Fund Apart from the four types of lending risk discussed above, lenders and investors usually have to deal with another type of structural challenge in international development finance: the enormous demand for capital and investment in developing countries and the limited capacity for any lender to fully meet that needs on its own. For instance, the Asian Development Bank (ADB) estimated that to cover the cost of building necessary infrastructure that is crucial to maintain economic growth and reduce poverty in regional developing countries, Asia alone needs more than $8 trillion between 2010 to 2020 (ADB 2013). The amount for development finance needed on the global level is certainly higher. In 2015 193 countries adopted the 2030 Sustainable Development Agenda. The UN estimates that achieving the Sustainable Development Goals will require investment up to $3.9 trillion per year. But at current investment levels, the estimated annual investment gap in developing countries is at about $2.5 trillion (UNCTAD 2014), suggesting a huge gap between how much is needed and how much is funded. As a result, in order to mobilize and make use of additional funding sources, 16 development finance is usually realized through international financial cooperation between the public and the private sectors and the key question now is how to establish a partnership between the two that can generate trustworthy, mutually-beneficial and sustainable cooperation.   17 Section 4 Towards A Functionalist Theory of MDB  Risk and uncertainty is inherent and widespread in international financial market. Also, as assumed before, sovereign creditors are essentially self-reliant in the world of finance. Because acquiring repayments through violent and military means is both excessively costly and morally unacceptable in today’s international community, it seems the only feasible way left for creditors to ensure their capital security is to find effective and efficient instruments and mechanisms to “hedge” and to manage risk, therefore reducing the possibility of defaults and stabilizing expectations of creditors. In this regard, this thesis argues that multilateral development banks, as a form of multilateralism in international financial cooperation, could be utilized as a financial vehicle to cope with the structural challenges aforementioned. More specifically, MDBs have the institutional capacities to perform the following functions: 1) alleviate the problem of asymmetrical information through monitoring; 2) minimize the credibility problem since debtors tend to prioritize their credibility reputation vis-à-vis MDBs; 3) reduce the market risk by “sharing the burden” among member states; 4) reduce the political risk by creating a firewall of domestic attention; 5) MDBs have been proven to be efficient vehicles of tapping private funds into development finance.  18 4.1 MDBs and the Information Risk Compared with sovereign and private creditors in the international financial market, international organizations like MDBs have several advantages in collecting needed information for their loan decisions. To begin with, international organizations tend to have more legitimacy to require data and information submitted from member states (Keohane 2006). Such legitimacy originates from the Charter or the founding constitutions of those international financial organizations, to which a state has to agree if it wants to attain membership, thus reducing the legal and authoritative obstacles in information gathering. Furthermore, from the perspective of the borrowing country, sharing information with international organizations is considered politically less sensitive than with another sovereign government or a private lender. Moreover, international financial organizations are usually equipped with highly capable personnel and strong in-house expertise who are able to develop methodology and tools for information gathering. Except for governments in a few advance economies like US, EU or Japan and top private lenders, most other international creditors do not have a similar capacity to collect and analyze information about sovereign debtors and thus have to rely on IOs for constant and reliable information input.        4.2 MDBs and the Credibility Problem 19 Credibility problem is often considered to be an even more severe and hard-to-solve challenge than the asymmetrical information problem. But the MDBs are capable to shape the preference and constrain the behaviors of borrowing countries thanks to their unique institutional characteristics. As a result, borrowing countries would have to prioritize maintaining a good credibility reputation in the eyes of the MDBs, which will motivate them to abide by loan agreement with their best efforts.  From the borrowing country’s perspective, when a state looks for external funding for its development agenda, it considers two determinants: first, accessibility, which is the likelihood that someone in the international financial market is willing to lend the money. More importantly, accessibility should not be transient or just for one transaction. Borrowing countries prefer funding sources that are long-term, repeatedly accessible and in particular ready-for-help during hard times.  Secondly, borrowing countries tend to prefer funding sources that can provide them with affordable and relatively “cheaper” money. Even though there are plenty of creditors and lenders in the international financial market, they offer different prices and loan terms to different borrowers. For private creditors, they typically charge higher price/interests to borrowers from developing countries than 20 those from developed countries since the former is perceived to be risker due to weaker market fundamentals there and the structural challenges as discussed earlier. However, such additional risk premium on borrowing cost often deters borrowers in the developing world to raise money from private capital because they often find the loan conditions too stringent and the price/interests too high. Considering market uncertainties and their own solvency ability, borrowing countries are also concerned about the nightmare of falling into any debt trap.  The simultaneous requirements for accessibility and affordability make multilateral development banks a rare and extremely valuable funding source in the eyes of sovereign borrowers. In terms of accessibility, by definition MDBs are supranational institutions set up by sovereign states, which are also the shareholders of the institutes. As a result, states are entitled to have access to MDBs’ funding resources and facilities. More importantly, the mandate of MDB is to promote economic and social development, meaning the institution prioritize long-term goals and returns. Therefore as long as the borrowing states can justify their funding requests as needed for broader social-economic development, they are likely to secure long-term, stable and all-weather (both good and bad times in financial market) funding support from the MDBs.   21 As for affordability, official international financial organizations like the MDBs are distinct from the private sector by nature as they are not profit-driven institutions. To be fair, MDBs also have to follow the basic operating principles of the financial market in that they need to consider and price risk factors in each loan decision as well and need to maintain a healthy and solid balance sheet, just like any other financial institutions would do for business survival and self-sustainability. Nevertheless, budget maintenance is a mean rather than a goal for MDBs. As mentioned earlier, the mandate and mission of these organizations is to support broader social-economic development in the regional and global level, particularly in developing countries. Given the fact that developing countries often have limited public financial management capacity, MDBs are less likely to price their loans towards the upper end of the market spectrum in order to make sure that their funding facilities will not be beyond the reach of developing countries where capital is needed most for social-economic development. As a matter of fact, a key institutional characteristic of MDBs is that they are equipped with low-cost funding facilities in the form of free grants and concessional loans, which are in most cases specifically designed and targeted at borrowers from the developing world.   Because MDBs are able to provide more accessible and more affordable funding, 22 they become highly preferred and valued funding sources for borrowing countries. Consequently, those countries will prioritize their debt repayment and credit reputation vis-à-vis multilateral financial institutions, meaning that even in the worst and most difficult situations, borrowing countries would still try their best not to default at least on loans from MDBs. Furthermore, as a financial intermediary between the debtor and creditor countries, MDBs are able to enhance the bargaining position of creditor countries by “bundling” them together a collective. In comparison to bilateral settings in which the borrowing country only has to face one counterpart in a given deal, it has to deal with much more sovereign stakeholders in negotiation with MDBs. When defaults occur in bilateral deals, the borrower country will lose credit reputation only to one funding source. But when defaults occur in multilateral situations, the borrower country will lose its reputation in front of a large group of creditors, making it extremely difficult for the country to seek foreign loans in future.  4.3 MDBs and Market Risk As discussed earlier, market risk tend to be higher in developing countries since they have weaker market fundamentals and their governments are often less competent in making and implementing the right macroeconomic policies. On the other hand, a large portion of projects related to development finance aim to 23 provide much-needed public goods like infrastructure, which at the same time are more vulnerable to economic uncertainty due to longer project term and larger capital demands. The creation of MDBs, however, makes it possible for creditor countries to share the burden among themselves and to reduce the risk exposure of each individual country.   4.4 MDBs as A Firewall For Political Attention  Apart from the institutional advantages of MDBs in risk management, multilateral financial institutions in fact have another strategic benefit for domestic policy makers in creditor countries in the sense that international organizations may serve as a firewall cutting off the transmission of political pressure caused by troubled loans and investment overseas. When politicians and policy makers from creditor countries make decisions about international development finance, they are facing a two-level game (Putnam 1988): internationally, they want to seek more control and influence vis-à-vis the borrowing state; domestically, they want to minimize any controversies around the lending that could be leveraged by their political opponents at home. In a bilateral setting, even though policy makers might maximize their control over the loans and the counterpart country, they are exposed to the risk of being perceived by domestic audience as responsible for any troubled loans or defaults and therefore they may have to bear the associated 24 painful political costs. In a multilateral setting like the MDBs, creditor countries give away certain degree of control by delegating power and resources to the multilateral institutions. With the MDBs as the intermediary, the focus of attention by the public could be shifted from domestic policy makers to the international organizations and their bureaucrats.   4.5 MDBs as Leveraging Vehicles As discussed earlier, another type of challenge any sovereign creditor has to face is that the amount of financial resources it is capable to mobilize on its own often falls short of the needs of the recipient states by considerable margin. Thus, it is crucial to find a way to mobilize capital from other sovereign creditors and most importantly capital from the private sector for the international development agenda and programs. In this regard, MDBs are considered to be functional and effective in tapping private funds as well. For instance, MDBs can use their leverage to influence borrowing government decisions and deter adverse events that might negatively affect project outcome which involve private investors (Hainz and Kleimeier 2012). In addition, credit risk could be reduced through multilateral guarantees and the extension of the MDBs’ preferred creditor status, which implies that private loans are excluded from debt rescheduling (Pereira dos Santos, P. and Kearney, M. 2018; Gurara et al,. 2018). Furthermore, to alleviate 25 the problem of asymmetrical information, private creditors can co-invest in the loan syndication with an MDB to take advantage of its technical expertise, monitoring capacity and better knowledge of the country and the industry (Chelsky et al., 2013; Ratha 2001; Gurria et al., 2001).  On the other hand, MDBs can also mobilize private capital through some indirect ways. The entrance of MDB loans into a given country could signal future investment opportunities. Plus, as MDB loans are long-term oriented, they could promote macroeconomic stability, growth and an investment friendly environment, all of which can attract private investors (Eichengreen and Mody, 2000). Similarly, the presence of MDBs itself can send a strong signal to private actors in international financial market showing the institution’s trust in the recipient country’s institutional capacity and its commitment to reform, therefore lifting debtor country’s creditworthiness and eventually encouraging private capital inflows (Morris and Shin 2006; Basilio 2014).  26 Section 5 Flooding Red Back: China As A Sovereign Creditor  The empirical part of the thesis is consisted of three sections. First, by tracing the trajectory of China’s economic and financial development, it shows how China has acquired a new structural position as major international sovereign creditor as well as the rising multilateralism in its international development finance agenda. Secondly, with regard to China’s motivation behind the AIIB in particular, evidence will be presented to indicate the growing awareness of international lending risk by key policy makers in China and how they realized multilateral financial institutions could be functionally effective to help China cope with challenges of international finance. Lastly, it will provide evidence that MDBs in general are actually capable and effective in reducing the structural risk faced by sovereign creditors and helping them mobilize more funds from the private sector to realize their international lending agenda.   5.1 Rise of The Red Creditor China’s high-speed economic growth in the past four decades has generated enormous wealth and turned the country from a poor, thirsty-for-capital nation into one of the leading economic powerhouses in the world now. When Deng Xiaoping secured his leadership in the late 1970s, the Chinese society and the economy had yet shred off the heavy debris of the Great Leap Forward and the Culture 27 Revolution. GDP per capita in China was merely 1.5%4 of that in the US. The Soviet-style central-planning system was still the backbone of the economy with its infamous low-efficiency and distortion in resource allocation. Private enterprises were considered illegal and exchanges with international market in terms of trade and investment was negligible.   It is against such historical background that China’s economic success today has been widely recognized as a miracle. Depending on which economic methods and measurements are used, China will soon pass the US to become the largest economy in the world, or has already done so. In the hard years of recovery from the 2008 global financial crisis, China has been a major economic engine and contributed more than one third of global economic growth (IMF 2018). Chinese companies -- both state-owned and private ones -- now climb up global rankings and become competitive players in international business. But perhaps the most striking feature of Chinese economy today is how deeply it is integrated with the international market, in comparison to forty years ago. Deng Xiaoping probably wouldn’t expect that China could become the world’s largest trading country, at least not so fast. Nor would he imagine China could launch the massive and ambitious Belt and Road initiative today to export its products, capital and even                                             4 Calculated by author using World Bank data on GDP, 1980. 28 development mode. The dramatic rise of China’s economy in a whole has brought many structural and strategic advantages to the country, among which the growing financial and monetary power possessed by China may have the most significant implications for rest of the world. For instance, in only a few decades, China has accomplished three big steps: from an isolated poor communist country to the largest developing country recipient of foreign direct investment (FDI), and then to the world’s second-largest source of outward FDI. Today, from Africa to South America, from natural resources to the most cutting-edge high technologies, Chinese investors and capital are seen around the globe and in every sector.  Figure 1: China’s Outbound Foreign Direct Investment, 2002-2017 (billion, US$)    Source: MOFCOM, China Outbound FDI Report, 2017 0	  50	  100	  150	  200	  250	  2002	  2003	  2004	  2005	  2006	  2007	  2008	  2009	  2010	  2011	  2012	  2013	  2014	  2015	  2016	  2017	  29 In addition to outbound foreign direct investment, which is mostly driven by commercial purposes, China has become a major foreign aid donor as well. In the year of 2000, the total value of China’s foreign aid and assistance was just over $1 billion and by 2014 it surged to $37.28 billion. It is also reported that during that period, China’s cumulative aid commitments was $354.3 billion to 140 countries, in comparison to $394.6 billion committed by the US (Dreher et al., 2017) Figure 2: China’s Foreign Aid and Assistance, 2000-2014 (billion, US$)  Source: Dreher et al., 2017 China’s massive financial power and international creditor position originated from the characteristics of its economic model. On one hand, state-controlled and distorted domestic financial system led to surplus savings and cheap capital which can be used for investment; on the other hand export-oriented development 0	  10	  20	  30	  40	  50	  60	  30 strategy made China a long-term trade surplus country and therefore accumulated large amount of foreign reserves. These lines of financial resources made it possible for China to exert more influence on the international stage.   The flooding red back worldwide served China’s interests in many ways. Economically, foreign investments and acquisitions helped China secure the stable and constant supply of key raw materials, which are indispensable for domestic economic development. Politically, China is able to leverage its newly gained financial power to shape the relationship it has with other countries to its favored directions. A good example of such leverages is the sovereign competition between China and Taiwan (Atkinson 2010). In order to access trade opportunities and to receive massive foreign aids from China, more and more countries that used to maintain official diplomatic ties with Taiwan decide to turn to China now, signaling an overwhelming diplomatic victory for China.  5.2 The Multilateral Turn of China’s Monetary Power The growing magnitude of the world’s second largest economy’s financial and monetary power is impressive. However, what is even more interesting is the changing ways and patterns in which China utilizes its monetary power. Broadly speaking, China deploys and projects its financial resources in three ways: 31 Table 1: Summary of Monetary Power Patterns by A Sovereign Creditor Pattern Advantages Disadvantages Example Bilateral Maximized leverage; Less constrains by international norms Sole risk exposure to the debtor states Bilateral Aid such as China to Cambodia One-to-Multiple High leverage; streamline policy framework; improved management efficiency Sole risk exposure to the debtor states;  Less tailored to the needs of a specific state Silk Road Fund; China-Africa Development Fund Multilateral Setting Burden and risk sharing; low administrative costs Limited leverage; More constrains by international norms and rules IMF; World Bank; AIIB  One-on-One Bilateral Setting Investment and aid through bilateral agreement is the most common pattern of financial interactions between states. The frequent use of monetary power in bilateral settings is not unique to China at all. As a matter of fact, the majority of aids, investment as well as other forms of capital flows among states around the world are negotiated and carried out bilaterally. For China, its preference for bilateral-based economic assistance dates back to the Mao era when China supplied food and weapons to other communist countries such as Vietnam and North Korea. Bilateral settings are supposed to bring some strategic advantages for countries having monetary power as an international creditor vis-à-vis the 32 borrowing countries. For example, lending countries tend to have a structurally advantaged position in the bargaining structure against borrowing countries since they have the full control of their own money and the associated discretion to determine the conditions and terms of loans and aids to the other party. What’s more, monetary aid is often packaged with certain political and strategic demands from the creditor country. On the other hand, compared to multilateral lending and borrowing, there is little coordination or cooperation costs and it is not necessary for bilateral financial transactions to fully comply with high standard norms and principles such as transparency and accountability requirements that are often found in international organizations. Therefore, bilateral financial agreements could be much more flexible/maneuverable and possibly more efficient in implementation.  One-to-Multiple  This is a relatively new model in China’s foreign financial and monetary policies, as a method to streamline and standardize China’s financial cooperation with other countries, as well as to reduce the cost in managing those increasingly complex financial relations. The $10 billion China-Africa Development Fund in 2006 and the $40 billion Silk Road Fund in 2014 are some recent examples of this pattern. However, it must be noted that this one-to-multiple approach is 33 essentially equivalent to the traditional bilateral approach since it doesn’t shift the power dynamics of the bargaining structure or change the mechanisms in management and governance.   Multilateral Setting This is the model in which China subscribes or contributes its financial resources to multilateral financial institutions that are created and entrusted with specific functions or missions by the international community. China may nor may not have the power and influence to shape the policies of these multilateral institutions into its own desired direction. However, even in those cases it is capable to do so, China faces much more constrains because the decision-making process involves more strategic players and higher requirement for transparency and rule-compliance, therefore reducing China’s bargaining advantages and increasing the cost for coordination. China’s participation in Chiang Mai Initiative Multilateralized (CMIM) and its proposal to establish the AIIB would be some of the best recent examples showing China’s use of its financial and monetary power in a multilateral setting.  As discussed above, among the three models of implementing monetary power, the bilateral model should be a preferred one for countries that have international 34 creditor status because debt relations under this model are easier for them to control and maneuver. On the other hand, the history of China’s foreign economic policies and activities confirmed that bilateral setting has been the dominant model for China to utilize and leverage its monetary clout vis-à-vis its borrowing countries in the developing world. Interestingly, however, recent studies on China’s foreign investment and aid have documented a multilateral turn in China’s monetary power (Sohn 2008), suggesting that while China still heavily relies on bilateral model, it is investing more and more valuable financial resources to a whole spectrum of international/multilateral financial institutions, with the founding of AIIB being the highlight moment of such strategic shift.         35 Figure 3: Gross Disbursement of China’s Foreign Aid (billion, US$)     Source: Kitano 2018 As data suggests, China’s contribution to multilateral financial organizations was roughly 100 million in the year of 2001, consisting only 14% of its net foreign aid disbursement. But for the most recent data-available years of 2015 and 2016, the number had increased to 27% and 24% respectively (Kitano 2018). In other words, China now puts nearly a quarter of its government-sponsored financial resources into multilateral financial institutions and ranks now as the second largest country with aggregate voting power across all MDBs (CFR 2016).   0	  1	  2	  3	  4	  5	  6	  7	  Multilateral	  Bilateral	  Gross	  disbursement	  of	  concenssional	  loans	  Bilateral	  Grants	  and	  Interest	  Free	  loans	  36 Some of the largest and most eye-catching contributions by China include: $29 billion increased subscription to IMF permanent resources as required by 2010 IMF reform plan; an extra $43 billion to the IMF’s crisis-fighting reserves; $10 billion initial subscribed capital to the New Development Bank; $76.8 billion commitment to the Chiang Mai Initiative Multilateralization; and most notably, subscribed capital stock of AIIB worth around $30 billion.     37 Section 6 Thinking About Risk and Leverage: The Creation of the AIIB In October 2013, during his attendance in the APEC Summit held in Indonesia, Chinese President Xi Jinping, who at that time took power less than a year after fierce domestic political struggles, announced officially for the first time to the world that China intended to build a brand new multilateral development bank to promote international and regional cooperation in infrastructure development in Asia.   However, the original idea of the AIIB dated back to 2007 when Mr. Xinli Zheng, then a policy researcher from the Central Policy Research Office of the Chinese Communist Party, visited a remote village in Laos and discovered that the lack of necessary infrastructure was a major obstacle for local economic development. Zheng realized that there could be an opportunity of regional cooperation as China itself faces similar infrastructure challenges and such cooperation can be economically complementary to China (New York Times 2015).  Mr. Zheng proposed the idea of a new multilateral bank in Asia to top policy advisors in China’s central government. At that time Hu Jintao was still China’s President and his administration wasn’t really interested in Mr. Zheng’s proposal. Two years later, Mr. Zheng brought up again the idea of AIIB, this time together 38 with another proposal of a new agricultural bank in Asia, at the Boao Forum in 2009. Still, it received little attention. At that time, Mr. Zheng had already retired from CPRO and joined China Center for International Economic Exchanges (CCIEE) as a senior policy researcher. CCIEE was a newly established high-profile think tank founded by retired vice-premier Zeng Peiyan. The institute liked Zheng’s idea and encouraged him to conduct more research on the feasibility of the plan. By 2012, Zheng and CCIEE had prepared a very detailed proposal. When they submitted a highly condensed, 3000-word policy proposal to the new leadership, they received written instructions from China’s top leaders this time, acknowledging the value of AIIB and the decision to put it into practice.  According to Mr. Zheng’s own explanation, the AIIB was established to serve a range of purposes: most obviously, it is a response to the huge demand for infrastructure financing in developing countries. More importantly, investing in MDBs could also serve as a diversifying strategy for China’s overseas investment portfolio. Zheng argued that the majority of China’s $3 trillion foreign reserves have been used to buy US treasury bonds with a not-so-impressive 3% return. By investing in regional infrastructure through MDBs, it will not only promote regional economic growth—which will bring long-term economic benefits—but also possibly generate higher returns on China’s foreign reserves (Zheng 2015).  39 Furthermore, the new MDB will operate in accordance to market principles and best practice in terms of risk management to ensure the repayment of loans and the efficiency of development fund. “Multilateral bank can be an effective institutional form to select appropriate project and to minimize investment risk. What’s more, the bank can be used as a financing platform… to attract investment from foundations, other multilateral institutions, multilateral enterprises and the private sector … it can issue its own bonds to borrow, and therefore the MDB-centered platform is an ideal for infrastructure finance” (Zheng 2015) From Zheng’s perspective, many of China’s previous overseas investment were bilateral official cooperation administrated by Chinese and local governments, which often suffered from the problems of low operational efficiency and investment mistakes. MDB with its enterprise style decision-making and governance structure could help solve these challenges and may even help promote the internationalization of Yuan (Zheng 2015). As a growing multilateral mechanism and international organization, the AIIB would be a much more competent risk manager than China’s domestic enterprises who “were fighting on their own”(Zheng 2015). As long as a project is backed by the AIIB, it is likely to proceed and finalize even facing criticisms and oppositions from the US and Japan, since “so many other countries are all bundled together to the 40 project…that it can not be stopped by a country or two… with AIIB’s participation, there would be no giving up halfway”(Zheng 2015). 41 Section 7 Market Performances of MDBs  The first indicator of MDSs functional role as competent risk-manager is how exceedingly credible they have been recognized by the international financial market. Whether it’s long-established organizations like the World Bank Group and the ADB, or the new intermediates like the AIIB, these multilateral financial institutions are remarkable in achieving and maintaining extremely solid credit ratings. For example, both Moody’s and S&P – two of the rating agency troika5 – have given their top ratings to the WB, ADB and AIIB, which is equivalent to the US sovereign credit rating and even higher than that of Japan and China. Furthermore, MDBs’ ratings are also higher than some of the biggest international commercial banks by a significant margin.                                                             5 The third major credit rating agency in the international financial market is Fitch Ratings. 42 Table 2: Credit Ratings for Selected Creditors, Long-term   Source: Complied in March 2019 by author  The trust that MDBs earned from the international financial market is the result of their “high capital adequacy, supported by a strong risk management framework that contributes to strong asset performance; ample liquidity buffers and conservative asset/liability management policies; and a large cushion of callable capital and very strong willingness and ability of global members to provide extraordinary support” (Moody’s 2019). But perhaps more importantly, major MDBs including the China-led AIIB have all established extensive and strict internal risk management mechanisms as well as social and environmental safeguard systems, which are built upon arguably the highest international standards and norms (AIIB 2017; World Bank 2015).  Institutions Type Moody’s S&P World Bank (IBRD)  MDBs Aaa AAA ADB Aaa AAA AIIB Aaa AAA USA  Sovereigns Aaa AAA Japan A1 A+ China A1 A+ JPMorgan Chase&Co.  Private Aa3 A+ Mitsubishi UFJ  A1 A- ICBC  A1 A 43 The solid ratings and sovereign-backed trustworthiness have enabled MDBs to borrow and raise money from the international capital market with considerably low costs. The interest that MDBs have to pay for their borrowings is usually comparable to that of US treasury bonds, which is widely considered to be a benchmark interest rate for global capital market (World Bank 2018). On the other hand, unlike private actors such as international commercial banks who are mostly motivated by profit maximization in international finance, MDBs are mandated to focus on and provide support to social-economic development around the world. Therefore they usually charge a relatively small price margin to the loans mainly for covering operational costs. All these factors have made MDBs very attractive and affordable financing sources in the eyes of developing countries.  As a matter of fact, in today’s international financial market there is a widespread practice known as Preferred Creditor Status (PCS), which describes the phenomenon that, when sovereign borrowers default on loans from private lenders, they commonly strive to continue repaying the part of their debts held by official multilateral creditors including the MDBs. Essentially, this means loans made by MDBs are effectively senior and prioritized to both commercial debts from the private sector and bilateral loans directly from another sovereign state. A 44 recent research documented 22 bond exchanges, 13 of which involved a reduction in principal with an average haircut of 48.3 percent. However, none of these include any reduction in the face value of debt from MDBs (Cruces and Trebesch 2013). In addition, the countries of the Paris Club have agreed with the market practice of PCS and exempted preferred creditor institutions like the MDBs from application of the comparability-of-treatment principle6 (S&P 2000).  Multilateral financial institutions have also proven that they are effective vehicles with regard to the perceived function of tapping and mobilizing funds from the private sector. Data suggested that in 2017 the total amount of long-term co-financing mobilized by the MDBs and other development finance institutions from private investors and other institutional investors (including insurance companies, pension funds, and sovereign wealth funds) worldwide as $163.5 billion. Nearly a third of this, $52 billion, was achieved through private direct mobilization and the rest was through indirect mobilization7.                                             6 The Paris Club Agreed Minutes include a “comparability of treatment” clause, which aims to ensure balanced treatment of the debtor country’s debt by all external creditors. In accordance with this clause, the debtor country undertakes to seek from non-multilateral creditors, in particular other official bilateral creditor countries that are not members of the Paris Club and private creditors (mostly banks, bondholders and suppliers), a treatment on comparable terms to those granted in the Agreed Minutes. See Paris Club official website: Assessed January 29, 2019. 7 Data source: World Bank Group. 2017 Mobilization of Private Finance By Multilateral Development Banks and Development Finance Institutions. The report defines private direct mobilization as financing from a private entity on commercial terms due to the active and direct involvement of an MDB leading to commitment. On the other hand, indirect private mobilization is defined as financing from private entities provided in connection with a specific activity for which an MDB is providing financing, where no MDB is playing an active or direct role that leads to the commitment of the private entity’s finance. 45 Figure 4: Long-term Co-Financing Mobilized by the MDBs, 2017        Source: IFC 2018  Evidence of mobilizing effects also includes numerous specific development projects carried around the world with MDBs’ participation. A highlighted example was the project of the Panama Canal expansion. The project aimed to expand the canal to allow larger ships to transit, therefore improving transportation efficiency and reducing market losses. Following a referendum in 2006, the massive infrastructure project was co-financed by the Inter-American Development Bank Group (IDBG), other three Multilaterals and the Japan Bank for International cooperation. It was the largest ever infrastructure investment in Panama since the Canal opened which amounted to 30% of the country’s GDP. But in the five years after its announcement it was estimated that almost $9.9 billion private investment 46 had been raised or “leveraged”, 1.8 times the project cost (Lanzalot et al., 2018; Broccolini et al., 2018). 47 Section 8 Conclusion  The rise of China in the past few decades has brought about seemingly endless puzzles to the world. It has been forty years since the government adopted the “Open and Reform” policy, but today people are still debating why and how exactly China achieved its economic success with a Leninist authoritarian political regime and how sustainable the current development mode can be. But even more importantly, China’s rise doesn’t only imply more prosperity and better life for the Chinese people. It generates crucial puzzles to the whole world, the answer to which affects the lives of billions of people living outside the country. What is China’s strategic ambition globally? Is China a revisionist country that wants to challenge US hegemon? Will there be wars of power transition? What’s the fate for the international liberal order?  While keeping these fundamental questions in mind as the broader context, this thesis chooses to focus on a specific and arguably technical case: why did China propose and establish the AIIB? And why is multilateralism becoming a preferred approach in China’s international finance agenda? I argue that the current debate around the AIIB focusing on the political and strategic logic is biased and incomplete. The underlying question that drives such a perspective is “what will China do?” This thesis, on the other hand, asks a further question of “who is 48 China?” By identifying China’s new position as a major international sovereign creditor, it finds that there is also a critical financial logic behind the founding of the AIIB which has been under discussed so far: multilateralism and multilateral institutions including MDBs could be technically functional in terms of reducing a wide range of risk in international lending and leveraging more funds from global financial market for sovereign creditors.   In terms of theoretical contributions, this study advances some key theoretical debates in contemporary international political economy. On one hand, it builds upon and strengthens further the neoliberal argument (Nye& Keohane 1982) regarding the role and functions of IOs by adding further evidence from a new wave of IOs proposed by a rising power in a changing era; on the other hand, it provides new insights to the debate on whether China is a revisionist country (Ian Johnston 2003& 2013) and the future of global liberal order since WWII (Ikenberry 2017& 2018). As such, it contributes to the study of international order and institutions.  In terms of empirical facts, this research tries to add new knowledge to the building process of China-led multilateral financial institutions and try to trace the concerns, debates and motivations of policy makers and stakeholders in China 49 with regard to financial multilateralism. As such, this research will contribute to the study of China and its foreign economic policies, which plays an increasingly critical role in global economy.  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