AIIB: regional solution or global threat?

President Xi Jinping chose September's 70th anniversary of the defeat of Japan that ended World War II to stage the greatest parade of military might in Chinese history. Along with the tight formations of troops marching past Mao Zedong’s portrait on the Gate of Heavenly Peace came the latest Dongfeng (East Wind) ballistic missiles. Named after Mao’s slogan that the “east wind will prevail over the west wind,” they are capable of sinking an aircraft carrier with a single strike.

A few blocks west of Tiananmen Square, an altogether different aspect of China’s emergence as global superpower is taking shape in the Xicheng financial district. The Asian Infrastructure Investment Bank (AIIB) is dedicated to peaceful construction and multinational co-operation, with China in the driving seat. Yet the United States and its close ally Japan have reacted to the bank’s establishment with the same suspicion and alarm that Western military observers showed at the display of Dongfeng ballistic missiles.

An American campaign to boycott the AIIB collapsed in March when George Osborne, Britain’s chancellor of the Exchequer, announced that Washington’s staunchest ally would be joining the Chinese-initiated bank. An unidentified American official was widely quoted accusing Britain of “constant accommodation of China”.

The rare chastisement, not denied by President Barack Obama’s administration, was then drowned out in a stampede of other nations to sign up to the AIIB; Switzerland, France, Germany and Italy were soon followed by Australia and South Korea, two key Asia-Pacific partners of the United States. The mass desertion to a China-dominated bank was a dramatic illustration of America’s waning power.

Membership of the AIIB has since swelled to 57 countries, more than twice the number that half a century ago joined the Asian Development Bank (ADB), the incumbent Japanese- and American-led rival based in Manila (see box below).

China’s leaders, starting with Xi Jinping, have been at pains to allay concerns about corruption, opacity and disregard of accepted environmental and labour standards in China’s international lending, assuring foreigners that the Beijing-based bank will be “lean, clean and green”.

AIIB president-designate Jin Liqun (see box, right), one of China’s ablest diplomats, promises to make it a multilateral development bank like no other, “grounded in the highest principles and ethical standards”, while being “client-responsive, pro-active, and results-oriented”, with “cost-effective” operations “delivered in a timely manner”.

All is now smiles and pledges of full co-operation on the surface, but underneath resentments smoulder, especially in the US and Japan, which opted to stay out. One positive outcome already is that the Chinese challenge has forced the ADB and the Japanese government to become more aggressive in funding Asian infrastructure.

Both the AIIB and its less prominent sister in Shanghai, the New Development Bank run by the Brics countries of Brazil, Russia, India, China and South Africa, exploded onto the scene after years of slow-burning frustration. The post-war Bretton Woods system of world monetary management had become a political powder keg.

Governance of the International Monetary Fund (IMF) and the World Bank, conceived at a conference in Bretton Woods, New Hampshire in 1944, and a string of multilateral development banks founded in the 1960s for Asia, Africa, Latin America and the Caribbean, has failed to adapt to the rise of new economic powers led by China.

China’s gross domestic product overtook Japan’s in 2011 to become second in the world. Some analysts prefer to point to purchasing power parity, on which measure China’s economy already surpasses that of the US.

Yet at the ADB in Manila, China has only 6.47% of the bank’s shares, compared to the 15.67% held by Japan and the 15.56% of the US.

Acting together, the two biggest shareholders are able to veto changes. “The way the system works is if Japan and the US say no, it cannot happen,” a senior source at the ADB tells Asiamoney. “The European position is if there is a consensus in the region, the Europeans will follow. But the region of course includes Japan, so if Japan says no, the European powers would not go against that.”

By tradition, the ADB president is always a senior bureaucrat from Japan’s Ministry of Finance. Haruhiko Kuroda spent 36 years at the MoF before becoming ADB president in 2005. When Kuroda became governor of the Bank of Japan in 2013, he ceded his place at the ADB helm to another vice minister for international finance, Takehiko Nakao, who had served 35 years at the MoF.

Nakao declined to be interviewed for this article, or to answer written questions submitted by Asiamoney. Robert Orr, US ambassador to the ADB, also did not respond to an interview request.

A louder voice

The enormous disparity between China’s shareholding and its share of global GDP is mirrored at: the World Bank, where the US has 16.5% of total votes, Japan 7.8% and China 4.8%; the African Development Bank, where the US share is 6.6%, Japan’s 5.5% and China’s 1.1%; and the Inter-American Development Bank in Washington, where the US wields 30% of total votes, Japan 5%, and China a miniscule 0.004%.

Across the street from the World Bank in Washington, the IMF has also been beset by demands for more equitable representation. IMF quotas are based on a member state’s economic strength, and determine its financial commitment and voting power in the fund. In 2010, the IMF Board of Governors agreed to raise China’s quota from 3.65% to 6.19%, although the US would still have by the far the largest slice of quota, at 17.398%, followed by Japan with 6.461%. The US Congress has blocked implementation of even this modest reform by refusing to ratify the increase.

A related issue for China, in terms of international profile and prestige, is obtaining IMF endorsement of the renminbi as a reserve currency. The IMF has been debating whether to include the renminbi in the basket that makes up the IMF’s virtual currency, the Special Drawing Rights, used in the fund’s own operations. At present, the basket comprises the dollar (41.9%), euro (37.4%), sterling (11.3%) and yen (9.4%).

A decision on RMB inclusion is expected to come in November this year. Even if the IMF board decides in favour, implementation would not take effect until September 2016, following feedback from SDR users that requested more time to prepare for the change.

The refusal of the US and Japanese governments to join the AIIB and their sometimes grudging responses to its creation have given credence to the notion that they see it as part of a larger Chinese strategy to undercut their global power and influence.

 “The reality is that the Americans couldn’t ever have easily joined the AIIB as a full equity-paying member, because that would involve getting the approval of Congress to put money into a Chinese bank, and that wasn’t a starter,” says Peter Drysdale, professor emeritus of Australian National University, and the leading intellectual architect of the Asia-Pacific Economic Cooperation (APEC) forum. “That didn’t prevent the possibility at all that the Americans might have reacted in a different way to the AIIB proposal, by offering facilitation without being a paying member, but I think they got caught up in their own web in the way in which that then was presented to other countries.”

Canadian absence from the AIIB roster has largely escaped notice, although China is Canada’s second-largest trading partner after the US. The Department of Finance in Ottawa declined to speak to Asiamoney on the matter, but according to Jack Austin, a former Canadian senator and influential politician who helped establish Canada’s diplomatic relations with China back in the 1970s, the decision not join the AIIB is entirely due to Canadian domestic politics.

Prime Minister Stephen Harper belongs to an evangelical Christian church that believes in the inerrancy of the Bible, and Christian fundamentalists are a core part of his support base, says Austin. “The constituency sees China’s regime as totally hostile to their values,” he says.

Depending on the result of a federal general election on October 19, Canadian policy on AIIB membership may change.

For its part, Japan cites AIIB governance concerns as the reason for not joining, but by doing so it has effectively ceded more management clout to China.

Power sharing within the AIIB depends on whether a member state is "regional" – part of Asia and Oceania – or "non-regional", and on its share of world GDP. Regional members have been granted 75% of the capital stock, and nine out of the 12 seats on the board of directors. (Russia has been granted classification as a regional member.)

China now has 30% of the AIIB’s capital stock and 26% of the voting share, followed by India with 8.5% of the capital and 7.5% of the vote. Russia is in third place with 6.6% of the capital and 6% of the vote, according to China’s state news agency Xinhua.

If Japan had joined, it would have vaulted past India and Russia to become the AIIB’s second largest shareholder, with the loudest voice after China.

The pitfall for Japan of this option is that it would reignite the debate into the basis behind Japanese and US leadership of the ADB — and the deficit in China’s representation.

Remit without limit?

The raison d’être for a new development bank is Asia’s enormous need for infrastructure, especially in transport and energy, which the ADB estimates requires $750bn to be spent per year over the current decade, or a total of $7.5tr. There is a yawning chasm between demand and present funding capacity. The total combined lending on the balance sheets of the ADB and World Bank, including outside Asia, is only slightly more than $200bn.

Where the AIIB’s remit becomes controversial is the degree to which it complements China’s wider strategic plans and ambitions. Over the past decade, China’s state-owned banks have lent hundreds of billions of dollars to unstable regimes with poor credit ratings in Latin America and Africa, as well as to Vladimir Putin’s Russia, Ukraine under deposed leader Viktor Yanukovych, military junta-ruled Myanmar, and Sri Lanka before Mahinda Rajapaksa lost power in a presidential election in January.

The Chinese banks charged high interest rates but there were no political strings attached, and loans were generally repaid or secured against the supply of energy products or raw materials.

Many of these bilateral loan deals will now be more challenging as falling oil and commodity prices make repayment terms more onerous, or in the case of Sri Lanka, Thailand, Ukraine and Myanmar, as a result of regime change that caught Beijing unprepared.

Xi Jinping unveiled the AIIB project in 2013 at about the same time as visionary plans for land and maritime new "Silk Roads" to Europe. This was no coincidence. Both the AIIB and the "One Belt, One Road" ideas originated with Wang Huning, director of the Central Committee’s Policy Research Office since 2002.

"One Belt, One Road" envisages billions of dollars being invested in transport infrastructure, hydroelectric dams and pipelines, which will help relieve severe overcapacity in China’s construction, steel and heavy industries. HSBC estimates total investment on domestic projects linked to "One Belt, One Road" could reach Rmb1.5tr ($235bn). The number of cross-border co-operation projects linked to the plan exceeds 900 and they involve 64 countries, with a total investment value of $890bn, according to China Development Bank.

One project in particular is causing sleepless nights in Washington, as it undermines the entire US naval strategy for dealing with China. The 3,000km China-Pakistan Economic Corridor will connect the troubled and impoverished Xinjiang Province of western China with the port of Gwadar in southern Pakistan. Unlike the billions of dollars in aid money Pakistan received from the United States, which had little noticeable effect on Pakistan’s economy or security, the $46bn Chinese investment — in roads, railways, oil and gas pipelines, fibre optic cable, and a greatly enlarged port at Gwadar — has the potential to transform Pakistan. To assuage anxiety, Pakistan has promised a 10,000-strong security force to protect Chinese workers on the project.

The corridor gives the world’s biggest oil importer access to the Gulf and Arabian Sea through Gwadar. This bypasses by land the Malacca Strait, the principal choke point that the US Navy would seek to blockade in the event of hostilities with China.

China has established a $40bn "Silk Road Fund" to invest directly in "One Belt, One Road" projects, in addition to lending from its state banks. The AIIB, however, will not be such an easy conduit. For starters, Article 13 of its founding charter states "The Bank shall pay due regard to the desirability of avoiding a disproportionate amount of its resources being used for the benefit of any member".

As Professor Drysdale at Australian National University notes, “it won't simply be a matter of rolling up China’s favourite projects if goals of efficiency and professionalism will be managed properly, and they will be, because everyone has skin in this process.”

Former senator Austin underlines that bilateral deal-making will remain a far more important means for China in achieving its strategic goals. “Don’t make the assumption that the AIIB is that important to the Chinese,” he stresses. “It is there, and they will use it when convenient, but they will act on their own far more than they will use AIIB as an instrument.”

A senior official at the ADB says the main purpose of the AIIB for China is to show a positive image to the world.

“The AIIB fulfils for China a similar purpose as the ADB did for Japan, which was to help Japan in re-establishing friendly relations with Asian neighbours after World War II — the AIIB shows the nice face of China," says the official. "It’s about prestige and establishing a new centre of gravity. It will be a top-notch bank, quick to lend a helping hand, better or at least as good as the existing development banks that have had 50 or 60 years to mature. That’s the agenda."

The official describes the AIIB as a political project, given that many other purposes can be achieved through the Export-Import Bank of China. "China has other tools for using aid as an instrument of foreign policy, of cultivating goodwill and political influence, and opening up markets. The AIIB might also support such interests, but I don’t think that’s its primary purpose.”

Given China’s rocky record in international lending, however, is there not much to be learned in carrying out due diligence and risk management?

“All the seasoned professionals I have talked to over the last few years have emphasised the importance of this initiative to improving China’s performance in international banking,” says Drysdale. “There’s also a reverse transfer of management technology into the Chinese development banking system, as a way of improving management of China’s international investment portfolio.”

The ADB official is not convinced. “Sure, they will do risk management, but why? Because if the market says ‘This Chinese-sponsored bank is bad. It has more non-performing loans than it should,’ that would be bad for China. It would be a diplomatic flop.”

Co-operation vs competition

China’s overseas lending profligacy and the inauguration of the AIIB have been a wake-up call to Japan. In the export of nuclear reactors and high-speed trains, the two Asian powers now compete fiercely around the world.

In Sri Lanka they vie to be the first to finance highway construction. In the Philippines, Japan pledged this summer its largest-ever loan of Overseas Development Assistance, some ¥240bn ($2bn) to build a 36.7km commuter railway to Manila. The appalling state of the Philippine National Railways, with only half its track length operational, was a source of embarrassment, especially being on the doorstep of the Asian Development Bank.

The successful launch of a rival upstart in Beijing has put the 50-year-old ADB on its mettle.

“The creation of the AIIB is immensely political, and the ADB is the exact opposite," says Mario Sander, the ADB executive director representing Austria, Germany, Luxembourg, Turkey and the UK. "I think the ADB is strong. It has good credentials, and in fact, the AIIB will start off by co-financing with the ADB. Already there is a joint pipeline being developed. There is a taskforce from the AIIB that talks to the ADB, and staff of the ADB, World Bank and UK Treasury are working in Beijing to help get the AIIB up and running."

One way that that the AIIB can enter the development business is through co-financing of ADB projects, which is how the European Investment Bank of the European Union operates. Sander points out that in 2014 the ADB funded operations with $13.7bn of its own money and $9.2bn co-financed by the likes of Germany's KfW, the UK's Department for International Development (DFID), and the EIB.

“That is not uncommon," he adds. "It is a good way for the AIIB to come into the business and develop a business process. It also makes sense for ADB because it is in line with our policy. So I think the AIIB will have a very smooth transition into the market.”

China’s selling of the AIIB as leaner, fitter and punchier than its flabby middle-aged rivals — eloquently rammed home by Jin Liqun in his nomination acceptance speech — clearly grates in Manila.

Sander argues that “in terms of admin costs per dollar lent, the ADB is the lowest of all the multilateral development banks — lower than the World Bank, the African Development Bank and the Inter-American Development Bank.”

The AIIB will have a non-resident board of directors, and the final decision for most projects will lie with an investment committee, which will set tighter deadlines.

“But they might be seeing things through a Chinese lens," notes Sander. "China is very fast. A project for China is quick, between identification, readiness and approval, but for other countries it may not be."

In a thinly veiled allusion to Benigno Aquino III of the Philippines, he says that a president might not sign any loans, meaning that nothing then happens.

“It doesn't depend on the ADB or the World Bank if the borrowing government just doesn’t do it, for political or whatever reasons, and that part you cannot capture," he says. "If you look at the long time it sometimes takes, it is not always because of bureaucracy and inertia and slowness of the bank and all its systems. It is very simply sometimes because the partner, the borrower, has its own timetable, which may be subject to parliamentary approval, or the parliament is not in session, or there is an election. There is always something that holds things up, and that is very difficult to capture.

"So I don’t know how the AIIB is going to do it. Let’s see. They put out the challenge.”