Enter the Dragon: China and the New Financial Order

For the past 50 years the United States and Western European nations have dominated and been at the apex of the international financial architecture.  This is evident from the membership and voting structures of important and influential international institutions such as the IMF and the Paris Club.  The Paris Club, an informal group of 19 official creditor governments from major industrialized countries, has since its inception in 1956, reached 426 agreements with 89 different debtor countries, having dealt with debt amounting to US$563 billion.  It has been the key institution governing official debt restructuring in recent decades.  Its powerful position in the international financial hierarchy has been uncontested, until now.

Today, the flow of credit no longer moves from the West to the rest.  The makeup of international creditors and debtors has changed dramatically. The former lenders, the United States and Western European nations, now grapple with sovereign debt woes, while China, which only became a net creditor in 2003, currently has over US$3 trillion in foreign currency reserves.  China’s creditor status is particularly troublesome to the international financial architecture, as China has not only shown its willingness to flex its bulging financial muscle, but also its lack of willingness to join existing structures such as the Paris Club.

As a result of being the world’s largest export economy (which it achieved through various methods including holding down the value of its currency), and through encouraging domestic savings, China has managed to amass more than US$3 trillion in foreign currency reserves, far more than any nation.  80% of this is estimated to be held in USD.  China is now the biggest foreign creditor to the US holding an estimated US$1.5 trillion in American government debt.

Within Asia, China has been vigorous in dispersing its new financial wealth.  It became the largest foreign investor in Cambodia in 2005 and its foreign aid is double that of the US in Indonesia, three times as large in Laos, and four times as large in the Philippines.  Yet, North Korea and Vietnam are perhaps still the biggest recipients of Chinese aid. Chinese loans and aid are also increasingly moving to Southeast and Central Asia, as China continues its ambitions to reposition itself as a regional leader in Asia.

China’s influence has also spread to Latin America and the Caribbean, where a decade ago it’s foreign aid and lending was negligible.  Today, Chinese grants within the region exceed US$700 million per year, and Chinese debt rescheduling/forgiveness in the region has been equally generous – with nations like Cuba receiving US$1 billion debt cancellation.

In Africa, Beijing’s influence is also growing rapidly with Chinese loans and aid flowing within the region, to the ire of the traditional western lenders.  In 2004, China’s US$2 billion loan to Angola enabled Angola to forgo a similarly sized loan from the IMF, and thereby avoid IMF conditionality.  Similarly, in 2006 Beijing made funds available to Chad for the Chad-Cameroon pipeline, which short-circuited negotiations between Chad and the World Bank over the same deal.

Not surprisingly, Chinese lending has stirred unease amongst the Western nations, who use rhetoric such as concern over China’s lending agenda, and its capacity to reverse their work of the past decade in writing off poor countries’ debts, to smear China’s aid and lending to developing countries.

Alongside these developments, circa 2009, Chinese officials made clear their full commitment to the internationalization of the renminbi (RMB) (China’s official currency), and their intent of making Shanghai a leading financial center by 2020 – less than 8 years from now.  Formidable indeed, but China has proven itself capable of big changes, and quickly.  In furtherance of this goal, Chinese authorities have taken steps towards creating a deep and liquid financial market open to foreign investors.  In the first instance, Chinese officials have encouraged the use of the RMB for trade-related transactions, and have begun actively trading in RMB with neighboring countries such as Cambodia, Vietnam, Mongolia, Nepal and North Korea, and with the special administrative zones of Hong Kong and Macau.  China has also entered into agreements with far-away countries such as Brazil for their bilateral trades to be settled in RMB.  This has resulted in a demand for RMB deposit accounts by China’s trading partners.  In response, Chinese officials have liberalized policies in relation to the holding of RMB-denominated deposit accounts – with banks in Hong Kong and New York now both providing RMB-denominated deposit accounts.   During the first six months of 2011, trade transactions settled in RMB totaled around US$146 billion, while RMB deposits in Hong Kong equaled US$85 billion by mid 2011.  Both of these amounts represent over a tenfold jump since November 2008.

What all this suggests is that the center of finance is shifting from the US and Northern Europe towards China.  If this is true, then the apex of international financial governance must also shift.  For institutions such as the IMF and the Paris Club, this promises to be a particularly turbulent time. Will these institutions survive the transition, and remain intact – with a greater role played by China?  Or will they be relegated to an inferior position in the new financial order, with Chinese institutions commanding the apex?  Or will they simply become historic relics?  The answer is not at all clear.  Yet, given the substantial Chinese holding of USD, China’s future may be inextricably intertwined with that of the US for some time to come.  For the IMF and the Paris Club, this may forestall any sudden deaths.