China and the Future of the Paris Club

In the face of shifting power, and changing global creditors and debtors, what is the likely impact on the existing institutional structure and what may any future legal framework for sovereign finance look like? Given these changes, three possible scenarios emerge as likely candidates for the future legal framework for sovereign finance.  These 3 scenarios and their supporting conditions are set out below.  These scenarios pose non-exclusive, plausible, challenging and divergent possibilities for the future.[1]  They are constructed in context, and are not in any way predictions, preferences or forecasts.  The purpose of putting forth scenarios is to consider the different combinations of global economic factors and domestic adjustments that may give rise to different combinations of risks and opportunities, to encourage analysis and debate, and to induce creative thinking about future challenges.  These scenarios can help inform international and domestic policy as governments and citizens seek to deviate or move towards a more desired outcome.

Scenario No 1: What has been in place since the 1950’s remains in place

In this scenario, the Paris Club maintains its dominant position in the sovereign finance landscape.  The process described above, whereby the Paris Club takes the central and lead role in sovereign debt workouts would continue, and other creditors, both public and private would carry on ceding to the comparable treatment provisions typical in Paris club negotiations.

The events of the last decade – China’s entrance and growing presence on the world financial stage; unsustainable sovereign debt in the United States and Europe; and the attempt at a European monetary union; would all be characterized as momentary glitches in the sovereign finance governance framework.  The existing institutions of the Paris Club and the IMF would continue their reign unaffected, impervious to these glitches.  The RMB will continue to be used with China’s immediate neighbors and some trade partners, but the USD will remain the primary international currency for trade and finance.

Global economic factors to support Scenario 1:

  • China’s economic power wanes – This could occur through slowing global growth, and a decreased demand for exports which would impact on China’s growth model and its current account surplus.
  • United States reconciles its fiscal position and the US economy begins to grow again.  The United States government re-invigorates local industry.
  • European political deadlock and stagnating growth lead to the fiscal union being disbanded, with each of the European nations re-instating their respective currencies.  This would restore the economic sovereignty of the permanent European members of the Paris club, as was the case from the inception of the Paris club up to 2001 when the European monetary union came into existence.[2]

Scenario No. 2: China becomes a permanent member of the Paris Club

In this scenario, the Paris Club would remain an important and dominant institution, though its membership base would be altered to allow a much greater participation by the new creditors. China would become a permanent member or at least a regular ad-hoc participant of the Paris Club, and hold a much greater voting share in the IMF.

The IMF and Paris Club would continue in place, however given the changing economic power of China, and the fiscal union of Europe, the parties would negotiate new terms of interaction, commiserate with the relative economic power of the new members.  The world will move towards a multi-polar currency system based on the USD, euro and RMB.  The US, Eurozone and China will manage to balance their competing interests and the framework of the IMF and Paris Club will stay in place, albeit modified by a greater role played by China, and a unified role by the Eurozone nations.

Global economic factors to support Scenario 2:

  • The growth in China’s economic power would continue, though perhaps not at such a rapid rate as over the past decade, and China would engage in dialogue with the existing structures.  There are several factors that may compel China to so engage, the most obvious being China’s substantial holdings of USD.  China is currently the biggest foreign creditor to the United States and the vast bulk of China’s foreign assets are held in US dollar denominated assets, in particular US Treasury bills and bonds of US government-linked institutions Fannie Mae and Freddie Mac.[3]  China is therefore extremely vulnerable to exchange rate risk, and its newfound creditor status is inextricably linked to US domestic policy.  It is the ultimate “too big to fail” global relationship.  If the US pursues more quantitative easing or other inflationary policy, or Beijing sells a substantial amount of its USD holdings, then the exchange value for the USD may drop and this would drive down the value of China’s US$3 trillion plus foreign currency holdings. So, while China surges forth in its plans for internationalization of the RMB, it will have to tread carefully around the USD.  It does not want too large a depreciation while its holdings in USD are still so large.  Such a depreciation could affect China’s lending capabilities – if its assets reduce substantially.

Another reason why China may choose to engage in dialogue with existing structures is because it wants access to the markets of the United States and Europe.  While China has been active in making soft loans and direct investments with the BRICS and the developing world, its growing capital account means it may increasingly seek to make hard loans which earn it a return on capital.  The United States and European nations are not only obvious borrowers, but operating within the existing structures mean China as a creditor is more likely to be repaid. The lack of formal legal system for sovereign debt means that enforcing sovereign debt contracts is more a function of international coercion and reputations rather than laws and courts.[4]   Accordingly, China the new creditor, may seek to participate in the existing system which has developed methods and systems to guard against wanton repudiation by debtors.

  • United States’ fiscal situation is stabilized
  • Europe puts in place successful economic governance reforms so that it emerges as an integrated monetary union.   The individual European nations begin to realize positive growth, and concerns over the longevity of the euro no longer exist.  The European nations who are simultaneously members of the European monetary union, and also members of the Paris Club, no longer  act independently of each other in Paris Club affairs. Eurozone members would act with a single, and joint voice in Paris Club agreements to reflect their joint economic concerns due to membership of the European monetary union.

While economic recovery of the United States and the Eurozone are not essential pre-conditions for China’s engagement and participation with the Paris Club, clearly a strong and stable US and Europe is more likely to incline China’s commitment.  These factors also make the US and European nations good prospects for Chinese loans – and as China the creditor becomes more and more economically exposed to the US and European governments, it is more likely to want a seat at the Paris Club.

Scenario No. 3 – A Paris Club and a Beijing Club

In this scenario we would see a splintering of power, and a two speed debt restructuring world: the Paris Club would continue to operate but without global dominance.  China will develop its own Beijing club which would have as its members the BRICs, Saudi Arabia, Kuwait, and South Korea. A BRICs monetary order emerges with the RMB, and the Beijing Club at its core.

The traditional Paris Club regime will continue to operate but with less political clout and having to concede the Paris Club comparable treatment criteria – often in the case where China is also a creditor country. In this new world, debtor countries can prefer loans of the Beijing club over Paris club creditors and vice versa.  Existing loans can be subordinated to new loans.[5]  Under this scenario, borrowers and creditors are more diligent in providing market signals such as more favorable terms to show their allegiances to specific creditors thereby maintaining access to funding from sympathetic creditors, or conversely, withholding transparency to gain access to maximum creditors.[6]

In this two speed world, data collection and inconsistent global standards and definitions frustrate reporting and global transparency, as the Beijing club members use different definitions of aid, finance, and investment; and different systems of reporting from those adopted by the Paris Club.[7]  Major questions arise as to how to reconcile and operate in the fractured system

Global economic factors to support Scenario 3:

  • China’s financial influence continues to grow at its rapid pace, and it actively pursues the internationalization of the RMB. China will continue to strengthen relations with the BRICS who are equally experiencing strong growth.  China will develop its own standards for lending and for debt restructuring/forgiveness, ultimately forming the Beijing club.[8] A BRICs monetary order emerges with the RMB, and the Beijing Club at its core.  The Bejing club may work with the IMF, though the IMF voting structure would first have to be restructured to reflect the economic power of the BRICs.
  • United States continues to grapple with its unsustainable fiscal situation
  • Europe continues to grapple with its debt problems, uncertain as to whether to continue with the monetary union or to disintegrate it.

While continued troubles in the US and Europe are neither necessary, nor sufficient conditions to bring about a Beijing Club, clearly they provide greater support for such an outcome.   Continued fiscal turmoil in the US and Europe will not only affect the attractiveness of the USD and Euro as reserve currencies, but also the attractiveness of these markets for Chinese investments.  Moreover, ongoing strife in the US and Europe will undermine the effective bargaining power of the Paris Club and therefore its credibility.  These turn of events are unlikely to inspire Chinese participation in the Club. In addition, if the US and European markets pose as unsatisfying investment prospects, then China’s exposure to debtors in the developing world and BRICS will continue to increase.  China would then have an obvious interest in bringing together the new creditors – the BRICs, Saudi Arabia, Kuwait and South Korea, who would equally have a mutual interest in joining a new sovereign debt framework with China at its helm.  The new Beijing Club would then be able to formulate its own rules and policies to signal cohesion and hence credibility in its bargaining capacity, which would enhance all its members likelihood of sovereign debt repayment.  And so a Beijing club consisting of the new world creditors would emerge to rival the old world creditors represented in the Paris club.

[1] See “Box 3, What are Scenarios?” in World Economic Forum, Euro, Dollar, Yuan Uncertainties, Scenarios on the Future of the International Monetary System,  (2012).

[2] It is interesting to note that Paris club membership and practices were not expressly reviewed in light of the 2001 European monetary union, even though this change had the capacity to radically affect the behaviours of certain permanent members.  The euro meant that certain Paris club members, namely Germany, France, Italy, Netherlands, and Spain, no longer had control over their currency, and were no longer likely to make economic decisions completely independent of their monetary union peers.  See Anna Gelpern, Sovereignty Backwards: The Problem of Quasi-Sovereign Debt, 121 Yale Law Journal 888(2012).

[3] Chin & Helleiner. 91.

[4] Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law., p.31-39.

[5] Currently a key concern for Paris Club creditors is that debtor countries are now granting better terms to China which jeopardizes the uncontested supreme position that has traditionally been held by the Paris Club in debt restructuring.  For instance, China signed a US$9billion minerals for infrastructure deal with Congo – the provisions of which give China priority access to state financial guarantees.  Because China is not part of the Paris Club, should Congo default, China could have priority over Paris Club creditors.  The IMF and the Paris Club creditors have pressed Congo to alter the terms of its deal with China. See Barney Jopson, IMF-Paris Club want DRC to alter China deal as they lend, AFRIK NEWS 23 February. 2009.

[6] For example, countries which have moved through the HIPC program are loathed to reveal new loans to them from China.  This is a sensitive issue for Paris Club creditors and the World Bank given that new loans may undo the relief granted by the Paris Club.  See Brautigam. P.27

[7] Some commentators note that BRIC countries do not report their aid, and where they do, the numbers are not particularly useful given the different definition attributed to “aid” by BRIC countries.  Also, there are assertions that media reports as to China’s financial flows to Africa are exaggerated: for instance reports of Chinese loans in Nigeria have been reported to be $5 billion or more, however according to Nigeria the amount is $589 million in 5 separate loans between 2000 and 2009. See id. at. p. 8, 13-14

[8] By 2009, China had canceled or pledged to cancel 2.7 billion in overdue debt from African countries (so has its own HIPC like program).  But there are no HIPC like conditions in China’s debt relief program.  Countries do have to request relief, but China relieves not on conditions, but on the countries’ continuing diplomatic relations with Beijing. See id. at. 27