China and the Economic Integration of Europe and Asia
Remarks to the Summer Roundtable of the Pacific Pension Institute
Ambassador Chas W. Freeman, Jr. (USFS, Ret.)
San Francisco, California, 23 July 2015
This gathering has featured lively discussions of investment in various forms of infrastructure, logistics management, and natural resources. Originally, I was going to talk about China’s role in commodity market volatility. I began preparing to do that but, with your indulgence and in line with the theme of this roundtable, I want instead to address the most massive project for infrastructure and logistics management investment the world has yet seen. I am referring to China’s “Silk Road Economic Belt” and the “21st Century Maritime Silk Road,” the “one belt, one road” project. This aims to bring into being a new economic order on the Eurasian landmass. Everything from the Atlantic to the Pacific is to be connected through hyper-efficient infrastructure and new institutional linkages.
Internationally, most attention has focused on Beijing’s ambition to build 81,000 kilometers (about 50,000 miles) of high-speed railways connecting itself to everywhere else in Asia and Europe. One trunk route is to go through Southeast Asia to Singapore. A second will cross the Karakorum Mountains and branch into two lines: one reaching Pakistani ports on the Arabian Sea; the other crossing Iran to Turkey, the Mediterranean, the Black Sea, and Southeastern Europe, with a branch connection to the Arabian Peninsula. A third trunk will go through Kazakhstan and Russia to Western Europe. China’s plan is to enable train travel from London to Beijing in a mere two days as early as 2025.
But the “one belt, one road” project is very much not limited to railroad construction. It aims at massive development of economic corridors traversing the entire Eurasian landmass and all its major peninsular extensions. It also has a large maritime dimension. China is in the process of becoming the world’s preeminent economy. The purpose of the “one belt, one road” project is to promote its economic integration with what has been called the “world island” – the conjoined continents of Asia and Europe. This is an area with a population of 4.4 billion and a current economic output of $21 trillion.
As one example of what China has in mind, consider the economic corridor that is to link Kashgar, in Xinjiang, with the port of Gwadar, in Pakistani Balochistan, 1,800 kms. (or 1,100 miles) away on the Arabian Sea, just outside the Strait of Hormuz. In terms of China’s overall program, this is a bit of a sideshow. Still, the next fifteen years will see at least $46 billion allocated to the development of the China Pakistan Economic Corridor. $34 billion of this will go into new power plants, with the goal of almost immediately (that is three years from now) generating an additional 10,400 MW of electricity for power-hungry Pakistan. The rest will be devoted to building roads, railroads, power transmission lines, fiber optic cables, and oil and gas pipelines. Pakistan estimates that this influx of Chinese investment will stimulate a 15 percent increase in its GDP by 2030.
In addition to its impressive physical dimensions, the “one belt, one road” project seeks to build institutional linkages and to break down barriers to cooperation between China and the various economic communities that populate the “world island.” These communities include ASEAN, the Russian-led Eurasian Economic Union, the Shanghai Cooperation Organization, the EU, the South Asian Association for Regional Cooperation (SAARC), and the Organization of Islamic Cooperation. A key building block in this effort is the so-called “regional comprehensive economic partnership” or RCEP. This will create a free trade area (FTA) embracing China, ASEAN, Australia, India, Japan, south Korea, and New Zealand. The target for concluding RCEP is the end of this year. In January, China agreed an FTA with south Korea. China’s Ministry of Commerce then announced its intention to use the China-Korea FTA as a model for additional FTAs with sixty-five countries along the Silk Road economic corridors.
China has set a goal of $2.5 trillion in trade with Silk Road countries by 2025. In support of this, China seeks to inspire mergers, acquisitions, and green-field investments to create what might be called “multinational companies with Chinese characteristics,” some with headquarters in Europe or elsewhere outside China. The current surge of Chinese merger and acquisition activity in the EU – much of it involving the German Mittelstand – reflects this objective. As the “one belt, one road” concept is implemented, the EU and China should draw ever closer commercially. The same, for other reasons, is true of China and Russia, and of China and Iran.
Meanwhile, as you all know, China is overhauling its economic structure. The old model based on integration of trade with global markets but with limited financial linkages has reached the end of its useful life. Chinese growth is weaning itself from dependence on domestic fixed asset investment and transitioning to reliance instead on the expansion of the services and domestic consumption.
Services overtook manufacturing and construction as economic activities in China in 2013. They now contribute almost half of Chinese GDP, up from less than one-third ten years ago. Chinese consumption overtook investment as the main driver of growth in 2011. While it remains relatively low as a percentage of China’s GDP, continuing rapid urbanization and the concomitant growth of China’s middle class promise to correct this. In 2014, 55 percent of Chinese lived in cities, up from less than 20 percent in 1980. According to the OECD, China is on its way to a 69 percent urban population by 2030. City dwellers are heavy consumers. This is the digital age. China is already the world’s largest digital marketplace.
As the Chinese economy evolves, we are beginning to see massive growth in China’s cross-border capital flows. Chinese investment abroad exceeded $100 billion for the first time in 2014. A lot more money is on the way. The majority of it will go into investments under the “one belt, one road” program. China’s emerging global financial role will be decisively shaped by its experience with Eurasian economic integration.
The “one belt, one road” initiative is partly a short-term measure to alleviate the current overcapacity in China’s cement, steel and aluminum industries by conjuring up export markets for them. It will let Chinese manufacturing and construction companies continue for a while to do the sort of work abroad that is winding down at home.. The initiative is also a way of developing Xinjiang and other parts of western China by making them key connectors to Central Asia, Russia, Europe, and the Middle East. But, in the longer term, “one belt, one road” is a strategy to use Chinese resources to tie Europe and Asia more closely and efficiently to each other and to China. The added efficiencies of its planned railroads, highways, pipelines, power grids, fiber optic cables, and air and sea ports respond to real market requirements and opportunities. Its institutional linkages will facilitate the investment necessary to realize these efficiencies.
The “one belt, one road” project has barely registered in official Washington. It is not taken seriously by many within the Beltway. Nor, as I vividly recall, was Deng Xiaoping’s 1978 announcement of his vision of “reform and opening.” Now, as then, there are lots of China specialists who dismiss China’s aspirations as unlikely to produce much. There are many skeptics in China itself. But China’s leaders are betting that the “one belt, one road” project can bring about a second major advance in their country’s long march toward wealth and power. They believe that their vision has the potential to be as transformative as Deng’s “reform and opening” has been over the past thirty-seven years.
These are early days in the development of a program conceived to span three or more decades. But slighting China’s latest effort to boost its wealth and power or its potential strategic implications strikes me as very likely a big mistake. In any event, while Washington works itself into a lather over Chinese pave-overs of reefs in the South China Sea, Beijing is focused on much bigger things. Chinese spokespersons are careful to describe their country’s Silk Road initiatives in purely economic terms. Still, if these initiatives work at all, they will have enormous geopolitical impact.
Beijing has indicated a willingness to commit as much as $1.4 trillion to its “one belt, one road” strategy. To put this in perspective, it is more than ten times Washington’s historic commitment to the Marshall Plan, which totaled $120 billion in today’s dollars. China has already deployed at least that amount of new money to its vision of Eurasian economic integration.
$40 billion has gone into the Central Asia-focused Silk Road Fund. An initial tranche of $50 billion has been committed to a new Asian Infrastructure Investment Bank (AIIB). $5 billion has gone into a new “Marine Silk Road Bank.” $46 billion has been allocated to the China-Pakistan Economic Corridor. An opening contribution of $10 billion – some of which will go to Silk Road projects – has gone into the BRICS-led New Development Bank. China Development Bank says it will finance up to $1 trillion in “one belt, one road” projects. Various elements of CITIC have just announced commitments to fund 300 projects from Singapore to Turkmenistan totaling $113 billion.
Meanwhile, China continues to leverage its membership in the Asian Development Bank (ADB), the World Bank, and other U.S., Japanese, and European-dominated institutions to the cause of improving Eurasian infrastructure. And Japan has announced its own $110 billion infrastructure investment fund for Asia. The justification for this Japanese fund is geopolitical rivalry with China. But the Japanese initiative seems likely simply to support rather than undermine the Chinese objective of strengthening pan-Eurasian economic ties. And China seems confident that its economic size and dynamism will make it a major beneficiary of any removal of barriers to trade and investment or improvement in the communications efficiency in the Indo-Pacific. The East Asian economy is already in many respects Sino-centric. China’s expectation is that as its ties to Europe, Russia, and the Middle East mature, Eurasia will become ever more Sino-centric too.
Next year, China will launch five years of collaborative strategic planning with foreign partners about projects to be carried out under its “one belt, one road” concept. Implementation is expected to begin in earnest in 2021, the 100th anniversary of the Chinese Communist Party. It will culminate in 2049, the 100th anniversary of the People’s Republic. The scale of what China is attempting is unprecedented, but the grand vision, long planning horizon, optimism, and tie to anniversaries are typical of contemporary Chinese political culture.
For the past two decades, China has devoted about 9 percent of GDP to the enhancement of domestic infrastructure. It has learned a lot about how to build things that boost transportation and communications efficiency. China built its first expressway in 1988. By 2011, it had the world’s most extensive expressway system. China’s first high-speed train went into service in 2007. By the end of last year, its high-speed rail network, with over 16,000 kms (about 10,000 miles) of track, was longer than all high-speed rail systems outside China combined. China has installed about 1 million kms (about 620,000 miles) of fiber optic cable. It now has the world’s largest broadband network. Almost half of the expansion in the world’s high-voltage electrical transmission lines is now taking place in China. Having produced amazing economic development in China itself, Chinese capital, energy, and infrastructure-building expertise are now focused on Central Asia, Russia, Europe, and the Middle East.
To this end, China is creating new international institutions that both supplement and compete with existing U.S.-sponsored funds and banks. It is promoting the Chinese yuan as a medium of trade settlement and public borrowing throughout Eurasia. These innovations are taking place as the obsolescence of existing exchange and development institutions has become increasingly obvious. The IMF and World Bank were born in 1944 at Bretton Woods. Seventy-one years ago, the United States led the capitalist world. It produced half of global GDP and held seventy percent of the world’s gold reserves. America does not occupy a similar commanding position now. More to the point, the United States has recently shown neither the will nor the political capacity to muster the means to adapt the Bretton Woods institutions to this century’s economic realities and development requirements. In this context, China’s initiatives amount to a tectonic shift in the global monetary system
China’s organizational initiatives incorporate, complement, and build upon numerous existing institutions. They are additive and do not supplant them. They are explicitly inclusive rather than conditional or limited to countries that meet Chinese-imposed criteria for lending. China’s financial commitments are for the most part credit availabilities, not specific project finance commitments. The availability of credit does not guarantee the availability of financially attractive projects, however desirable they may be in terms of their overall impact on China’s economy and its relations with the other societies in Europe and Asia. Hence the importance of the international consultations and strategic planning efforts that are about to get underway
China has a record of making extravagant offers of credits abroad that are then underutilized. This justifies a certain measure of skepticism about the numbers China has attached to its aspirations. Not all of the money China is making available will find projects. Still, given China’s emphasis on collaborative planning with foreign partners, a good deal of it seems certain to be used actually to build things. A majority of Chinese private sector and state-owned enterprises in the construction, mining, and telecommunications sectors have already built utilization of “one belt, one road” credits into their business plans. Every province and megalopolis in China is developing specific plans to support “one belt, one road” projects. A large part of the work on these projects – as much as 70 percent, if past practice is a useful guide, but far from all of the work – will be done by Chinese companies.
China’s economic planners want to make private enterprises the backbone of the scheme – to leverage their energy, flexibility, and sensitivity to investment efficiency. But the initial emphasis on state-owned enterprises replicates the infrastructure-investment-led approach to development that has run out of steam in China’s domestic economy. The best that can be said for this is that it gives such companies an opportunity to ease their transition to a new system with new rules and practices. They can continue for a while to do abroad what they will have decreasing opportunities to do at home.
China’s private sector companies are very good at exploiting opportunities for investment fueled by credits from the Chinese state. But, for the program to succeed over the long term, the planning process that is getting under way will have to begin to develop new models for Chinese investment that empower private enterprise along the Silk Road as well as in China itself. Perhaps the key to accomplishing this is partnership with foreign companies and lenders with greater experience in risk-based lending and turning a profit outside home markets. As the late Deng Xiaoping would have put it, China and its foreign partners will have to find their way across the many rivers between the Atlantic and Pacific by feeling their way with their feet as they ford them. Some projects envisaged for the “one belt, one road” program will be financially attractive or made so. Others may be more problematic. The market will decide.
This raises a key question. Many of the countries that lie between China and Europe have troubled political and economic environments. What return on investment can China and its partners reasonably expect from “one belt, one road” projects?
In the short term, on the macro level, even under conservative assumptions, investment in Asian and European infrastructure looks like a good bet. Chinese state-owned enterprises have more money for infrastructure build-out than they can profitably deploy in China, where returns on such projects are very low at present. Investing in roads, railways, fiber optic cable, and power generation and distribution assets outside China could enable the productive use of China’s industrial overcapacity, stabilizing employment and the Chinese economy.
One study estimates, for example, that a relatively modest five percent growth rate in such assets from their current base could create 137 million tons of demand for Chinese steel. This would reduce oversupply in the Chinese steel industry from 22 percent to 8 percent. It would expand access to markets and natural resources to China’s West, while linking both to the Chinese economy. It would also offer a new outlet for the investment of China’s huge foreign exchange reserves, which have been concentrated in U.S. Treasury bonds and other instruments with very low yields.
As another example, consider the benefits of shorter, land-based telecommunications routes that connect the two ends of the “world island.” China is connected to Europe at present by 39,000 kms (about 24,000 miles) of mostly underwater cable following legacy telephone links. Digital packets transmitted from Western Europe to Shanghai or Tokyo must either cross Europe, the Middle East, the Indian Ocean and the South China Sea, or transit the Atlantic, the United States, and then the Pacific Ocean. Too many cables pass through heavily trafficked choke points like the Strait of Malacca or the Suez Canal. Accidents in these choke points cause several hundred disruptions of the global undersea system each year.
Trans-Eurasian networks will be more stable. They will not just improve connectivity for landlocked countries along the “one belt, one road” routes but also speed up data exchanges between Europe and Asia. Investors are willing to spend hundreds of millions of dollars to gain a few milliseconds in highly profitable “high frequency trading” – the automated buying and selling of financial instruments by computers. By some estimates, a one millisecond advantage could be worth up to $100 million a year to a single hedge fund company. Shorter routes are the keys to speed – and profit. And routes under Chinese, Russian, and European control will arguably be more secure from exploitation by the much-feared U.S. National Security Agency.
The devil is always in the details, but if China’s vision is realized in any significant respect, in time all roads in Eurasia will lead to Beijing. China will become the center of economic gravity of a vast, loosely integrated region that already has 55 percent of world GNP, 70 percent of global population, and 75 percent of known energy reserves. The “one belt, one road” program includes no military component, but it clearly has the potential to up-end the world’s geopolitics as well as its economics. It is an entirely non-coercive, market-directed means by which to aggregate all of Europe and Asia’s wealth and power to China’s own as China becomes the world’s largest economy. If it works, it will place China in an ever more central position of influence on the Eurasian landmass and the world. It will, in short, make China the most important single national actor on the entire Eurasian landmass.
But the implications of the “one belt, one road” project are not in any way limited to geopolitics. A post-Bretton Woods global financial order is being born. It will be shaped in large measure by what happens under China’s Silk Road initiatives and in the institutions China is organizing to support them. Nations and financial institutions that collaborate in these initiatives will be in a position to shape them and the reformed international financial system they constitute. Those who stand aside from these initiatives will not. The American and Japanese decision to boycott the Asian Infrastructure Investment Bank and related Chinese initiatives is a major forfeiture of strategic influence. As such, it is a blunder of epic proportions. The United States is in denial about the nature and direction of change in the global political economy. Washington has lost intellectual command and practical control of geopolitics in the Indo-Pacific region.
Americans like to apply military deterrence to threats and coercive solutions to problems. China’s return to wealth and power certainly has military implications that must be addressed. But China’s main impact on world affairs has been and will continue to be politico-economic. The challenges posed by a more prosperous and internationally engaged China have no military solution. The world’s future is far more likely to be determined by the peaceful economic integration of China with the rest of Eurasia than by the U.S. “pivot to Asia.” In this context, the military aspects of the “pivot” are irrelevant. And the conceit that rules for trade and investment in the Indo-Pacific can set by arrangements that exclude China, like the Trans-Pacific Partnership (TPP), is preposterous. China is every country in TPP’s biggest trading partner and greatest potential source of future foreign investment.
In many ways, the U.S. and Japanese responses to China’s increasing role in global economic affairs remind me of the dysfunctional reactions of an entrepreneur as the private equity boys reorganize the company he founded, change its management, do transformative mergers and acquisitions, and deprive him of all pretense of control over his company as they take it public. Waving a gun in the air may make the man feel good but it is beside the point. And it will not earn him the support of the new stakeholders. To continue to lead, one must engage and contribute, not deny the reality of change or boycott, bluster, and block needed reforms. As the great conservative, Edmund Burke, declared: “the heart of diplomacy is to grant graciously what you no longer have the power to withhold.” Doing this is how one repositions oneself to future advantage.
China is now near the heart of the global capitalist economy. Despite many internal problems, it is currently outplaying all rivals, including the United States and Japan. It has a vision of reform and opening of itself to its neighbors to the west that is potentially transformative on many levels. If China realizes its vision, it will fully deserve the name by which it calls itself –中国, the country at the center of the world’s affairs. We cannot hope to prevent this through military maneuvers and exclusionary trade arrangements even if it were in our interest to do so, which it is not.
What we can do is find ways to leverage China’s rising prosperity to boost our own. To do this, we need to ramp up our competitiveness and deal with the world as it is, not as it used to be. China has its act mostly together. We need to get our act together too.