Development finance has undergone a shift. Though traditional aid flows once dominated the sector, foreign direct investment (FDI) is now by far the leading source of development finance in most of the world's emerging states. At the same time, competition for influence in these countries is heating up, led by China's massive investments in infrastructure projects in Asia, Europe, Africa and the Middle East. The race in development finance is already altering the balance of global geopolitics and will have major economic, military and political repercussions.
A Short History of Development Finance
The modern era of international development began in 1944, when the Allied nations met in Bretton Woods, New Hampshire, to devise a plan for rebuilding postwar countries and stabilizing their economies. The meeting created the World Bank and International Monetary Fund, known as the Bretton Woods institutions. For the next 40 years, these institutions — along with the eight similar organizations that later joined them — largely drove international development.
That changed in the mid-1980s, when FDI started growing dramatically. Today, it is the biggest source of external financing for many low- and middle-income countries, surpassing development assistance, remittances and portfolio investment. Foreign private capital makes up over 5 percent of gross domestic product across income groups, though the largest FDI inflows go to high-income countries. Along with changing how economies evolve, FDI has become a potent tool for investor nations to expand their influence.
China Changes the Game
Foreign investment from China has played a central role in this transformation. In 2007, the country accounted for just 4 percent of global investment flows, but by 2016, that figure had risen to 17 percent. China now holds nearly 11 percent of global FDI assets, second only to the United States.
Chinese foreign investment grew in conjunction with its need for natural resources and for better global transportation links beyond its borders. China created the China-Africa Development Fund in 2007 to build energy and transportation projects in 36 countries. Six years later, it upped the ante with the announcement of its Belt and Road Initiative, a $1 trillion project to link land and maritime routes between Asia, Africa, Europe and the Middle East. A linchpin in China's economic statecraft, the Belt and Road Initiative covers some two-thirds of the world's population and involves three-quarters of its energy resources. Major projects under the initiative include roads, railways, ports, hydroelectric facilities, and mining, energy and communications infrastructure. Most funding for Belt and Road endeavors comes from the China Development Bank, the Asian Infrastructure Investment Bank, China's Export-Import Bank, state-owned enterprises and regional Chinese authorities.
For China, the Belt and Road Initiative is a way to increase connectivity, expand access to natural resources, diversify trade routes and facilitate investment in foreign currency reserves. It will also create work for the country's state-owned enterprises, which administer most overseas Chinese infrastructure and have subsidiaries in nearly 200 states and regions.
For developing countries, the Belt and Road Initiative offers a path toward economic growth and, in states such as Afghanistan, improved security. The recipients of Chinese investment get all the benefits of improved infrastructure and financing along with an alliance with a top military and economic power. Some countries also like that China isn't as particular about governance, environmental and human rights issues as are the Bretton Woods and bilateral development institutions.
Coming to Terms
Nevertheless, Chinese infrastructure investment comes with some strings attached. Many of the loans that fund the projects, for instance, favor China at the cost of the borrowing countries, raising the chances of default, which Beijing can then turn to its further advantage. Sri Lanka learned this lesson firsthand when it defaulted on an $8 billion loan for developing the Hambantota Port and had to sell China a controlling stake in the project as a result. The International Monetary Fund fears similar defaults will happen, especially in small island countries like Papua New Guinea, Tonga and Vanuatu.
But even larger states are growing wary. Pakistan, Nepal and Myanmar canceled $20 billion in planned hydroelectric projects with China last year, citing concerns over loan terms, irregularities in financing and changing priorities in the energy sector, respectively. To avoid some of these issues, and to reduce its reliance on China, Thailand recently announced plans to create a Southeast Asia infrastructure and development fund to manage jointly with Cambodia, Laos, Myanmar and Vietnam. The European Union, likewise, is considering more stringent processes for screening Chinese investments in technology, strategic infrastructure and natural resources, while U.S. lawmakers on both sides of the aisle support revising the criteria for inbound FDI deals.
The money is only part of the equation, however. For the United States and regional allies such as Australia and Japan, China's wide-ranging investment and infrastructure projects also pose a strategic threat. While China downplays the military dimension of the Belt and Road, the defense applications of its expanding infrastructure networks are undeniable. China has built a military base next to the Port of Doraleh in Djibouti, which it has developed under the Belt and Road Initiative, and it has similar plans for the Port of Gwadar in Pakistan. Plans for possible military bases in Vanuatu and Papua New Guinea are also in the works. The United States and its allies recognize the benefits of China's hefty investment in developing countries — the Asian Development Bank estimates that Asia alone will need $1.5 trillion a year in infrastructure projects through 2030. Even so, they are under no illusions about Beijing's use of the Belt and Road Initiative to advance its military objectives.
The West Reacts
Despite the challenges that China's ambitious development investment presents, the United States has neither the means nor the desire to try to compete with the Belt and Road Initiative, though it still supports overseas development. In addition to the State and Commerce departments, the Office of the U.S. Trade Representative, and the U.S. Agency for International Development, the U.S. Trade and Development Agency, the Export-Import Bank and the Overseas Private Investment Corp. will play critical roles in maintaining U.S. influence internationally through development aid. These organizations will enable the United States to continue supporting infrastructure projects worldwide through joint ventures with U.S. firms, loans, private debt financing and political risk insurance.
Traditional financial institutions, meanwhile, are rethinking their approach to development aid. Investors today inject $1.1 trillion each year into emerging markets — more than the $900 billion the World Bank has spent in total since its establishment in 1944. To stay relevant, the organization is expanding its financial horizons to partner with sovereign wealth funds, private equity firms and insurance companies that can supplement the government contributions it historically has relied on.
China's aggressive use of FDI is a game-changer. The Belt and Road Initiative will increase regional connectivity, advance the integration of Europe and Asia, increase China's access to natural resources and help catalyze economic development in the target countries. And while it may help to solve problems like Afghanistan's geographic isolation, it is also aggravating other issues, like the conflict between Pakistan and India. As strategic infrastructure investment opens new doors, moreover, China will slowly expand its military footprint — stepping on the United States' toes along the way. The effects of these developments will help shape global affairs for years to come.