China’s business interests in Latin America have grown at a breakneck pace in last two decades. China is currently the largest trading partner of Brazil, Argentina, Chile, and Peru. China has stepped in to play a unique and unprecedented role in Latin America’s economic development. Latin America, like much of the developing world, struggles to secure development financing due to weak institutions, high political risk, and corruption. These countries struggle to secure significant amounts of financing from multilateral development institutions like the World Bank, the IMF, and the EU development banks because they require strict conditions related to strengthening rule of law and minimizing corruption. These conditions are in place to ultimately increase the chances paying back the loan.
China is a very attractive alternative lending partner because it omits these conditions when offering development loans. This is likely done on the calculation that, even if the lending country does not pay back the loan, the long-term economic and strategic interests of China will nonetheless be served. One of these interests has been to secure raw materials to feed China’s development. Another one is that the Chinese foreign policy establishment may believe that increasing the economic ties between these nations will ultimately increase the political ties between these countries. Closer relations with Latin American economies have more basic economic benefits such as helping China alleviate its domestic overcapacity and promoting the globalization of Chinese companies.
Belt and Road Initiative Extended to Latin America
In January 2018, the Chinese Foreign Minister Wang Yi invited Latin America to participate in the Belt and Road Initiative. However, given that the Belt and Road Initiative is ostensibly a megaproject to integrate the Eurasian continent, it is somewhat unclear what Latin America’s participation specifically means. In all likelihood, it simply refers to aligning the development goals of the two regions as well as expanding infrastructure and increasing trade.
Concerns of a Bubble
Emerging markets investors, in particular, need to be on the lookout for risks that might lead to a financial crisis. At times, vast quantities of foreign capital are drawn to emerging and frontier markets due to the promise of high return. However, when weaknesses in the financial system or economy begin to show, the capital inflows may stop. Even worse, the capital flows may reverse and foreign investors will race to sell their assets and local currency. This pattern is exacerbated by weak institutions which promote low transparency. When there is little transparency, investors become concerned about all of the unknown variables that could affect their future investments in the country.
Due to the fact that Chinese capital has flowed in such large quantities, a destabilizing crisis could be a major concern. The key question is whether or not China is in this for the long haul and will be able to continue supplying capital. If too many loans are unable to be repaid, the Chinese government may feel that their presence is a liability to their own financial position and may cease to offer lending. This could precipitate the kind of crisis that many emerging markets underwent in the 1990s or that Argentina and Venezuela are undergoing today. China has extended concessionary loans to Venezuela as its economy deteriorated due, in part, to the falling price of oil. When it became clear that the country would seriously struggle to repay debts, the Chinese government adjusted the terms, allowing Venezuela to focus on interest payments, and delay principle repayment to a later date.
While these concessions appear favorable in the short term, they could increase long-term moral hazard risk and reduce the health of Chinese development investments in Latin America. That is, governments may expect that China will be a particularly merciful lender when repayment is difficult (since it has been this way with Venezuela, for example) and will, therefore, be encouraged to take greater risks which further decrease the likelihood of loan repayment. Additionally, the promise of easier loan conditions and future concessions will discourage governments from undergoing reforms and reducing corruption, which will, in turn, increase the ability to repay loans.
Sustainability of Lending in Latin America
While China currently has enough foreign exchange reserves to absorb a series major losses on these loans to Latin America, it may not always be able to. China’s foreign exchange reserves have declined significantly since 2014. They will likely continue to decline as China’s economic base moves increasingly further away from low-end, export-oriented manufacturing.
Nonetheless, China has been wise to diversify its investment strategy away from government-to-government lending. The country has put some focus into market-based financing solutions including private equity funds and public-private partnerships. In some respects, this is analogous to the work of the U.S.’s Overseas Private Investment Corporation or the World Bank Group’s International Finance Corporation.
In recent years, China’s business interests in Latin America have moved away from merely infrastructure development and purchasing of raw materials. They are increasingly focused on other sectors such as manufacturing, e-commerce, and technology. By making economic ties between the China and Latin America more comprehensive, China increases the prospect of long-term ties and government cooperation. However, the sustainability of China’s role as a development lending partner will be most telling of the prospect of deeper geo-economic ties between the regions.