September 20, 2018

Beware of Chinese Gifts: A Warning for Central and Eastern Europe

A picture taken on February 15, 2016 shows a container on the first train connecting China and Iran upon its arrival at Tehran Railway Station.
A picture taken on February 15, 2016 shows a container on the first train connecting China and Iran upon its arrival at Tehran Railway Station.

China is often seen in Central and Eastern Europe (CEE) as a potential source of huge economic gains, in trade and investment and in providing lessons for domestic economic development.

This view of China is understandable. It is of course true that over the last 40 years there has been a Chinese economic miracle. In 1979, Chinese GDP amounted to 176 billion US dollars (or about one-third of the current size of the Polish economy); in 2018 it is estimated to be over 14 trillion dollars. However, the “Chinese option” is not what it appears. Whilst it is true that China now has a huge continental domestic economy, trade restrictions make it very difficult for foreign firms actually to trade successfully into that market. Business opportunities are likely to be further diminished by a slowing Chinese economy.

Furthermore, much Chinese “investment” involves taking loans from Chinese banks under conditions that can undermine state finances in the receiving country, most notably in the recent case of a bridge in Montenegro (discussed below). Even when Chinese capital is provided, as opposed to loans, there are significant security questions over the control of acquired CEE companies by Chinese entities under the effective control of the Chinese Communist Party (CCP). In addition, much of the Chinese capital and loans directed to Baltic and CEE states appears to support the Belt and Road Initiative (BRI), whose projects are aimed at making it easier for China to export to those states. In other words, the Baltic and CEE states are paying for or encouraging inward investment into their countries that will only increase their trade deficits with China.

This paper argues that many so-called Chinese opportunities are unlikely ever to appear, and what may appear may actually bring economic and security problems to the region. The solution is to deploy the European Union and the law of acquis as a shield to protect against these threats and seek to use the EU as a sword to ensure that some market access and opportunity for the region does arise from the Chinese market.

A Chinese Opportunity?

Given 40 years of economic growth—much of it at over 10% a year—it is understandable that business executives and policymakers in the Baltic and CEE states have focused on China. It has been viewed as a land of tremendous economic opportunity, as both a trading and an investment partner. From a CEE perspective, China could provide an additional major market to the EU single market and the US for the region’s goods and services. In times of economic recession at home, China could provide an alternative outlet for exports, providing more balanced trade and greater economic security.

The potential of the Baltic and CEE states also appears to have been recognised by China. In 2012, Beijing launched the “16+1” programme. The 16 included 11 Baltic and CEE countries within the EU, together with five non-EU Balkan states. The programme included ministerial conferences and commercial and cultural cooperation agreements. It also appeared to include the prospect of considerable new investment in the Baltic and CEE states. The investment potential of 16+1 was reinforced by the launch of a ten billion-euro regional investment fund in 2016. The prospect of Chinese investment in the region appears to be also underpinned by Chinese plans to connect the Baltic and CEE countries into the BRI, which appeared to have the potential to draw substantial infrastructure investment into the region.

Chinese Opportunity: A False Dawn?

However, on closer examination the opportunities seem to be more apparent than real. Whilst China does have a 14 trillion-dollar market, it is a market that is extremely difficult to enter. As the US Chamber of Commerce reported in 2015, the Chinese state creates multiple layers of formal and informal restrictions that make it difficult to obtain market access. Access is in fact declining rather than opening up. Onerous technology-transfer requirements to obtain access are imposed by the Chinese state; CCP-connected domestic partners are often needed in order to establish an operation, and the business operation itself can be undermined by new (or old) regulations suddenly sprung on a foreign investor.

More fundamentally, the Chinese economy is slowing. Thirty years of 10%-plus growth have been replaced since 2008 by a much more anaemic rate of 6%. This post-2008 “growth” is suspect. As the sinologist David Shambaugh has pointed out, by 2015 Chinese public and corporate debt amounted to 283% of GDP. This is high for what is still a developing country. That this debt is post-2008 pump-priming is evident in the fact that three-quarters of it has been generated since that year. Worse still, this gargantuan borrowing has not been deployed constructively. Much of the debt has been used to fund inefficient state-owned enterprises (SOEs) to expand production. This is one of the principal reasons China (by no means 50% of the world economy) produces 50% of the world’s flat glass, steel and aluminium. It is also why businesses across the world, including in the CEE and Baltic states, are being flooded by Chinese products dumped in their markets. The debt has also been deployed to fund the BRI (300 billion dollars loaned or invested so far), which is itself unlikely to generate much in the way of significant returns (of which more below).

Since 2008 China should have sought to restructure its economy, build up consumption, and shift towards a more decentralised entrepreneurial high-tech economy. While domestic consumption has increased, the CCP has huge difficulties in fundamentally restructuring the economy for fear of losing control over the market and society it has long policed. In addition, there are too many potential losers at the top of the CCP, who in any fundamental restructuring would see their power diminished, from the boards of SOEs and state-run banks to CCP apparatchiks across economic and civil society institutions. Resistance from such elites makes genuine economic reform extremely difficult, even if there were a CCP leader who was determined to undertake such reforms—and Xi Jinping is not that leader.

BRI: Silk Road or Road (or Bridge) to Ruin?

Instead of real economic reform, we have projects like the BRI, the principal element of which is the building of new overland trade routes between China and Europe across Central Asia. This has been labelled a new “silk road”. The hype over the new silk road overlooks the reason that the old one fell into disuse. First, from around 1650 ships became much more reliable, navigation became better and insurance rates fell. Consequently, sending goods by ship became significantly cheaper than road transport. That economic reality does not change by installing motorways and high-speed rail across Central Asia (the railways are currently being subsidised by Beijing to the tune of 300 million dollars a year). Second, shipping goods by sea from China permits the use of the high seas, to which all have access. By contrast, crossing Central Asia involves relying on several national governments, with the looming presence of Russia casting a shadow along the route.

Much of the BRI investment outside China is through loans from Chinese state banks to local firms along the route, guaranteed by their own governments. The real concern here is that the 16+1 nations will be drawn into this web of loan finance for which there is no realistic prospect of economic return for the receiving state—only greater debt (and greater Chinese influence).

Montenegro provides a case study in the dangers of relying on Chinese loans. The country’s total GDP is approximately four billion dollars. Nevertheless, the government in Podgorica struck a deal with the Chinese to build bridges and tunnels across the Morača river canyon to link the port of Bar on the Adriatic coast with Serbia. In total the loans to Montenegro amount to about one billion dollars. The highway bridge and road project had previously been rejected as economically unviable, a result of studies in 2006 and 2012 which indicated that projected low traffic flows would mean the state would have to provide a substantial subsidy for the highway for decades. The Chinese ignored the earlier reports, commissioned a new one indicating that the highway would be viable, and signed a deal with Montenegro to build the road, which will cost Montenegro about a quarter of its annual GDP. In order to fund this borrowing for just the first half of the project, Podgorica must increase taxes and reduce public spending. Montenegro is liable for the debt and is subject under the contract to an arbitration panel located in China.

It is also open to question whether even the touted ten billion-euro 16+1 fund is more an exercise in dangling funds in front of states in the region to gain political leverage than it is actual investment, as not much investment from that source has actually occurred in the last two years. Even when there is direct capital investment from China, the CCP’s control over the allocation of capital to corporate entities via ownership or party committees in all major firms creates a security risk. This is particularly so if Chinese firms seek to acquire shares in strategic industries, such as energy, telecommunications, media or transport. Only 12 of the 16+1 countries, largely in Western Europe, have significant foreign investment regulations.

Waking Up to Chinese Realities: The EU is the Shield and Sword

The key argument of this paper is that for countries across the region the safest and most effective way to deal with China is via the EU. For instance, in order to limit the dumping of Chinese products in their markets (and their trade deficits with China), the Baltic and CEE states should be seeking more vigorous enforcement of the EU’s anti-dumping rules. It is true that these have recently been strengthened; however, more measures can be taken in terms of speed of action to introduce temporary and higher duties.

CEE countries should be wary of China dangling potential trade and investment deals before them to get them to oppose tougher anti-dumping duties. The record suggests that there is likely to be much more dangling than actual trade or investment.

Given that the EU is one of the three major global markets along with China and the US, the Baltic and CEE states should be encouraging the EU to work more closely with the US to challenge Chinese protectionism and encourage it to begin to open its markets.

The European Commission should be encouraged to review all Chinese investments in the EU for illegal state aid. Any state guarantee which has not been notified to the Commission is, prima facie, unlawful state aid, and any guarantee will be void. For the non-EU Balkan states such as Montenegro, the EU should offer to extend the scope of the Energy Community Treaty to cover all infrastructure projects. This would provide those countries with a significant degree of protection from any Chinese demand for state guarantees.

In the Slovak Republic v. Achmea BV case in March, the Court of Justice of the European Union ruled that intra-EU bilateral investment treaties (BITs) were unlawful. Many of the region’s states intervened on Slovakia’s behalf to challenge the BIT. The difficulty with opposition to intra-EU BITs is that one of the principal sources of real, as opposed to apparent, Chinese investment in the region is from other EU countries. Undermining the BITs system is likely to reduce EU investment and increase Chinese leverage. This is particularly worrying because any Chinese investment will involve accepting a binding arbitration panel based in China. The CEE states need to reconsider their opposition to intra-EU BITs and seek an EU pathway to encourage EU and US investment in the region.

All countries across the region need to adopt their own foreign investment review system and seek a robust version of the system proposed by the European Commission.

In an ideal world China would provide significant market opportunities for the Baltic and CEE states, and flows of Chinese investment would be a positive addition to local economies. Sadly, the reality is that there are unlikely to be any significant market opportunities any time soon, and much of the touted investment is likely to prove non-existent or only available under conditions that raise significant economic or security concerns. For countries across the region, the best approach is to focus on using EU measures to constrain the potential threat and, where possible, open up some market access.