AIIB must avoid pitfalls to be effective

The new Asian Infrastructure Investment Bank should respect transparency and fairness

The Asian Infrastructure Investment Bank, initiated, headed and for the time being funded by China, enjoys tailwinds from two arguments that are intertwined. One is political, the other is based on economics.

First, politically, the AIIB is seen as a move against the established multilateral pillars of development cooperation dominated by industrialized countries, the World Bank and regional and subregional development banks in all continents.

In these banks, shareholder ratios decide on voting rights. In the Asian Development Bank, for instance, in which Japan traditionally plays a leadership role, China's borrowing shareholding of 6.5 percent, as of 2013, visibly contrasts with that of Japan's non-borrowing shareholding of 15.7 percent. It is globally accepted that voting rights are no longer in line with economic performance and the importance of individual countries for the world economy.

Deep dissatisfaction in emerging markets and developing countries about delayed reforms of voting rights has been one driving factor for the generally positive response that the Chinese initiatives received in pushing for new institutions such as the New Development Bank (often called the "BRICS Bank"), the Silk Road Fund and the AIIB. In these institutions, the industrialized countries are invited to join as partners not as decisive powers.

But political arguments only would not have been sufficient for thumbs up responses worldwide, with the exception of the United States. What ties the political argument to the economic one is the perception that those who pay the piper call the tune.

In fact, empirical studies on decision making at the World Bank support the view that donors (or creditors) often act selfishly in favor of their own political and economic interests. These interests comprise the political partisanship of recipients in relation to powerful donor countries, as well as a high proportion of companies from donor countries represented in the import content of development projects (so-called implicit or explicit tied aid).

Furthermore, traditional donors or creditors in the development banks are said to exert pressure on the focus of development cooperation. Arguably, investment in infrastructure has been neglected by donors, with the result that an annual infrastructure gap of $1 trillion necessary to sustain economic growth has emerged.

If this is true, traditional donors obviously have turned a blind eye to the opportunity costs of neglecting investment in roads, airports, electricity grids or telecommunication networks. If so, why did they fail in identifying the costs of benign neglect, thus missing gains from assumedly selfish loans or grants? Their economic power would have enabled them to secure orders and jobs for their construction companies and to exclude companies from emerging markets and developing countries from making successful bids.

In fact, there are good arguments to question "gap" theories. In the past, they have often proven to be misleading. This holds for instance, for the famous assumption of a savings gap in developing countries as "proof" for the necessity of development aid.

Gap theories are notoriously mechanical, static and extrapolating. They underrate structural change in production patterns, shifts in the competitiveness of locations and changes in productivity of capital and labor. The assumption that infrastructure investment triggers private investment is too simplistic. After German reunification, private investors urged the German government to invest heavily in East Germany's rotten infrastructure as a prerequisite for their investment. The government followed suit but later the private sector shied away from investment, complained about high labor costs, and invested in Eastern European Union member states as being obviously more competitive. Thus, infrastructure investment remained idle.

This is not to deny that infrastructure can trigger private investment but it is by no means a panacea. Nor is the sequence clear. Economic prospects can trigger infrastructure investment. There are other caveats that a new funding institution should consider when concentrating on infrastructure. There is a "cluster" risk with high costs at the beginning because infrastructure projects are often technically indivisible and cannot be sliced up in small portions. Gestation periods are long so that discount rates should be low enough to take future net income sufficiently into account.

And above all, the construction sector worldwide is known as a breeding place for violating fair social, political and environmental standards. It is still a widely closed and intransparent sector protected against international competition and dominated by local companies with strong lobbying power. Thus, it does not come as a surprise that this sector is often subject to investigations about corruption, pollution and exploitation of labor.

Can the AIIB avoid these pitfalls? Yes, with some rules. As the Chinese government already announced, it should subject the AIIB to "best international practices" with respect to transparent and fair standards. It should tap the pool of technical expertise of the other banks and cooperate with them.

Complementarity is the key word. It should not become the hunting ground of Chinese construction companies (being No 3 in world exports of construction services). Tied aid in any form would immediately frustrate the recipients and diminish the economic value of cooperation. Projects should try to avoid cluster risks by dividing them into managable and overseeable modules.

The author is professor and former vice-president of the Kiel Institute for the World Economy in Germany.