There has been so much non-nonsensical thinking by even people outside the Chinese Propaganda Establishment that I think we need to go back to some real basic financial concepts. In this post, I am not going to really focus on the geopolitics because really, everyone knows that OBOR is about Chinese Power Projection so let us just leave that aside.
What I think most people are missing in the financial side, I am just going to bang out issues that need to be addressed.
1. Belt & Road require Countries to become USD Surplus Countries.
Despite stated desire to make RMB global currency, China is lending in USD. When a country borrows in USD, they have to increase their export earnings. Take a simple example. Assume China makes a $1 billion USD loan to a country with a 5% coupon payment due at the end of every year.
That country has to increase their surplus at least $50 million plus some amount of amortisation to be able to make that interest payment. If other countries are not generating more USD, they cannot pay China back.
China is using its model as a large USD surplus country from an undervalued exchange rate, but the fact of the matter is simply that the China model is not a realistic alternative for most countries.
2. For most Countries to increase their USD Surplus, they have to compete with China.
While there are some countries that can run USD surpluses based upon some type of commodity export (think oil, gas, copper, aluminum, etc) for most countries that is not realistic. That means they have to compete on manufactured products and specifically low wage manufactured products.
Guess who they need to displace to generate the USD surpluses? China. That means that for BRI borrowers to repay China, they probably have to displace Chinese exports to developed markets to be able to repay the USD loans.
3. What is special about Infrastructure Investment the area where China has focused?
Infrastructure lending is low term and low return lending. Because it is long term and low return, that means it must be very low risk. Let me give you an example and a comparison. Assume you are investing in tech startups, where most VCs try to get success on about 10% of investments, so you know that 10% of investments will go to zero.
However, that 1 investment out of 10, will go up 100 times, so that one successful investment will balance out your losses in others. Furthermore, because of the growth nature of VC tech investing, it will go from zero to 100x in a few years.
You can accept the very high risk (variance) on short term high return Investments. Conversely, the opposite is true on infrastructure investment. Infrastructure Investment is typically defined by very high upfront and fixed costs.
Take the example of solar panels. Almost all the investment cost of solar panels is the upfront purchase and installation of panels. Revenue is generated from a 20-30 year agreement with an electrical company who purchases the electricity from the investment owner of the solar farm.
The investment cost and returns are well known by both sides, typically determined by electricity price formula. In this case, the cost of capital has an enormous impact on the feasibility of a project. Due to the non-linear nature of changes in the cost of capital (borrowing), a project which can borrow at 5% might be feasible but borrowing at 8% becomes infeasible.
Projects where the asset (solar farms, airports, roads, trains) has an expected life of 20-30+ years simply do not survive where the weighted cost of capital is high in relative terms.
4. Why does the risk and return of a project matter?
Finance guys while imperfect without a doubt, are trying to match the expected rate of return with the expected risk.
Low-risk projects receive low return funding but high-risk projects receive high return funding. Think of it this way: a) tech startup may receive funding that ultimately costs them 10,000% in implied equity costs, but given that 90-95% of tech startups fail, that matches the risk taken by the investor with the returns given to the investor but b) infrastructure investment with 99% probability of success receives lending rate of 4% because the rate of failure is so low.
5. So how does this apply to China and OBOR lending?
If we return to point #3, China is actually funding what should be low-risk long term investments, with short term high-cost capital. Virtually all lending where documents have come forth is in short to medium term (under five years) lending at high-interest rates.
Equity is reported to earn more than 30% while debt rates approach 10%. This creates two specific asset-liability mismatch problems. First, there is a cost-benefit mismatch.
If an infrastructure asset is projected to earn say an 8% return but the capital cost (blending debt and equity cost) is say 15%, the project is not financially viable. Second, there is a “duration” mismatch between taking out a 2 year loan for a highway that is expected to operate for 20 years before needing significant maintenance work.
All known Chinese investment to date suffers from an enormous asset-liability mismatch.
6. Is China stepping in and filling the gap that other investors have left in emerging markets?
Yes and no. Yes they are funding projects that others have not but that does not mean a funding gap exists only that China is willing to accept levels of risk that others are not. Many see investors not funding projects and assume that there are no funds available for projects in countries like Pakistan, Cambodia, and Kenya from non-Chinese investors.
There is enormous amounts of capital available but that does not mean that those investors are willing to accept the level of risk that China is. Let’s us again take some stylized examples looking at how a deal might be analysed.
Let’s assume that that two investors, a Chinese and non-Chinese investors are looking at building a railroad somewhere. If the railroad is able to get enough riders then the project is feasible to pay a 10% capital cost because it will earn a 15% return on assets. However, both investors believe there is only a 50% probability the railroad will get enough riders.
If the Chinese investor funds the deal they are accepting enormous risk that the railroad will not get enough riders and will lose enormous sums of money.
7. If we expect risk and return to match, does that mean China is being fairly compensated for the risks they are taking?
Given the enormous risks they are taking that other investors are not taking, they probably are being compensated fairly. However, because infrastructure cannot be funded competitively at high cost short term basis, this presents an inherent contradiction.
China is funding infrastructure at high cost short term while infrastructure can only be realistic on a long term low cost basis. Funding a bridge is not VC investment.
8. So how is China covering the risks associated with OBOR funding?
Beijing bails them out. Whether it is receiving Venezuelan oil or taking over ports, Chinese firms know they will call Beijing in if the recipient is unable to pay. What makes much of the OBOR initiative so pernicious is Beijing trying to bring the ancillary services under Party auspices.
For instance, there are already international tribunals where states and investors can resolve disputes and independent parties used to either litigate or create third party (like the World Bank) oversight to manage ongoing investment issues.
The Chinese Communist Party is explicitly rejecting these mechanisms and their impartiality for Chinese judges under the CCP.
9. Does China have a comparative advantage in infrastructure construction?
No evidence they do. A study from Oxford found that delays and cost over runs were just as likely on Chinese construction projects as they were in other parts of the world.
10. What about the argument they are offering money when others aren’t or they offered with no strings?
This is an excuse by recipient countries. If you are undertaking an investment in the hundreds of millions or billions of USD, you need to really do your homework. Any good project will have multiple interested parties from contractors to financing entities. If you are a country and the Chinese are the only interested party in the proposed deal, there is something seriously wrong.
Then if you are a responsible country, you should want the strings attached. I know that is counter intuitive but you should want the strings attached. Why? Institutions like the World Bank, donors like USAID, or even commercial outfits like Goldman Sachs understandably and not without reason get criticised for all the paperwork they do before something gets done.
However, there is also a method to the madness. If you are going to build a massive new railroad, you want a couple people checking your assumptions or estimates of how many people will ride the new railroad; you should want public procurement bidding so that you get the lowest cost bid to conduct the work; you should want financial institutions trying to be the providers of capital after reviewing the project planning.
What the countries who take Chinese loans fail to grasp is that not only is China making bad financial risks lending to countries without high quality due diligence, but the countries taking out loans with China are effectively borrowing from the mobs loan shark. Countries that want to think they are taking money that isn’t available are not doing their homework by blindly accepting Chinese capital.
11. So what should countries looking to boost investment do and especially Chinese investment?
Let me emphasise, I have nothing specific against Chinese Investors. I understand the reasons for taking Investment, but that does not mean money should be taken with no regard for consequences.
Point´s of emphasis that Countries should consider when looking at major infrastructure projects whether it is over Chinese or any other capital:
1. Do your due diligence. Everyone starts projects thinking everything will have profitable from the first day and double digit growth for the next 20 years. The reality is a lot more sobering.I saw one country cited that is counting on 15% annual GDP growth for the next 5 years to pay off Chinese loans. Is that possible? Sure almost anything is possible. Is that probable? No. Use realistic assumptions about ridership or ship docking or whatever else is generating the revenue for the project.
2. Solicit other investors and contractors. A high quality project will have no difficulty getting capital whether it is from multilateral institutions like the World Bank or from commercial investors on the capital markets. Then make sure that the bidding for contracting work is transparent and above board. Lowering the probability of corruption occurs via making the contracting work transparent so that why firms were chosen over other firms is clear and if a higher cost firm was chosen there is a very clear reason for why there was a trade off for higher cost.
Countries that do not solicit interest from multiple parties whether in contracting or funding in today’s world are grossly negligent at best. Given the cost benefits that can be achieved, this is a major factor in project success.
3. Set out and achieve best practices in project finance. There is nothing wrong with looking to increase investment, but there are also very clear best practices. Rather than just arguing money should be accepted with no regard for consequences is grossly negligent at best.Countries should look to best practices with industry experts from a variety of potential institutions from for profit firms through to multilateral institutions like the World Bank or other development banks. China has no interest in best practices and it is incumbent on recipient countries pushing to make these centrepieces of projects.
4. Protect yourself with papering and dispute settlement. Even in best of circumstances, whether it is Chinese capital or Goldman Sachs, you write the contracts, have the due diligence, accounting, and insurance to reduce the risks associated with large infrastructure projects.These strings that countries accepting Chinese capital talk gleefully protect the recipient with better litigation or dispute or other risk management venues than trying to beat Beijing in Beijing.
I think good deal due diligence, legal representation, transparency, and project management which are skills available to emerging market economies are vital to avoid unnecessary risks whether with China or others.