6 May 2017

Chinese Investment in Pakistan: Rhetoric or Reality?

Much has been written and said about the announcement by the Chinese government in April this year to invest $46 billion in building an economic corridor, the China Pakistan Economic Corridor (CPEC), in Pakistan linking China to the Central Asian republics. The announcement came on the back of the $12 billion loan package made to Pakistan by the World bank the previous year.

However, despite the political rhetoric and the show of bonhomie between the leaders of the two countries, and, the media frenzy that followed such announcement, there are serious questions that need to be raised as regard the risks of the promised Chinese investment in Pakistan.

The lion’s share of the investments are largely going to be in the form of loans of $22 billion by Chinese banks to help resuscitate some of the ailing debt-ridden Pakistani coal and nuclear power plants. The loans can be broken down into two broad temporal categories, the ‘Early Harvest’ ones in the next 3-4 years, and, the other loans promised after 2020. [1] The key question that China watchers need to raise here is, how much is the Chinese government willing to stretch it’s banks now that there is a stock-market meltdown, currency devaluation, import stagnation and deepening recession within it’s own country?

Advocates of China’s overseas investment model will no doubt point to the muscular investment by China in countries fraught with high political, financial and credit risks in Latin America and Africa in the last ten years. In fact, the example of Venezuela, a politically and financially high-risk country in which China has invested over $52 billion from 2008 up till 2014, the biggest Chinese investment in any single country so far, may hold some of the answers.

Although foreign loan-related information is hard to come by as regards most Chinese state-owned lenders, it is estimated that international investments comprised one-fifth of China Development Bank’s loans in end-2014. The majority of the loans were commodities-backed and have gone to resource rich countries in Latin America and Africa which were deemed extremely high risk by western banks or western multilateral institutions. [2] The overseas investment model of China Development Bank was based on the oil-for-loan model originally pioneered by Standard Chartered Bank. In most cases, the loans made by China Development Bank typically went straight to the Chinese companies contracted for the project. It created a win-win scenario for the Chinese government by marrying off low-wage Chinese labour to long-term infrastructure projects in exchange for secure and continuous supply of oil and commodities. All the Chinese loans to Venezuela were commodities-backed, under which Venezuela was obliged to keep supplying to China millions of barrels of oil to feed the Chinese economic boom.

As oil prices plummeted this year, Venezuela along with most of the other South American countries slumped into a severe recession. This forced the lender, China Development Bank, to extend loan maturities reportedly close to USD 37 billion and rewrite the entire loan repayment terms with Venezuela early this year. [3] This is as good as a technical default by one of the biggest borrowers of Chinese debt and it led to Chinese policy-makers question the wisdom of Chinese banks going on lending to such risky countries. [4] The only comparable example of a similar recent event of technical default is when Greece reneged on it’s repayment of a IMF loan in June this year. There is a growing understanding amongst Chinese lenders and policy-makers that this outward investment model was only good enough to last as long as the oil and commodities boom lasted.

Given the above background of technical default by Venezuela and the fact that China has entered it’s own recession in decades, it is only reasonable for both the Chinese government and the banks to ask whether the financial and political benefits of investing 46 billion in Pakistan outweigh the risks and costs of their involvement in all the projects. It may be quite instructive in this regard to highlight two recent examples that bring out some of the issues faced by the Chinese banks as regards lending to Pakistani power projects.

The first one is an instance of a Chinese bank lending directly to a Pakistani power company. Just the previous year, in 2014, Chinese banks refused to lend $ 560 million to the Thar coal fired plant because of the inability of the equity owner, Sindh Egro Coal Mining Company (SEMC) to share the project risks equally (50:50) with China Export and Credit Insurance Company (Sinosure). SEMC was not prepared to bear more than 20% of the project risks. [5] The disagreement was not limited just to the percentage of risk-sharing but also the interest margin and the Sinosure premium. The Chinese banks wanted to charge 5.5% interest margin over LIBOR (the London Inter-bank Lending Rate) and Sinsoure wanted to charge 9% premium for their cover which were both above that specified by the National Electricity Power Regulatory Authority (NEPRA).

Although an announcement was made implying sharing of risk by Chinese lenders in majority of the Pakistani power projects at 80:20 ratio as part of the $46 billion investment package, it is still unclear as regards the details of any agreement reached on issues of interest margin over LIBOR and the premium for credit risk the Chinese banks are looking for to go ahead with the project.

The second example relates to a recent disagreement arising on a loan given by a Chinese bank to the Pakistani government. The Exim Bank of China agreed to grant concessional loans of about 7.8 billion USD (85% of 9.2 billion USD total project costs) to the Pakistani government for the 2200 MW Karachi Coastal Nuclear Power Plants K2 and K3. [6] Since Pakistan is under an IMF programme which places certain obligations on the government as regards maintaining a budget deficit threshold, the government wanted to create a separate public sector company to finance the project well after the loan agreement terms were agreed. The government suddenly decided to keep the entire project costs off-budget in order to avoid showing any sharp increase in their budget deficit. This was not acceptable to Exim Bank of China as it would have led to making significant changes in the terms of the loan agreement. Further the nature of the loan would have changed as such changes would have required the loan to be reclassified as a commercial loan instead of a loan given to a sovereign government.

The fact that the Chinese government and the Chinese central bank are having to fend off a daily worsening foreign exchange problem amidst a gradually deepening recession, it is unlikely that they will be too keen to prop up another high-risk sovereign like Pakistan. The recent policy decisions by China aimed at tightening capital outflows includes certain foreign exchange restrictions imposed on banks and mitigating the problem of over invoicing by Chinese companies doing business abroad. [7] A crucial factor of policy significance that the Chinese government must now take into account is that Chinese state-owned companies will gradually begin to experience a tightening of credit as the growth slows down and domestic spending begins to shrink. It is unlikely that the Chinese government can continue to grant the kind of subsidies it has been doling out to state-owned banks and companies since 2008 which in turn fed on a lending frenzy to high-risk, resource-rich sovereigns across the world. [8] In fact, in a directive by the People’s Bank of China (PoBC) this month, Chinese banks transacting abroad have been mandated to deposit 20% of their contracted value of future foreign exchange transactions. This step needs to be construed as one of many that will require Chinese lenders to assess risks flowing from future foreign exchange transactions with other countries much more cautiously than they are used to doing.

The People’s Bank of China (PoBC) is clearly rattled by the extent of capital outflow in the last couple of months that saw it’s foreign exchange reserves drop by $ 94 billion in a single month, ie, August, by conservative estimates (the higher estimates are in between $150-$200 billion). [9] As of date, it was the single largest monthly fall in Chinese foreign exchange reserves in absolute terms. In fact, the foreign exchange outflow situation became so severe that the PoBC had to rush to offload $110 billion of US Treasury holdings in August to defend its currency. [10] At a time when capital outflows are presenting such a huge challenge to the PoBC, and, the PoBC is struggling to mitigate the volatility in the currency and stock markets, it is difficult to see the Chinese government continuing with the policy of leveraging Chinese household savings towards propping up countries with poor credit fundamentals and histories of political instability. Encouraging domestic consumption by leveraging household debt instead is expected to be part of the ‘new normal’ in Chinese economic policymaking.

Last but not the least, a fundamental question that Chinese policymakers need to raise is how much geopolitical or strategic benefit will China gain from lending to a high-risk sovereign like Pakistan. As of now the CPEC comes out as a barren road without much significant geopolitical or strategic benefits for China. China shares a common border with various central asian countries and have already invested in building infrastructure there. As Sushant Sareen has clinically analysed, the only geopolitical advantage being mainly sought by the Chinese in Pakistan is their close involvement in operating from and maintaining Gwadar Port. [11] The rest of the investments are thrown in as sweeteners by the Chinese government which will undoubtedly be negotiated hard on the ground by all the Chinese lenders.

It is not very clear right now as to what deal the Chinese government has struck with the Pakistani government as regards extraction and future supply of mineral resources. Regardless of that though, it is not lost on either the Pakistanis or the Chinese that loans from Chinese lenders will be all dollar denominated and they come with the usual strict stipulation of at least 70-75 per cent of the project workforce being Chinese. With Chinese wages having gone up significantly in the last five years, the role of Chinese workers as low-cost labour is mere nostalgia. At a time when China is busily reorienting it’s domestic growth model, the grandiose plan to build an expansive economic corridor in the middle of nowhere will surely entail long-term costs for Pakistan that can both be painful and burdensome.

– Saptarshi Ghosh

Saptarshi Ghosh is based in London and consults on banking and securities regulation and policy, governance and compliance issues, alliances and collaborations. His interests encompass political economy undercurrents influencing strategic relationships between countries.

[1] Sushant Sareen, ‘Chinese Chequers in Pakistan: Hyperbole, Hazards and some Heft for the Economy’, VIF India, 27th April 2015 available at http://www.vifindia.org/article/2015/april/27/chinese-chequers-in-pakistan-hyperbole-hazards-and-some-heft-for-the-economy

[2] Deborah Brautigam and Kevin P Gallagher, ‘Bartering Globalisation: China’s Commodity-backed Finance in Africa and Latin America’, Global Policy, Volume 5, Issue 3, September, 2014

[3] Prudence Ho, ‘Venezuela Oil Loans Go awry for China’, Wall Street Journal, June 18, 2015 available at http://www.wsj.com/articles/venezuela-oil-loans-go-awry-for-china-1434656360

[4] Xue Li and Xu Yanzhuo, ‘Why China Shouldn’t Get Too Invested in Latin America’ The Diplomat, March 31, 2015, available at http://thediplomat.com/2015/03/why-china-shouldnt-get-too-invested-in-latin-america/

[5] Zafar Bhutta, ’Thar Project: Chinese Lenders Refuse to Accept Government Guarantees’ The Express Tribune, October 25, 2014, available at http://tribune.com.pk/story/780748/thar-project-chinese-lenders-refuse-to-accept-sovereign-guarantees/

[6] Mehtab Haider, ‘Chinese bank to withdraw loan if Pakistan changes accord’, The News International, January 10, 2015, available at http://www.thenews.com.pk/Todays-News-2-295215-Chinese-bank-to-withdraw-loan-if-Pakistan-changes-accord

[7] James Anderlini, ‘Beijing clamps down on forex deals to stem capital flight’, Financial Times, September 9, 2015, available at http://www.ft.com/cms/s/0/0f825e12-56cf-11e5-a28b-50226830d644.html#axzz3lkg35Fel

[8] Nyshka Chandran, ‘The risks behind China’s growth gamble’, CNBC Sunday, 12th April 2015, available at, http://www.cnbc.com/2015/04/12/the-risks-behind-chinas-growth-gamble.html

[9] ‘China forex reserves slump by record $93.9 billion in August’, CNBC, 7th September 2015 available at, http://www.cnbc.com/2015/09/07/china-foreign-currency-reserves-fall-by-record-amount-in-august.html

[10] Matt Clinch, ‘China dumping Treasurys? Here’s what you must know’, CNBC, 28th August 2015, available at, http://www.cnbc.com/2015/08/28/china-dumping-treasurys-heres-what-you-must-know.html

[11] Sushant Sareen, ‘Chinese Chequers in Pakistan: Hyperbole, Hazards and some Heft for the Economy’, VIF India, 27th April 2015 available at http://www.vifindia.org/article/2015/april/27/chinese-chequers-in-pakistan-hyperbole-hazards-and-some-heft-for-the-economy

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