The BRI is a hugely ambitious plan that will take decades to realise. If successful, it will fundamentally alter the geopolitical map of Eurasia, writes Paul Gruenwald, Managing Director, Chief Economist, S&P Global Ratings.
Conceived in 2013, China’s Belt and Road Initiative (BRI) aims at nothing less than connecting—or under some interpretations, reconnecting—the Eurasian supercontinent. This is to be done by land and sea “Silk Roads”, using infrastructure and industry, led at least initially by Chinese official financing. Many of the specifics of the BRI remain fluid, but it will be a decades-long effort involving dozens of countries, with a cost running into trillions of dollars. An undertaking of this magnitude has potentially large payoffs, as well as potentially large risks. Success will ultimately rest on whether BRI projects can win local hearts and minds in the recipient countries, and whether China’s initial “seed money” in the BRI will create credit-worthy projects that attract private sector investment. Seen in this way, the BRI is arguably the world’s largest venture capital (VC) project.
Chinese President Xi Jinping introduced the Silk Road Economic Belt concept in a speech in Kazakhstan in September 2013. This initial strategic vision was developed further in the ensuing years, converging around regional connectivity and economic integration through the movement of goods, services and information. This culminated with a report by the National Development and Reform Commission entitled “Vision and Actions on Jointly Building the Silk Road Economic Belt and 21st Century Maritime Silk Road.” Given its somewhat fluid definition there is some debate as to whether the BRI is a new initiative as opposed to a platform on which to group a collection of existing initiatives. Whatever the correct interpretation, the ambition and scale are massive.
GEOGRAPHY AND GEOPOLITICS
China is bordered by no fewer than 17 countries. Of particular interest to Beijing are the western borders, which abut Central Asian countries once part of the former Soviet Union. These nations tend to be Islamic and less politically and economically stable than China. They are seen as potential sources of risk, particularly in Xinjiang province in China’s northwest. Engaging these countries economically and connecting them to western China through the BRI serves several purposes: It improves economic outcomes in these countries and lowers the risk of tensions spilling over national borders, in effect creating a buffer zone. It increases China’s sphere of influence. This means achieving better political alignment with neighbouring countries, in tandem or as a result of infrastructure and investment projects under the BRI. It potentially creates a network of countries that use the Chinese currency, Chinese engineering standards, and where China plays a dominant role amongst competing regional and global powers.
A second driver of the BRI calculus is energy security. China’s image as a structural trade surplus economy does not apply to energy, where it runs persistent trade deficits. Although China had an overall 2017 current account surplus of two per cent of GDP, the energy trade balance showed a modest deficit. Over time, the energy trade balance deteriorates or improves as global energy prices rise or fall, respectively. But the fact remains that China is an “energy short” country, since the energy trade deficit has averaged three per cent of GDP over the past decade. Moreover, China’s continued projected fast growth means energy demand is expected to continue outstripping supply.
The vulnerabilities of this recurring deficit factor prominently in the BRI. In physical security terms, there is potential choke point at the Straits of Malacca, roughly where Singapore sits. Around 85 per cent of China’s oil imports pass through the Straits of Malacca, as well as about 50 per cent of its gas imports. Several of the early BRI projects directly address the vulnerability represented by the Strait of Malacca chokepoint: The China-Pakistan Economic Corridor is one of the more advanced, and reportedly the biggest, BRI project to date. The corridor involves extensive energy and transport infrastructure projects that will link western China to the port city of Gwadar on the Arabian Sea. Chinese firms are converting Gwadar into a multipurpose, deepwater port.
Recently built oil and gas pipelines from the Bay of Bengal traverse Myanmar and terminate in the western Chinese city of Kunming in Yunnan province, where considerable refining capacity is reportedly being built. Kunming is also the terminus of an extensive rail network for Southeast Asia, parts of which are currently in various states of construction. In Central Asia, the BRI envisages upgrading and extending an earlier gas pipeline system built by the Soviet Union.
The goal is to tap further Turkmenistan’s sizeable gas reserves, as well as Kazakhstan’s large oil reserves. The newest pipeline will pass through Khorgos, along the Kazakh border, where China is currently constructing the world’s largest dry port. In addition to supply diversification, another strategy would be to lessen China’s reliance on imported fossil fuels. China is moving aggressively in the areas of improving energy efficiency and adopting renewables—in some cases spearheading the technology to do so—but demand for fossil fuels is still expected to rise strongly out to 2050.
VENTURE CAPITAL SCHEME
The BRI can be viewed as a VC fund with a twist. Getting infrastructure financed and built has been a chronic problem for Asia Pacific. This is particularly true in Southeast and South Asia. The Asian Development Bank (ADB) now estimates that the infrastructure needs of Asia will exceed $22.6 trillion through 2030, in order to maintain sufficient growth momentum. Over half of this will be for power generation and about one-third will be for transport. More importantly, the ADB sees an infrastructure funding gap—the difference between investment needs and investment levels—of five per cent of GDP in the group of countries excluding China.
China’s gap is 1.2 per cent of GDP. The funding gap is not an issue of supply and demand. There is no shortage of infrastructure demand in the region, and the potential supply of longer term investors, both regional and global, is also ample. Pension funds, insurance funds and sovereign wealth funds all seek long-term assets to match their long-term liabilities. Multilateral development banks including the ADB and World Bank have deep pockets and broad mandates to fund spending on public goods such as infrastructure. The sticking point has been the risk return trade-off.
Construction risks, political risks (both policies and expropriation), exchange rate risks, commodity price risks and environmental risks have made creditors hesitant to commit longer-term funds. As a result, infrastructure demand threatens to remain unmet, and investment and growth will correspondingly suffer.
However, there are a number of factors which suggest a better risk-return tradeoff for China than for other creditors:
Trade benefits: BRI projects will likely make the recipient countries more likely to trade with China (and use the renminbi), bringing economic benefits beyond the project itself. The size of markets for Chinese exports would also increase.
Energy security: BRI projects will result in improved energy security for China as sources are diversified, bringing benefits beyond the narrowly defined output of the project. The energy build out will also help develop and raise incomes in China’s poorer, western provinces.
Network benefits: China’s sphere of influence across the region will increase as a result of BRI projects as both economic and non-economic ties increase. This will provide in-network benefits as well as a buffer zone against outside influences.
The Chinese government develops infrastructure under a build-operate transfer (BOT) model. Once an agreement (concession) is granted by the host government, the projects are built and financed mainly with Chinese materials and labour. A Chinese firm then operates the facility, usually for a period of 20 to 30 years, splitting the proceeds with the local counterpart or government. Finally, at the end of the operating lease period, the project is transferred to the host government or entity. The idea is that the costs of the project, including a target rate of return, can be amortised by payments during the lease period. This is the intent, but it is not assured.
There are a number of risks being taken by the Chinese project companies, including political risk (including change, or change of view, of the government), technical or construction risk, market risk (inputs prices, interest and exchange rates) and income risk. Ideally, the outcome is that the cost of the project is amortised and the Chinese project company is able to exit. In a bad outcome, the project company may be holding an illiquid asset in a foreign country.
The Chinese government is investing seed money to fund infrastructure and industry projects in the target countries. These target countries are the equivalent of early-stage or emerging firms in VC parlance. The objective is to reap returns from these investments, cash out and exit. However, in a pure VC model the financer would simply cash out and move on to the next emerging firm. In the BRI model, the Chinese project company would also cash out, but there is a clear expectation of an ongoing relationship between the Chinese government and the recipient country.
Success can be measured in terms of soft power and financial sustainability. Soft power boils down to winning the hearts and minds of the recipient countries. The objective here is to build a network of commercial and political alliances that will serve China’s broader geopolitical aims— regional influence and security. Measuring this part of the success equation will be difficult since much of it will be behavioural.
Building ports, road, bridges and pipelines will be necessary but not sufficient. Local populations will need at least to feel that they have some say in the Eurasian integration project and that their national identity is being both respected and preserved. In short, via the BRI, they will need to buy into the notion of a Chinese-led, but not Chinese-dominated, Eurasian block. Financial success can again be defined along the lines of a venture fund. As projects get up and running, Chinese firms will attempt to amortise their investment under the BOT model.
Ultimately, the locals will take control. The key here is whether the project (and its spinoffs) will have long-lasting value to the recipient country or will just be seen as an extractive exercise. The composition of funding in the latter stages of projects will be important as well. Private sector participation will signal that the BRI has created value in the initial stages, and that the risk-return trade-off has improved to the point of being able to attract private capital. Success will also be determined by how the BRI accommodates or challenges the existing regional powers on the Eurasian supercontinent, as well as the current global superpower, the United States. Managing these relationships will be a challenge, and this dimension of the BRI challenge should not be underestimated. The cost of tensions is this area could overwhelm gains generated elsewhere.
Yet, if successful, the BRI will alter the geopolitical map of Eurasia, as well as China’s economic and political relations with its neighbours near and far, for decades to come.