Industry Trend Analysis - Diversified Financing Necessary To Sustain Belt And Road Investment - SEPT 2017

BMI View: Investment into the Belt and Road will remain a priority of the Chinese government, w ith policy banks , dedicated funds and state-owned commercial banks providing the bulk of financing. Crucial to the longer term sustainability of the initiative will be increasing private capital participation and this will necessitate greater de-risking of projects and increased scrutiny in project selection.

Progress on the Belt and Road (B&R) has been considerable over the last year illustrating the Chinese government's commitment to advancing the initiative. Significant volumes of capital have been directed into projects in B&R countries - a designation which is expanding almost daily - provided by a combination of state owned commercial banks, dedicated funds and policy banks.

Sustaining this rate of capital deployment will become increasingly challenging and will necessitate a greater diversification of financing sources, including increasing the degree of cooperation from international financial institutions. In turn, this will likely see both an increase in the involvement of non-Chinese companies and require greater scrutiny of project development. This will lead to either a shift in focus to lower risk and more financially viable projects, or a shift to deploy capital to de-risk projects across the more frontier or high risk markets in the initiative.

Full Steam Ahead For Belt And Road

Investment into Belt and Road associated projects will continue to progress at the current elevated rate as it hits on several key policy goals of the Chinese government. Investment into industries and countries covered by the B&R were largely included in the areas of 'Encouraged Investment' under recent guidelines established by the State Council on August 18 th and intended to further dampen outbound investment. Consequently, although we expect total Chinese outbound investment to remain below previous levels, B&R investment will remain a priority ( see, ' Furth er Tightening Policies To Weigh On Outbound Investment ' , 25 August).

Outbound Chinese investment into infrastructure and industrial capacity globally remains a major policy goal in itself, as part of the Go Out or Going Global initiative ( see 'China Going Global ' special report series), with B&R an expression of this goal. Investments in these sectors have the combined benefits of supporting demand for China's excess construction and materials capacity in addition to increasing China's influence globally. Additionally, much of the investment is made in Renminbi and supports the goal of greater internationalisation of the currency, both promoting the currency as an international reserve currency (which it was formally designated in late 2016) and increased use for international transactions. In contrast, much of the drive to reduce overseas direct investment has been related to private investments in US dollars and has focused on non-strategic sectors such as real estate.

Exporting The Excess
China - Trade Balance With South, South East And Central Asia B&R Participants (USDmn)
Source: Trademap

Three investment trends have defined the Belt and Road, and we expect a broad continuation of these over the coming months:

  • Both the scope and scale of the Belt and Road continues to expand. Increasingly the idea of '64 plus 1' countries, is shifting to include all countries that want to participate. Additionally, the breadth of activities classified as Belt and Road continues to expand - with a mandate that exceeds the more traditional understanding of the initiative as an infrastructure and manufacturing scheme, but also incorporating social aspects. Included in the most recent developments of the initiative are: a fibre optic network in Tanzania, a Belt and Road Health Forum, expanding Chinese tourism in Thailand and new airports in Zambia and Nepal.

  • Project development remains dominated by Chinese companies, a factor that is unlikely to change whilst funding is primarily from Chinese-backed sources. We have seen a sustained uptick in contracts signed by Chinese companies in Belt and Road countries, reaching USD126bn in 2016, up 36% from 2015 and expect international contracts to account for a growing portion of backlogs for the major companies. China Communications Construction Company (CCCC) for example, one of China's most internationally exposed contractors, saw the portion of new contracts from outside of China increasing from 33.8% in 2015 to 50.6% in 2016 ( see, Diversification To Support CCCC As Domestic Outlook Weakens, 13 July).

Internationalisation Supported By Belt And Road
Chinese Construction Firms - Overseas Revenues as % of Total Revenues
Source: Company Annual Reports, BMI
  • Financing remains reliant on a few concentrated and Chinese-government backed sources, including China's major policy banks (China Development Bank (CDB) and the Export-Import Bank of China (EIBC) and to some degree the AIIB), the major commercial banks (CCB, ICBC, BOC) and dedicated funds including the Silk Road Fund. Since 2016, over USD400bn has been invested by a combination of these sources into funding projects, according to Pan Guangwei, executive vice president of China Banking Association (CBA), as cited by Caixan. This will be complemented by a further lending drive announced in August by China's commercial banks - with the major banks reported to be raising billions of dollars for investments into Belt and Road projects.

China Doing The Heavy Lifting
Belt And Road Lending, By Source, USDbn
Source: CAIXAN, Belt And Road Portal

The level of financing concentrated at primarily government-backed entities is a significant threat to the sustainability of the initiative, given the sheer scale of capital outlays and the uncertain quality of the loans due to high levels of project risk. Many projects supported under the Belt and Road are in high risk countries for project development raising the risk of non-performing loans. Although Chinese companies are likely to import both labour and materials which will reduce some of the construction risk, challenges in securing permits and land will be significant for many projects. With significant risks of project delays this raises the potential for delayed debt repayments or heightened debt levels for governments or other beneficiaries of loans.

Operation risk is also significant given the low GDP per capita in many of the Belt and Road countries making user fees an unrealistic revenue stream. Further the need for integrated networks and facilities to create a steady source of demand heightens revenue risk and raises the risk of non-productive investments. For example, the development of major ports needs to take place in conjunction with special economic zones and industrial facilities, either alone would present major bottlenecks for operations.

Sri Lanka's Hambantota port is a prime example, the project was funded in part by the Export Import Bank of China, but has been unable to generate the traffic to see sufficient revenue to repay the loans due to its isolated position, unconnected to any industrial hubs or logistics networks. Consequently, the port has now been sold to China under a 99-year lease in order to raise capital to repay the debts, a deal which has seen significant opposition in Sri Lanka.

Sizable Investments Exposed To Construction Risk
B&R Project Values And Construction Risk Index
Note: PRI = Project Risk Index. Source: BMI

Diversifying Financing Essential For Sustainability

Diversifying financing sources for the initiative will be essential to the longer term sustainability of the investment plan, necessitating greater scrutiny over project development, however, this could slow the pace of progress. With Chinese banks already having doled out hundreds of billions of dollars, the scale of financing required to progress on the initiative is unsustainable even for the deep pockets of China. We believe there are several options for additional financing sources, but all will require either a greater scrutiny in project selection or increased mechanisms to de-risk projects.

  • International development community: the Belt and Road summit in May illustrated an effort by the Chinese government to court the international community to support the initiative. In addition to support of the initiative in principle, we expect financial support from other countries to be increasingly encouraged. The AIIB is a key example of this route to raising more capital, with the bank having been established with seed money from over 50 member countries globally. More recently, in June, the European Investment Fund (part of the European Investment Bank Group) and the Silk Road Fund signed a Memorandum of Understanding to establish the China-EU Co-Investment Fund, which is intended to provide EUR500mn in capital for Belt and Road projects in Europe. The potential for more multi-lateral or bi-lateral Belt and Road funds is highly likely. In tandem, this is likely to promote greater diversification in the companies active in developing projects under the Belt and Road initiative, as governments look to promote their domestic industries in return for financing contributions. This will mandate greater transparency over project tendering, feasibility and development.

  • International Financial Institutions: commercial banks and other financial institutions have expressed interest in supporting the Belt and Road initiative. In June, Deutsche Bank was one of the first major international financial institutions to show financial support for the initiative, signing a cooperation agreement with China Development Bank to finance Belt and Road projects - the first phase will last five years and is expected to see USD3bn in investments. However the major challenge for greater participation is the commercial viability of the projects. With many of the developments located in frontier and high risk emerging markets, raising commercial debt for specific projects will prove challenging without some form of guarantee or greater clarity over credit risk.

De-Risking To Focus On Construction And Operation Risk

Addressing the high risk of project development in many of the Belt and Road countries will therefore be essential to sustaining the initiative and creating more widespread benefits and productive infrastructure. Construction and operation risk (especially demand risk) are the two areas presenting the greatest risk. Construction and planning concerns include permitting procedures, quality of regulations, institutional capacity to process projects, transparency in the regulatory environment, as well as access to labour and materials (all measured under the Construction phase of BMI's Project Risk Index (PRI)). Demand risk in addition to security or political risk are the major threats to revenue generation for greenfield developments in these markets (measure under the Operation phase of the PRI).

Efforts to develop public-private partnerships, a more traditional mechanism to encourage private investment into infrastructure, have seen varying degrees of success in countries under the scheme and give some indication as to where the financing and development bottlenecks lie. Whilst developed Asian markets and Central and Eastern European countries have greater degrees of regulatory oversight and precedent for private infrastructure investment, emerging markets in Asia and Africa have broadly struggled to enact efficient and productive PPP programmes ( see special report: ' Infrastructure Project Risk Outlook ' , September 2016).

De-Risking Efforts Needed
Belt And Road Country Average Project Risk Index Scores, By Region, Construction And Operation Phases
Notes: Scores out of 100, higher score = more attractive market. Source: BMI

In order to address these issues, project de-risking mechanisms will be essential. In particular, we would highlight the potential for loan guarantees and greater technical and institutional support. The former has been a common mechanism to encourage commercial debt into high risk infrastructure projects, and entities such as the World Bank's Multi-lateral Investment Guarantee Agency have been pivotal in this area. Governments have also played this role. In both cases, the strength of the underlying project still needs to be secure in order to receive the guarantee in the first place. Addressing the underlying structural problems is an area that DFIs have increasingly been involved in, and we would highlight the role of the AIIB, the World Bank, the ADB and similar entities are increasingly expected to play in de-risking projects and reallocating capital from direct project loans to more technical support.