Through its Belt and Road Initative (BRI), China is offering support for long-term development in infrastructure-poor regions. It provides opportunities for financing much-needed projects to improve regional integration and links to external markets. It also helps strengthen the strategic planning capabilities of recipient countries. The risks arise from the questionable commercial and economic viability of many ventures, the effects on China’s debt-fueled investment-driven growth, and the implications for future BRI financing.
There are three broad perspectives on the BRI. The “China conquers the world” interpretation sees the initiative as a move to reshape the global political economy. As Admiral Harry Harris, then head of the US Pacific Command, put it last year, the BRI “is a concerted strategic endeavor by China to gain a foothold and displace the US and [its] allies and partners in the Indo-Pacific region.” A related view is that, with the BRI, China is setting a “debt trap” to seize control of strategic assets in participating countries, particularly emerging economies with limited options. The most often cited example of this is Sri Lanka’s 99-year lease of Hambantota port to a Chinese firm in a swap when Colombo could not meet its debt repayments.
The “China integrates the global economy” narrative casts the BRI as a comprehensive “ecosystem” for connecting the global economy through hard and soft infrastructure to support vital economic corridors. Beyond Asia, BRI projects in Italy in Europe, Djibouti on the Horn of Africa, and Venezuela in South America reflect the BRI’s global ambitions.
Then there is the rationale that “China is outsourcing its economic problems”. According to this analysis, the BRI is a massive construction program for addressing China’s significant surplus industrial capacity, particularly of China’s state-owned enterprises (SOEs) in key sectors including steel, cement and construction. The initiative would also promote the renminbi (RMB) as an international currency, primarily at the expense of the US dollar.
A closer look of the evidence suggests a different interpretation. The term “debt trap” may apply more to China than to recipient countries. This can have significant implications for China’s domestic development, and for its future financing of BRI projects.
The vast majority BRI financing takes the form of loans at market rates, estimated in mid-2018 to be around US$400 billion. A review of a sample of BRI projects found 40 cases of debt renegotiations, involving 24 countries, totaling more than US$50 billion. This usually took the form of China unilaterally cancelling debt or deferring repayment. Examples include writing off loans of US$90 million to Cambodia (2016) and US$2.2 billion to Mongolia (2017). The Sri Lanka debt-trap case is therefore an exception, not the rule.
Resource- and asset-backed loans seem to provide limited leverage. Between 2007 and 2014, China lent Venezuela US$63 billion, with repayment to be made in oil. At the time of the agreement, oil prices were about US$100 a barrel. When oil prices dropped to US$30 a barrel in January 2016, debt service costs skyrocketed, as did Venezuela’s repayment problems. Caracas still owes US$20 billion on the loans, according to China’s commerce ministry. China’s loans to the Ukraine, secured by wheat deliveries, are experiencing similar difficulties.
Many BRI ventures, as with most infrastructure, are generally not commercially viable. Furthermore, countries borrowing for these high-risk projects often have poor sovereign credit ratings. China therefore may itself be accumulating debt in financing unproductive projects. While the BRI may be China’s signature strategic initiative, economics matter. If China’s own economic growth and wellbeing come under threat, so would social and even political stability.
The term “debt trap” may apply more to China than to recipient countries. This can have implications for China’s domestic development and future financing of BRI projects.
China’s recent growth has been driven to a large extent by expansion in debt. The International Monetary Fund notes that more and more credit is needed for the same amount of output. This points to increasingly inefficient investments. For example, in 2007-08, about RMB6.5 trillion of new credit was needed to increase nominal gross domestic product (GDP) by about RMB5 trillion per year. In 2015-16, it took more than RMB20 trillion in new credit for the same nominal GDP growth.
The core challenge to China’s growth and long-term stability is this rapid expansion of debt-driven inefficient investment. Any BRI project loan that is not repaid, would add to the build-up of unproductive debt. China’s state banks including the China Development Bank and the Export-Import Bank of China are financing over 70 percent of BRI projects, depleting China’s foreign exchange reserves. SOEs such as COSCO Shipping Ports are taking the lead in implementation, doing 95 percent of the work. Private-sector participation has been minimal and declining, accounting for only 4% of BRI loans in 2018.
China’s banks, in taking on debt to finance underperforming BRI investments by SOEs, add to the growing non-performing domestic loans already on their balance sheets. In implementing BRI projects, the SOEs behave as they do domestically, maximizing investment and output, not return-on-investment or profit. This distorts pricing of investment risks, pushing up the borrowing costs of generally more efficient private firms. In 2018, rising SOE debt levels reached RMB100 trillion, or 120 percent of GDP. SOE return-on-assets (ROA) averaged 3.9 percent, compared with 9.9 percent for private companies.
Financing unproductive BRI projects contributes to overall distortion of resource allocation. This is important given China’s significant capacity needs. For example, investment in human capital, especially in rural areas, has been lagging. Local governments have invested in infrastructure, whether productive or not, as a sure-fire way to pump up the GDP figures. This is has been at the relative neglect of long-term investment in social services such as health and education.
The misallocation of resources is particularly important at a time when regional disparities in China are growing. Furthermore, given the key role of SOEs in BRI projects, this may delay reform of the state sector, including inefficient lending by policy banks and unproductive investments by the state firms. This can complicate Beijing’s ongoing efforts to shift from investment-driven growth since canceling unproductive projects and writing off the losses would contribute to China’s growing unemployment problem.
Host economies should certainly take advantage of the opportunities that BRI offers. However, if financially or economically questionable projects are done primarily because money is there, this may distort their development. Countries must look at investment projects from a strategic perspective to insure that they are in the public interest. But in considering BRI projects, the China country risk should not be overlooked. At some point, China will have to address the problem of mounting non-performing loans, including for BRI projects, to ensure continued economic growth and social stability. Recent debt forgiveness and deferments of repayments, and Beijing’s falling foreign exchange reserves, will raise uncertainty about China’s capacity to finance future BRI projects.
It is in the interest of both China and recipient countries to ensure that BRI projects are commercially and economically viable. In this context, it is important to develop mechanisms for increasing private-sector participation. It is also essential to ensure that BRI projects address development priorities. These were issues that the Chinese leadership and partner nations addressed at the Second Belt and Road Forum held in April in Beijing. While the challenges may be well understood, they now have to be addressed effectively.