On the Fifth Year of the Belt and Road Initiative
Photo Credit: Reuters
By Henry Hing Lee Chan

On the Fifth Year of the Belt and Road Initiative

Aug. 21, 2018  |     |  0 comments

The reported news that the incoming Imran Khan government of Pakistan will ask the IMF for a USD 12 billion bailout package highlights the new economic reality facing some Belt and Road Initiative (BRI) participating countries and the need to formulate new rules governing the program.


Pakistan is the most active participant under the BRI. The country’s BRI projects under the banner of the China-Pakistan Economic Corridor are estimated to cost around USD 62 billion and will run into the 2030s. Press reports note that the Chinese have so far spent more than USD 10 billion in the initial phase of the multi-year program.


The Pakistani economy moved into a Balance of Payments (BOP) crisis in 2018. The State Bank of Pakistan reported that its liquid foreign exchange reserves dropped from USD 14 billion at the start of 2018 to less than USD 10 billion by the end of June. The reserve figure is barely enough to pay for two months of goods imports. This is short of the generally accepted minimum forex reserves which is that the reserves should be sufficient to cover at least three months of imports.


The Chinese commercial banks had provided bridge financing of several billion dollars to shore up the foreign exchange position of Pakistan in the past 12 months, and the Islamic Development Bank also promised a USD 4.5 billion three-year oil financing facility recently to the country in addition to multi-billion dollars in finacing from Saudi Arabia recently. However, Pakistan’s external position remains precarious, and the market expects a new IMF program to stabilize the BOP position. The press had reported that the US is asking Pakistan to disclose the terms on its BRI projects and to include them in any restructuring conditionalities imposed by the IMF. The American move is an attempt to cast shadows on the viability of the BRI.


Pakistan’s dilemma has revealed several new economic realities that call for reviewing some economic assumptions behind the BRI in its fifth year since its launch.


Firstly, infrastructure development helps a developing country to address bottleneck issues hindering their economic growth, but the question of earning sufficient foreign exchange to service the associated infrastructure loans are not straightforward. The case of Pakistan highlights this problem. The country’s economic growth had improved from 4 percent in fiscal 2014 to more than 5.6 percent in fiscal 2018 since it joined the BRI, yet it slid into a BOP crisis. Domestic growth often means increasing imports but translating domestic growth to export competitiveness is often not easy. The looming slowdown of global trade arising from the trade war threat means the ability of many developing countries to generate export earnings is getting murkier, even though their domestic economic performance may have improved.


Secondly, China had a current account deficit of USD 28.3 billion in the first half of 2018; it is the first current account deficit in twenty years when the country started reporting its GDP on a quarterly basis. Most economists are looking for the country’s current account position to deteriorate with the surplus to drop below 1 percent of GDP this year and then turn into negative territory by 2020-2021. The ability of the country to provide long-term infrastructure loans through the China Development Bank (CDB) or the Export-Import Bank (Eximbank) will be severely affected in the face of the turnaround of the current account. The trade tensions will likely put persistent pressure on China’s current account in the next few years. China did not expect the worsening current account position when it set up the BRI in 2013.

China must develop its expertise on working with multilateral agencies, especially on the potential BOP problems of BRI countries and be ready to do it alone if it cannot come to terms with these agencies.

Thirdly, the ongoing restructuring of the Chinese financial sector will affect the funding mechanism of CDB and Eximbank, the twin primary funding vehicles under the BRI. For their funding of domestic infrastructure, these two institutions raised funds by selling ten-year bonds to local banks and added a thin spread for performing the role of credit gatekeeper. Their bonds enjoy high credit ratings and the credit spread from the China government bond is usually very small. The spread has been widening lately, and the cost of funding is now hovering around 4 percent. CDB and Eximbank then lend the money out at 4.5 percent to 5.5 percent. The two banks do not disclose their funding mechanism for BRI projects, but the market believes that it is similar to local loans with the central bank providing additional currency swap facilities to shield CDB and Eximbank from foreign currency risk. CDB’s domestic infrastructure loan runs typically for less than ten years while that for the BRI often runs for twenty years.


The world is entering a new rate increase cycle following the unwinding of Quantitative Easing (QE). The mismatch in borrowing ten-year bonds and using the proceeds to lend against longer-than-ten-year infrastructure loans creates duration mismatch risk. Also, depending on the structure of the loans, raising funds tied to commercial rates and use the funds to lend against long-term infrastructure loans creates interest rate risk to either borrower or lender.


These new economic realities of BRI projects’ host country BOP problems and funding duration/cost mismatch merit a review of rules governing the BRI and call for improving the national capacity to deal with the new situation.


There are two critical skill sets required in handling the BOP challenge. First is the skill to develop a sound debt sustainability analysis and monitoring procedures to ensure that the BRI recipient countries’ internal and external financial conditions stay sound in the face of the multi-year nature of BRI loans. Second is the skill to work out a restructuring plan with the host countries in the adverse event of an unexpected BOP crisis, putting up spending discipline with minimal conditionality and disruption to the people and the economy.

In April 2018, the Chinese government set up the new China-IMF Capacity Development Centre (CICDC) with the expressed aim of developing the capacity to address implementation challenges on issues arising from the BRI.


The IMF is the acknowledged leader on dealing with BOP crises. It has developed a framework for monitoring its member countries’ debt sustainability and leading the debt restructuring of its distressed members. The new economic realities mean that China must accelerate the learning process to acquire the skills described above.


However, one should note that the IMF’s objectives might not align with the intentions of the lenders as the Greek bailout in the 2010s has shown. In the Greek bailout, the triumvirate of the European Commission, the European Central Bank, and the IMF formed the rescue team with the two European institutions providing most of the rescue funds while the IMF provided the technical expertise. The European partners often overruled the IMF recommendations as they had the broader objectives of preserving the eurozone and European unity, while the IMF was more focused on restoring Greece’s external payment position and tend to impose more onerous conditionalities.


China is going to face similar problems if it wants to work with the IMF on country restructuring. The IMF mandate means that it is more focused on the financial aspects of BOP crises, while China will have broader considerations about its long-term bilateral relationships. In addition to learning the essential skills on handling BOP problems, China must develop its expertise on working with multilateral agencies, especially on the potential BOP problems of BRI countries and be ready to do it alone if it cannot come to terms with these agencies.


On the issue of the funding model for BRI projects under a rising rate environment, China should look at the funding model of CDB and Eximbank to ensure the long-term viability of the model in funding BRI projects. Based on the publicly available record, the assets of CDB at the end of 2017 was 15.96 trillion yuan and it had outstanding foreign currency loan of approximately USD 300 billion, while that of Eximbank was 3.33 trillion yuan at the end of 2016 with foreign currency loans which accounted for 30 percent of its lending book. The two banks are the largest financial institutions of their kind in the world. The ongoing financial sector reform is an opportune time to look into their positions in the financial system and address any potential weaknesses.

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