Tuesday, May 26, 2015

China's cunning plan to revive growth

By now, we all know the story of China's troubles. China achieved its stunning growth through a combination of the adroit utilization of cheap surplus labor and financial repression, which financed much of the infrastructure required for its initial growth phase. In the wake of the Great Recession, Beijing unleashed a shock-and-awe monetary and fiscal stimulus campaign of credit fueled infrastructure spending. And boy, did the economy respond.

Seven years later, it's time to pay the piper. The country is littered with see-through property developments and white elephant infrastructure projects like airports, port facilities, railways and so on. At the same time, China seems to be hitting its Lewis turning point, when running out of cheap labor is hampering its export competitiveness.

The Party's response was outlined in the Third Plenum, where it aimed to re-balance growth from credit fueled export and infrastructure growth to consumer driven growth. At the same time, it would gradually open up its capital account and do away with financial repression, which financed the growth surge of the last twenty years on the back of the household sector. But re-balancing growth means slower growth - and slower growth will increase social pressures. If uncontrolled, social pressures have the potential to undermine the Party's legitimacy. Taken to its logical conclusion, it would mean the end of Communist Party rule in China.

Almost every week, we see news of faltering growth in China. Moreover, slowing growth undermines the stability of the financial system, because much of the infrastructure growth was built by debt. Measures such as interest rate cuts and RRR cuts are only band aid solutions, designed to prevent the roof from caving in.

Even the stock market bubble is only a temporary device to alleviate financial pressure. It has been suggested that elevated stock prices allow SOEs to do a debt for equity swap at sky high valuations, which would alleviated some of the debt pressures facing those companies. In addition, the PBoC has unveiled a LTRO-like program where banks could exchange limited amounts of local government debt for central government debt (see the problems with that plan as outlined by FT Alphaville). In effect, it would transfer local government debt to Beiing`s balance sheet. All these initiatives are stop-gap measures, but do not constitute a legitimate growth adjustment strategy.

What to do?

A cunning plan
If this was television, one of the underlings would whisper in the leader`s ear, "Sir, I have a cunning plan!"

Enter "One Belt, One Road", or OBOR. Here is how CNBC explained it:
Years in the making, the 'One Belt, One Road' (OBOR) initiative is composed of two primary projects: the "Silk Road Economic Belt" and "21st Century Maritime Silk Road," a network of road, rail and port routes that will connect China to Central Asia, South Asia, the Middle East, and Europe. President Xi Jinping hopes the plan will spur more regionally balanced growth as annual gross domestic product hovers at a 24-year low.
The Chinese knows all about building infrastructure projects. Now that infrastructure driven growth isn't working for China anymore, BoAML suggested in a report that Beijing plans on exporting infrastructure building to its regional neighbors:
"OBOR tries to export China's savings and import foreign demand, so it represents a continuation of China's old growth model (which had brought China to its current predicament in the first place)," it said.

"We suspect that many local governments may leverage off OBOR for a new round of infrastructure spending…This, while helpful in holding up short-term investment, will delay the long overdue rebalancing toward consumption in China," it added.
There are a number of problems, such as the ability of the recipient country to pay back the loans and the ability of Chinese contractors to execute:
The Center for Strategic and International Studies (CSIS) agrees. In a note this week, it stated that borrowers' failure to pay back loans, or businesses' inability to recoup their investments could place additional stress on the Chinese economy.

Beijing's past difficulties investing in infrastructure abroad, especially through bilateral arrangements, suggest that the proposed projects could end up "little more than a series of expensive boondoggles," CSIS remarked.

"Given Chinese construction companies' poor track record operating in foreign countries (including frequent mistreatment of local workers), a major increase in the scale of their external activities increases the risk of damaging political blowback that could harm Beijing's image or lead to instability in host countries."

Pakistan as the next OBOR victim aid recipient
Recently, Pakistan got very excited about the prospect of USD 46 billion in Chinese investment (via WSJ)
Chinese President Xi Jinping is set to unveil a $46 billion infrastructure spending plan in Pakistan that is a centerpiece of Beijing’s ambitions to open new trade and transport routes across Asia and challenge the U.S. as the dominant regional power.

The plan, known as the China Pakistan Economic Corridor, draws on a newly expansive Chinese foreign policy and pressing economic and security concerns at home for Mr. Xi, who is expected to arrive in Pakistan on Monday. Many details had yet to be announced publicly.

“This is going to be a game-changer for Pakistan,” said Ahsan Iqbal, Pakistan’s planning minister, who said his country could link China with markets in Central Asia and South Asia.

“If we become the bridge between these three engines of growth, we will be able to carve out a large economic bloc of about 3 billion living in this part of the world…nearly half the planet.”
The ambitious plan would involve building roads, railroads and power plants through Pakistan from the Chinese border to the Indian Ocean:
If realized, the plan would be China’s biggest splurge on economic development in another country to date. It aims over 15 years to create a 2,000-mile economic corridor between Gwadar and northwest China, with roads, rail links and pipelines crossing Pakistan.

The network ultimately will link to other countries as well, potentially creating a regional trading boom, Pakistani and Chinese officials say.

The Pakistan program has been described by Chinese officials as the “flagship project” of a broader policy, “One Belt, One Road,” which seeks to physically connect China to its markets in Asia, Europe and beyond.

A dubious record
An editorial in Dawn, Pakistan`s leading newspaper, however, warned that there is no free lunch. The record of Chinese companies to execute large projects like these have been mixed at best:
Obviously, an impoverished country like ours can’t afford to look a gift horse in the mouth, especially if the horse in question is Chinese, and happens to be the only ride in town. ‘Game-changer’ is the expression most commonly being bandied about to describe the windfall. If we were to believe the TV anchors and their chat show guests, it’s as though we had hit the jackpot, and could all retire to Dubai.

For a dose of reality, just look what has happened in (and to) Sri Lanka with its spate of Chinese deals. The new government of Presi­dent Sirisena is struggling to cope with the Chinese-financed and built projects it has inherited from the Rajapaksa administration.

The most contentious of these is the Colombo Port City with an investment of $1.35bn coming from the China Communi­cations Construction Company, a huge government-controlled entity. This ambitious project — halted since the new government came to power earlier this year — is spread over 575 acres, part of which is to be reclaimed from the sea off Colombo’s shore.
 When the project got into trouble, the locals were left holding the bag:
Aimed at developing residential, entertainment and business spaces and facilities, the venture was designed to make Colombo a popular destination for tourists as well as a vehicle for investment in real estate. The problem is that the sponsors took many short cuts, ignoring important environmental requirements. Now if Sri Lanka cancels the deal, it stands to lose millions of dollars in penalties.

Several other public-sector projects funded and built by the Chinese are now lying virtually abandoned. Hambontota Port in the south is a case study in how to invest in useless infrastructure projects. When the new port was declared open about four years ago, a huge boulder was discovered in the channel that made navigation impossible. This obstruction was dynamited over months, but even now, it took a government directive to force car-carrying ships to dock there. Cars then have to be transported 250km to Colombo by road.
Some of the infrastructure projects wound up as (surprise!) white elephants:
Other Chinese-financed projects in the area include an international airport and a cricket stadium. Both are unused. A huge conference centre, financed by South Korea, is virtually derelict. The major users of the motorway around Hambantota are water buffaloes. One reason for all this ill-considered construction activity is that it happens to be in the ex-president’s constituency.
A major road went way over budget:
But to his credit, Rajapaksa focused on road-building, and there is now an excellent network in place. However, the huge difference in construction cost has raised many questions about transparency, especially about roads built with Chinese funding and by Chinese contractors.

For instance, the Southern Expressway connecting Colombo to Galle, financed by the Asian Development Bank and Japan, cost $7 million per kilometre. By contrast, the Outer Circular Highway connecting the airport to the Galle Expressway, financed by a Chinese loan and awarded without competition to a Chinese firm, is going to cost $72m per kilometre.
For some context into the USD72 million per kilometre price for the highway, studies by the World Bank and Oxford University showed that typical developing country road development cost between USD 0.9 to 7.8 million per kilometer. A cost of USD 72 million is roughly equivalent to Japanese highway construction, which reflects the astronomical costs of land acquisition.

No doubt many well-connected Chinese construction companies will get very rich off the OBOR initiative.

Mitigating credit risk
What about financing? The CNBC report questioned the financial risk to Chinese institutions financing such projects:
Some of the countries participating in the OBOR scheme have large current account deficits and unfavorable economic fundamentals, making them high-risk borrowers, BoAML pointed out. This means Beijing is taking on greater default risk by providing them with capital and financing projects in those nations.

"For example, China swaps renminbi for country Z's currency at the current exchange rate. If country Z uses the funds to buy Chinese rail equipment and China doesn't immediately spend currency Z to purchase goods from country Z, China would be exposed to the risk of partial default if currency Z depreciates," the bank said.
That's where China's latest Asian Infrastructure Investment Bank (AIIB) initiative comes in. Countries have been falling all over themselves to become charter members of AIIB, which is a development bank designed to finance development projects in Asia (like OBOR). The latest count shows 57 countries as founding members, with the US, Canada, Mexico and Japan as the major holdouts, with Japan possibly relenting and joining soon. Caixin reports some of the problems that China encountered with a bilateral approach to development and how a structure like AIIB could help:
In the years leading up to the AIIB, China built bilateral partnerships for infrastructure projects in emerging-market countries, such as the nine-year-old China-Africa Development Fund. More than half of the 89.3 billion yuan in overseas development funds spent by the government between 2010 and 2012 was in the form of policy bank loans.

This bilateral approach, however, triggered disputes between many recipient countries and China. The friction was tied to problems with project operations, environmental protection and social issues, for example.

These problems point to "one reason that China is attracted to a multilateral approach, namely by starting the new Asian Infrastructure Investment Bank," said David Dollar, a researcher at the John L. Thornton China Center at the Brookings Institution think tank in Washington. "On the other hand, (China's bilateral approach) track record makes some countries, like the U.S., nervous about how the new bank will operate."
In addition,AIIB could then to finance OBOR projects. Chinese banks wouldn`t have to bear all the credit risk and overload their balance sheets. Instead, Bejing could sucker the foreign devils persuade their major trading partners to financing these projects instead.

In addition to Pakistan, I see that China has announced a bilateral infrastructure development deal with Brazil (via the BBC):
China is planning to invest up to $50bn (£32bn) in Brazil for new infrastructure projects.

The deal is due to be signed by banks from both countries during a visit by Chinese Prime Minister Li Keqiang to Brazil next week.

The money will go towards building a railway link from Brazil's Atlantic coast to the Pacific coast of Peru to reduce the cost of exports to China.

It says the fund will also finance a joint venture to produce steel.
BBC has also reported that China is considering funding a Brazil-Peru railway link, which could bring Peru into the Chinese orbit:
A Chinese scheme to build an east-west railway across South America, cutting across parts of the Amazon rain forest, has moved a step closer after Peru agreed to study the proposal.

The scheme would link Peru's Pacific coast with Brazil's Atlantic shores.

The decision came after talks between the Chinese Prime Minister Li Keqiang, and Peruvian President Ollanta Humala.

If completed, the railway would stretch 5,300km (3,300 miles) but campaigners fear the impact on indigenous people.

Brazil, China and Peru will now begin feasibility studies into the railway.

Beijing plays the long game
These initiatives are examples of how Beijing plays the long game in formulating a growth strategy. Export and infrastructure strategy wobbly? No problem. We'll take steps to rebalance the economy towards household consumption. To avoid the catastrophic effects of a hard landing, use monetary, fiscal and what`s left of the command economy to cushion the worst effects of the slowdown as the economy rebalances. At the same time, export the capabilities and expertise of infrastructure building to other parts of the world.

In the meantime, these benefits from foreign infrastructure growth would serve to offset the falloff in Chinese domestic infrastructure growth as the economy slowly re-balances towards household consumption. At the same time, Beijing would enhance its political influence throughout Asia.

What I have written is highly speculative, but if it were true, it would indeed be a cunning plan. (In case you were wondering, that`s a tinfoil hat.)


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Enis Taner said...

Cam, this is a stellar example of why I love reading your posts. While you often deal in speculation and possibility rather than certainty, your ability to tie together various, disparate threads into coherent themes is truly a unique skill.

Well done, and thank you very much for sharing your thoughts.

Enis Taner

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