China s Belt and Road Initiative: Assessing the Opportunities

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1 Ryan Lam, CFA Senior Economist China s Belt and Road Initiative: Assessing the Opportunities Good infrastructure connectivity is just a starting point for creating a Eurasian economic corridor. The Chinese leadership will likely use the Belt and Road initiative to push forward with its Go Global strategy. We have identified several areas in which Hong Kong has the potential to capitalise on the opportunities presented by the initiative. Infrastructure revenue bonds are a natural choice for financing. As the leading offshore renminbi bond market in the world, Hong Kong has a lot to offer in terms of supporting renminbidenominated bond sales. In addition to its role as a trading platform, Hong Kong can also play a proactive role as a provider of capital. The newly established Future Fund could benefit from the stable returns and inflation protection that infrastructure assets can provide. Regardless of the nature of the build-operatetransfer or build-own-operate agreements put in place, conflicts of interest often build up between investors and governments over issues such as ownership, control and profit sharing. There is a great deal of room for negotiation in contractual arrangements. Backed by world-class legal professional services, Hong Kong could serve as a convenient location for liaison in terms of holding conferences and undertaking contract negotiations. With area for improvement in logistics and limited supply of proper construction materials in host countries, Chinese developers may choose to hire external parties to develop project-specific logistics facilities that will help streamline delivery of major equipment and building materials from the Mainland. Hong Kong's logistics and maritime advantages put the city in a strong position to seize such opportunities.

2 Forging a new path In 2005, then US Fed Chairman Ben Bernanke gave a landmark speech in which he drew attention to the issue of rising global imbalances. A growing number of economists have since come out in support of Bernanke s argument that a global savings glut, emanating in large part from emerging economies, had fuelled the credit boom and greater risk-taking in advanced economies. Based on this view, a rebalancing of the global economy requires high-saving countries to spend more so that advanced economies can rebuild their savings and reduce their trade deficits. Parking large amounts of savings into US Treasury securities is no longer an optimal policy in economic terms. This reality is a major driving force behind the Chinese Government s recently announced plans to reallocate its savings away from financial instruments and towards the development of much-needed transport and energy infrastructure throughout Eurasia. The Belt and Road (BAR) initiative, which aims to bolster trade with Europe and build infrastructure across Asia, is comprised of two key elements a land-based belt and a maritime road. The Silk Road Economic Belt encompasses three routes that will connect mainland China with Central Asia, Russia and Europe; the Persian Gulf and the Mediterranean Sea through Central and West Asia; and Southeast Asia, South Asia and Indian Ocean. The 21st Century Maritime Silk Road will include two routes that will link the Mainland to Europe through the South China Sea and the Indian Ocean, and to the South Pacific through the South China Sea. There are three distinctive features of the BAR initiative: China s Ministry of Commerce estimates that the countries along these routes encompass a population of 4.4 billion people and have a collective GDP of USD21 trillion, an amount equivalent to 29% of the global economy. While there is currently little information regarding how bilateral negotiations will proceed, there is a strong commitment on the part of Chinese Government. The BAR initiative s main tool for releasing untapped growth potential in the region is the development of an array of transport and logistics corridors to xxxx 2

3 draw Central and South Asia into a unified transport network. The focus on removing transportation bottlenecks is not accidental. Delivering goods on time and at a low cost has been a crucial part of Emerging Asia s 1 integration into the global production chain. Good infrastructure connectivity is just a starting point for creating a Eurasian economic cooperation zone. The Chinese leadership likely views this as a gateway step to facilitate moving forward with its Go Global strategy. We expect more detailed plans focusing on the creation of a Eurasian economic corridor to be laid out at the provincial level. A strategy with incentive compatibility Despite the growing optimism that is being reflected in recent asset prices, there is no shortage of examples to demonstrate that policies with good intentions often lead to unexpected or less-than-desirable results. The keys to successful policy formulation are recognising the constraints of participants and designing an incentive-compatible strategy. Under the post-world War II Marshall Plan, for example, the US provided funding for recovery initiatives, but required the Europeans themselves to be the driving force and assume responsibility for drafting the reinvigoration plans. Considering the long lock-up periods and significant up-front capital requirements of infrastructure investment, the BAR initiative stands little chance of success if any of the participants suspect that other players will not fulfil their roles. The good news is that the BAR plan appears to be mostly incentive compatible and is therefore likely to remain as a keystone of development policy for the long term. The key points in this respect are as follows: The Mainland is currently facing challenges of overcapacity, particularly in the steel, cement and shipbuilding sectors. For Chinese firms, capacity cut in these sectors has proved harmful to short-term business performance. Exporting excess capacity would be a possible way to ease the pain of adjustment. The engineering expertise and risk management skills of Chinese companies 1 Emerging Asia as includes most economies in East Asia, Southeast Asia and South Asia, excluding Japan, Hong Kong, Singapore, South Korea and Taiwan 3

4 could prove valuable tools for host nations looking to play a bigger role as factories and granaries for the world. Equally important, Chinese operators are generally aggressive bidders - with prices often as little as half of those of their global rivals. One indication as to the success of this strategy is provided in the number of Chinese-led railway projects with multibillion-dollar price tags that are already underway in many nations (Exhibit 1). Exhibit 1: Chinese-led Overseas Railway Projects Country/Region Project Investment Estimated Completion Date US California High-Speed Rail USD68.0bn 2030 South America Peru Brazil Pacific Atlantic railway USD60.0bn 2024 India Delhi-Chennai High Speed Rail Over USD30bn - Southeast Asia Pan Asia railway USD30.4bn 2025 Russia Moscow Kazan High-Speed Rail USD25.0bn 2030 Nigeria Nigeria railway USD13.1bn 2025 Southeast Asia Kuala Lumpur Singapore High Speed Rail USD12.0bn 2022 Kenya Kenya railway USD3.8bn 2020 Eastern Europe Belgrade-Budapest High Speed Rail USD2.9bn - Source: Hang Seng Bank For the Mainland authorities, the BAR plan promises several significant benefits. First, enhancing regional transport infrastructure will reduce the country s exposure to commodity supply disruptions. Second, stronger ties between the Mainland s interior provinces and its western-frontier neighbours should help narrow regional income disparities. Third, project financing will enhance the renminbi s role as an international settlement currency. Increased overseas use of the yuan will, in turn, force domestic financial institutions to embrace market forces and facilitate further financial liberalisation. BAR riding high on official agenda The determination of the Chinese Government to push forward with the BAR initiative is reflected in the rapid pace at which it is rolling out its plans (Exhibit 2). The vision of a more closely integrated Eurasian continent was first put forth by President Xi Jinping in September The BAR initiative was again discussed in the March 2014 Government Working Report and, just a few months later in July 2014, the New Development Bank was established with a starting capital of 4

5 of USD100bn. Less than a month following the set up of The Asia Infrastructure Investment Bank (AIIB) in October 2014, President Xi green-lit a Silk Road Fund with an endowment of USD40bn. This rapid progress compared with the pace of strictly domestic reforms highlights how much is riding on the BAR plan in the eyes of the Mainland authorities. Exhibit 2: Major policy initiatives related to the BAR initiative Time September 2013 October 2013 March 2014 July 2014 September 2014 October 2014 Details President Xi proposes the construction of a Silk Road Economic Belt while delivering a speech in Kazakhstan President Xi calls for creation of a 21st Century Maritime Silk Road while delivering a speech in Indonesia Inclusion of BAR initiative in Government Working Report New Development Bank established with starting capital of USD100bn Establishment of first phase of Railway Development Fund Asia Infrastructure Investment Bank co-founded with 56 countries November 2014 Establishment of Silk Road Fund with USD40bn endowment March 2015 Vision and Actions on Jointly Building Silk Road Economic Belt and 21st Century Maritime Silk Road unveiled Source: Hang Seng Bank Hong Kong assessing first-mover advantage As the initiative is in still in its infancy, conventional wisdom would suggest that Hong Kong should act promptly and capture first-mover advantage. This assumed advantage, however, is far from guaranteed. Not every first-mover will end up setting the tone of the game and much depends on the circumstances in which any advantage is sought. With this in mind, we have accounted for a number of region-specific features and characteristics of infrastructure investment in our identification of several areas in which Hong Kong has the potential to capture some of the many opportunities presented by the BAR initiative. Securing funding There is much evidence to indicate that infrastructure investment is in high demand in Asia s emerging economies. In the 10 years between 2010 and 2020, the Asian Development Bank projects that infrastructure in Emerging Asia will require investment of over USD800bn a year 2 (Exhibit 3). The Mainland has 2 Infrastructure for a Seamless Asia, Asian xxxxxxxx Development Bank and Asian Development Bank Institute (2009) 5

6 Exhibit 3: Infrastructure Investment Needs ( , USD billion) already committed sizeable sums of capital to found or co-found various institutions aimed at supporting infrastructure financing, but our estimates suggest that the funding gap remains significant (Exhibit 4). Closing this gap will require a greater commitment from the private sector. Exhibit 4: Funds Available Asian Infrastructure Investment Bank New Development Bank Registered capital Loan to equity ratio Loan repayment period Annually available funding USD100bn years USD18.75bn USD100bn years USD18.75bn Silk Road Fund USD40bn years USD10bn Total USD240bn - - USD47.5bn Source: Asian Development Bank, Hang Seng Bank Source: Hang Seng Bank On its own, however, the presence of funding gap does not warrant private sector participation. Commercial viability is crucial if projects are to attract private partners. It is important to note that Emerging Asia as a whole has run a current account surplus since the late 1990s (Exhibit 5). What this essentially means is that national savings are more than enough to finance domestic investment needs 3. In other words, even in the face of an exceptionally low funding cost of the US dollar, domestic firms currently feel no need to borrow abroad. Exhibit 5: Current Account Balance of Emerging Asia (% of GDP) Source: IMF, Hang Seng Bank 3 Current account balance is equal to national savings minus domestic investment 6

7 Perhaps more than any other factor, Asian savers shy away from infrastructure projects because of the difficulties in risk assessment and diversification. In many countries in Emerging Asia the financial instruments needed for sound risk assessment are simply not in place. Because perceptions of risk, not just interest rates, determine the supply of credit 4, a shortage of credit persists amid lingering concerns over credit risks. The mispricing of risk is an important factor in the relative backwardness of infrastructure in Asia, in our view. Hong Kong could play a pivotal role in releasing credit constraints. The city s financial system could shape risk perception through pooling risk (aggregating savings so that each investor shares the risk of infrastructure projects), hedging risk (creating financial instruments to transfer part of the risk to other interested parties) and diversifying risk (grouping the infrastructure investment into large portfolios of assets). More specifically, financial history suggests that debt obligations are more likely to be honoured than equity obligations. The infrastructure revenue bonds (IRB) secured by cash flows of the infrastructure projects would likely receive stronger market interest. As the leading offshore renminbi bond market in the world, Hong Kong has a lot to offer in supporting renminbi-denominated IRB sales to fund the BAR plan. Of course opportunities do not usually come without challenges. Other AIIB founding members also aspire to capitalise on the rolling out of the BAR initiative. London in particular has emerged as a leading centre for project finance and infrastructure asset management. Over the years, the city has developed wellintegrated trading platforms for insurers and pension funds to assess the risk of construction delays and cost overruns of infrastructure projects. For the Hong Kong Government, measures to improve the regulatory and tax framework to attract alternative investment fund managers looking to relocate deserve specific attention in this regard. In addition to its role as a trading platform, it is also worth considering whether Hong Kong can take a step further and act as a capital provider. In 2014, over 50% of sovereign wealth funds (SWFs) with assets totalling between USD1bn 4 Financial Fragility and Economic Performance, The Quarterly Journal of Economics, 105(1), , Bernanke and Gertler (1990) 7

8 and USD9bn included an infrastructure allocation (Exhibit 6). Hong Kong s public finances are currently robust enough to support infrastructure spending in the region. We contend that the newly established Future Fund could benefit from the stable returns and inflation protection that infrastructure assets can provide. Exhibit 6: Proportion of SWFs Investing in Infrastructure (by Assets Under Management) Source: 2014 Preqin Sovereign Wealth Fund Review Seeking local partners Large-scale infrastructure projects have characteristics of natural monopolies and are particularly vulnerable to political risks. While public-private partnerships (PPP) are a popular financing vehicle for mitigating such risks, profit-sharing arrangements with governments could become a liability if there is regime change. Even in advanced economies such as Australia and the UK, such partnerships have been criticised for delivering high returns to foreign investors without a commensurate delivery of benefits to local users. An alternative form of financing is to sell debt or equities to local investors in host countries. Although Dubai and London are currently at the forefront of the Islamic finance market, Hong Kong s deep pool of financial professionals and its extensive experience in creating diversified financial products give the city an edge in helping Chinese firms to secure overseas funding but more needs to be done to strengthen its potential role as the gateway for Islamic finance in East Asia. One crucial first step is to give meaningful consideration to how Hong Kong might attract international experts in Islamic finance to help build the necessary financial infrastructure and advise on religious and regulatory matters. 8

9 Contract consultation Regardless of the nature of the build-operate-transfer (BOT) or build-ownoperate (BOO) agreements that are usually put in place, conflicts of interest often build up between investors and governments over issues of ownership, management control and profit sharing. In the ideal scenario, ownership, control and financial flows should be packaged in ways to satisfy investors need for control while at the same time addressing the political concerns of host countries. There is a great deal of room for negotiation in the contractual arrangements that govern infrastructure deals. Backed by world-class legal professional services, Hong Kong could act as a convenient location for liaison in terms of holding conferences and undertaking contract negotiations. Project logistics Another major opportunity lies in the logistics sector. Chinese infrastructure developers have traditionally used and managed their own supply chains. In recent years, however, it has been more common for infrastructure developers to seek third-party logistics support for their oversea projects. With area for improvement in logistics and limited supply of proper construction materials in host countries, Chinese developers may seek to hire external parties to build project-specific logistics facilities to help streamline the delivery of major equipment and building materials from the Mainland. Hong Kong s logistics and maritime advantages put the city in a strong position to grasp such opportunities. The Hong Kong authorities may therefore wish to revisit the city s port capacity and facilities to examine whether upgrades or expansion might prove a valuable investment over the longer term as activity under the BAR initiative picks up momentum. 9

10 Hong Kong Economic Monthly Statistics GDP Retail sales (value) Retail sales (volume) Exports Foreign Trade Trade balance Consumer prices HKD bn Real growth yoy (%) yoy (%) yoy (%) HKD bn yoy (%) HKD bn yoy (%) HKD bn % yoy (%) , , , , , , , , , , , , , , , , , , , , , , , , , , , F 2, , , F 2, , , Q Q , Q , Q , Q N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Jan 2014 N/A N/A Feb N/A N/A Mar N/A N/A Apr N/A N/A May N/A N/A Jun N/A N/A Jul N/A N/A Aug N/A N/A Sep N/A N/A Oct N/A N/A Nov N/A N/A Dec N/A N/A Jan 2015 N/A N/A Feb N/A N/A Mar N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A YTD N/A N/A Imports Unemployment rate (s.a.) Total Deposits RMB Deposits Total Loans Money supply (Total M3) Residential Property Price Index Office Rental Index Tourist Arrivals HKD bn yoy (%) RMB bn yoy (%) HKD bn yoy (%) yoy (%) ytd (%) ytd (%) '000 yoy (%) , , , , , , , , , , , , , , , , , , , , , , , , , , , , F 11, N/A N/A 8, , F 12, N/A N/A 9, , Q , , , Q2 9, , , Q3 9, , , Q4 10, , , , Q 2015 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Jan , , , Feb 9, , , Mar 9, , , Apr 9, , , May 9, , , Jun 9, , , Jul 9, , , Aug 9, , , Sep 9, , , Oct 10, , , Nov 10, , , Dec 10, , , , Jan , , , Feb 10, , N/A N/A 5, Mar N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A YTD 10, , , Note: (F) Forecast Source: Census and Statistics Department of HKSAR, Hong Kong Monetary Authority, Rating and Valuation Department, Hong Kong Tourism Board, CEIC, Hang Seng Bank 10

11 Hong Kong Retail Sales Volume Hong Kong Unemployment Rate Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank Hong Kong Exports Volume Hong Kong Total Loans and Deposits Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank Hong Kong CPI Inflation Hong Kong Property Prices (overall index, 1999 = 100) Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank 11

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