The Belt and Road (B&R, or One Belt, One Road) is an ambitious vision for global trade, infrastructure development, and diplomacy. First articulated by Chinese President Xi Jinping in 2013, the initiative frames China as the geographic and financial center, with ties radiating toward Europe, Asia, and Africa.

Source: © The Economist Group Limited, London (2 July 2016).⁴

As shown in Figure 1, the Belt and Road draws inspiration from the ancient Silk Road, and similarly features a series of physical routes that carry broader political and economic implications. Unlike the original Silk Road which arguably sprang up around the single motive of trade, today’s Belt and Road addresses a dizzying array of objectives, as illustrated in Figure 2.

Through the execution of B&R, China can project a positive example of leadership and progressiveness by making much-needed infrastructure investments in the region. With the formation of the Silk Road Fund and Asian Infrastructure Investment Bank (AIIB), China presents nimbler, Asia-focused alternatives to the established multilateral institutions.

The timing and recent comments by the Communist Party leadership suggest that B&R is part of a larger national pivot as China seeks to exercise influence commensurate with its economic might. A more concerning view is that B&R provides channels for China to broaden and extend its military reach as it coordinates and protects its investments. China’s plan to secure sea-lanes for its navy through a series of ports (the “String of Pearls”) has been met by vociferous and sometimes violent opposition in India, Sri Lanka, the Philippines, and Thailand.

This paper will side-step geopolitical speculation and other interesting facets to focus on the more mundane: financial incentives and risks. Specifically, what are the financial origins of B&R? Where is the money coming from? What types of projects are getting funded? And how are investment rewards and risks being shared?

Economic Origins of Belt and Road

As China continues a multi-year transition toward a private investment-driven economy, it must simultaneously navigate a backdrop of stagnating global trade and alleviate excess capacity at its state-owned enterprises (SOEs). Compounding this struggle is the law of large numbers. World Bank statistics show that between 2005 and 2016, the ratio of credit growth to gross domestic product (GDP) growth had increased from 1x to approximately 5x (Figure 3). This implies a challenge with sustaining economic expansion: as China’s economy has grown, the associated leverage has grown even faster. Put another way, the “debt intensity” of China’s economic activity has increased meaningfully since 2007 and continues to trend upward.

Source: World Bank. Data as of 25 September 2017.

In an ideal world, the solution would involve sending excess labor and materials to less-developed neighbor countries that need more investment, while China’s SOEs profit from lucrative new contracts. To that end, China has pledged to lead the $4 trillion of global investment that it envisions across a region spanning some 65 countries. As for the funding, the last three years have seen a flurry of capital injections, investment announcements, and several dedicated B&R-themed funds.

Project payments have substantial implications for China’s position in the financial markets as well. While the renminbi (RMB) is progressing toward internationalization and has become a world reserve currency as of 2016, the currency is still a long way from global acceptance, and comprised less than 2% of global payment value as of June 2017.⁷ International payments made to China are still primarily denominated in U.S. dollars, but RMB usage is growing rapidly in some Belt and Road countries.⁷ As new projects emerge, they could entail billions of dollars in RMB-denominated transactions for contracting work as well as loan repayments. As more countries become comfortable transacting in and holding the RMB, the currency’s status on the global stage should be meaningfully enhanced. To that end, China’s central bankers are actively exploring ways to increase RMB usage in global commodities pricing.⁸

At least $900 billion in projects have been committed to date.³ To put this number in context, President Truman’s Marshall Plan was worth about $140 billion in current dollar terms, or just one-sixth the size.⁹ China ultimately expects B&R spending to surpass $4 trillion. This is extremely ambitious, although the true project size will be extremely difficult to quantify. However, this also means that even if the initiative reaches a fraction of Xi’s vision, it would still be sufficient to transform the face of development and politics in the region.

The main entities to watch are the policy banks, commercial banks, and development funds that supply the money, as well as the SOEs that provide materials and labor.

Banks and Funding Institutions: “The Money”

Commercial banks and development funds have been adamant that their B&R investments are driven by commercial and development imperatives, but as we have seen, there are many overlapping motivations. Funding entities with differing commercial motives and varying levels of autonomy have invested in one another and invest alongside one another in the same projects.

In the medium term, B&R’s viability rests in the Chinese government’s ability to manage credit risk, as well as enterprises’ belief in this risk management. The implicit understanding is that China will not allow B&R loans and the issuing banks to fail. Whether or not this is realistic remains an open question. However, the Communist Party has many tools at its disposal, including the ability to limit capital outflows and direct inter-bank lending. Thinking for the long-term, China has also created various avenues for foreign investors to participate, and may even introduce opportunities to involve its private citizens.

Policy Banks

Policy banks have been behind some of the largest and riskiest B&R deals. Two policy banks that are closely associated with B&R, China Development Bank (CDB) and Export-Import Bank of China (Exim), have written low-interest infrastructure loans that are contingent on the recipient’s purchase of Chinese equipment or construction services. These “concessionary loans” charge as little as 1-2% after a 10+ year grace period, and are often protected under policies written by the state-owned China Export & Credit Insurance Company.¹²

For policy banks, at least some of the seed capital comes from China’s trove of over $3 trillion in foreign reserves - primarily U.S. dollar (USD)-denominated instruments that would otherwise be earning close to zero.¹⁴ In 2015, China’s policy banks received over $100 billion from reserve fund injections and the Ministry of Finance.¹¹

As government-owned entities, policy banks are required to provide very little reporting detail, but receive favorable credit ratings due to their strong backing by the central government.

Commercial Banks

Commercial banks form the next line of funding. At the forefront of activity are a handful of large state-owned banks, including Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB) and CITIC Bank.

State-owned ommercial banks need to balance their SOE status with the market’s expectations of these publicly traded companies to pursue profitability. One retired senior executive responded impatiently to SOE complaints about the pressure to do B&R-deals: “A lot of SOEs are stuck on this idea that ‘the country is making me do it, and I don’t want to do it’. Well, do you want to be an SOE or don’t you? Have you ever counted all the benefits you get from being an SOE?”¹⁷

Compared to policy banks, commercial banks extend shorter-term loans with higher financing costs.¹² Their support from the Communist Party is less explicit, and so they seek other forms of protection - for example, participating in syndicated lending blocks, investing alongside policy banks, and obtaining credit insurance from state-owned insurance companies. Commercial banks have also expanded into complementary financial services at the central government’s encouragement, and provide renminbi settlement, cash management, and trade financing. Since 2013, at least nine Chinese banks have set up 62 branches in countries along the B&R route.¹⁹

Multilateral Funding

Multilateral development banks (MDBs) such as the World Bank and Asian Development Bank have been funding infrastructure projects for decades. However, their dispersed mandates and decision-making have often meant slower action. In part to address this issue, China initiated the Silk Road Fund (SRF) and Asian Infrastructure Investment Bank (AIIB) between 2014 and 2015. AIIB’s leadership has taken care to emphasize the role of its infrastructure investments in driving social benefit, but China’s political image also plays a part. As AIIB’s president Jin Liqun explains: “China needs to do something which can help it be recognized as a responsible member of the international economic community and maybe in the future be recognized as a responsible leader.”²¹

Compared to policy banks and commercial banks, these two entities are smaller in their relative investment scale. The AIIB is a multilateral bank that is authorized to lend up to $250 billion.²¹ With a member base that includes 16 of the 20 largest economies in the world, the bank has many financing tools at its disposal: it can tap interbank credit, issue sovereign bonds, or absorb private capital under a public-private partnership program.²⁰

Even though China has nearly 30% of votes in the AIIB (the next highest block belongs to India at 8%), it insists that it will willingly shed its veto power as more countries join, and is already working with the more than 60 other member countries.²⁰ Unlike existing MDBs that have a general aim of alleviating poverty, the AIIB only focuses on Asian infrastructure investment.²¹

China established the Silk Road Fund as an investment fund with a tighter B&R focus. The fund primarily uses direct equity investments rather than loans, and insists that its investments meet high commercial return hurdles.²⁰ While SRF’s capital has primarily come from China’s foreign exchange reserves and policy bank injections, other countries can participate at the sub-fund level.²⁰

Other Sources

Private citizens could soon become yet another funding source. In April 2017, Hong Kong’s Securities and Futures Commission announced plans to selectively relax listing conditions for infrastructure companies connected with B&R.²² Separately, an executive at ICBC suggested an offshore stock exchange to allow B&R region companies to go public.²⁰ If this continues, Chinese banks may face a lighter financial burden, but leave retail investors directly bearing more of the risk.

State-owned Enterprises: “The Muscle”

With China’s president providing the political will and its banks supplying the money, SOEs with materials and engineering capabilities provide the final leg of the B&R stool.

SOEs have less complicated economic incentives. According to China’s State-owned Assets Supervision and Administration Commission, an estimated 1,700 B&R projects are lining the order books of at least 47 key SOEs.²³ SOE bids for multi-billion dollar rail and port projects are looked upon favorably because their services are tied to preferential funding terms from the policy banks. Stable funding and state-backed credit insurance also improve the chances that these SOE projects will be successful. As with their commercial bank counterparts, the presumption is that state-owned infrastructure firms will benefit from President Xi’s interest in seeing B&R succeed.

If there is any risk, it may lie in SOEs being too eager to meet the supply of funding and associate themselves with projects that are even tenuously linked to B&R. Charles Parton, a former European Union (EU) diplomat in China summarized, “If you want to get projects or programmes approved, you say it’s OBOR [One Belt, One Road], so everything becomes OBOR.”³

The value of Chinese mergers and acquisitions (M&A) in B&R countries continued its growth through 2017, which appears at odds with China’s efforts to rein in “excessive capital exports.”²⁴ In Africa, where China has made some of its earliest investments, observers have pointed to a “chaotic” environment in which 54 African countries were rapidly originating project ideas, while numerous Chinese banks and contracting companies competed intensely for the new business.²⁵

To that end, the Chinese government may already be preparing to re-assert itself. The last three years have seen $1 trillion of assets combined through government-directed SOE mergers, as part of an ongoing SOE reform.²⁶ An anecdotal but important trend involves many SOEs appointing Communist Party committee members to their boards, and combining the roles of company chairperson and party secretary. Taken together, these efforts can be read as a way for Xi’s party to take control and perhaps rein in the bottom-up “chaos.”

A Mixed Record of Project Implementation

China’s Early Successes in Africa

Because of the long project timelines and B&R’s relatively recent start in 2013, it may still be too early to point to definitive B&R success stories. While not technically a part of B&R (China’s investment in Africa began some fifteen years earlier), investments in Africa can serve as a proxy for political and economic ramifications. Beginning in the early 2000s, Chinese banks began financing billions of dollars in infrastructure projects - dams, roads, universities, railways, and airports - in a series of transactions that have dovetailed with blossoming trade and diplomatic relations. As illustrated in Figure 4, between 2000 and 2016, trade between China and Africa multiplied to over $100 billion, overtaking the U.S. by a substantial margin.

Source: International Monetary Fund. Data as of 25 September 2017.

Certainly, there have been complaints of poor labor and environmental protections, and not a little unease about China’s intentions. But at the same time, these highly visible transportation and energy projects - which make a difference in peoples’ daily lives, were financed successfully, and completed on schedule - have won a measure of local respect. In a 2016 Afrobarometer survey spanning 36 African countries, 63% of respondents found China’s influence to be “somewhat” or “very” positive, and 24% of respondents believed that China represented the best development model for Africa, compared to 30% for the US.²⁷

Starts and Stops

Something as grand and ambitious as B&R inevitably faces challenges. Overseas infrastructure investments are inherently complicated by disparate regulatory and tax regimes, negotiations over asset ownership and financing, military tensions (real or perceived), and terrorism threats. Within China, deals require coordination between numerous ministries as well as banks and SOEs.²⁸

Despite this, very few projects have been definitively canceled. More commonly, projects are announced with vague timelines, and proceed to slog through long negotiations and government clearance delays. One interesting example is the proposed building of canal across the narrow land mass of South Thailand. While plans for this were originally drawn up as early as 1677, the modern iteration - a 102 kilometer long, 400 meter wide waterway expected to cost $28 billion - has been part of China’s maritime strategy since at least 2005, and for good reason: the project could secure China’s energy imports by reducing its reliance on the heavily trafficked Malacca Strait.²⁹

Thailand’s position has been ambivalent at best. Supporters argue that the project could bring jobs and transform the area into a global economic and transportation hub, while opponents object to a project that would “cut the nation into two countries” and potentially embolden separatists in the south. There are also prickly questions about the project’s affordability and environmental risks.

In May of 2015, a hasty announcement that a memorandum of understanding had been signed by the China-Thailand Kara Infrastructure Investment and Development Company was swiftly followed by denials from the Thai government, and it seemed that the project was winding down.³⁰³¹ But as of early 2017, the proposal had again found domestic support with a group of political and former military leaders. Their hope - and China’s - is that Thailand’s new King will be more amenable to a deal.²⁹

Credit Risk in South and Central Asia

Another risk category involves stretched project loans that could lead to default and “debt traps” for the recipients. B&R skeptics warn that China is investing in poor countries for their access to natural resources and strategic ports, or their potential as future markets for Chinese exports. Outside of concessionary loans, debt available to poorer countries typically charge higher interest to reflect both the elevated risk and the countries’ lack of alternatives. But even if the loans fail, Chinese contracting firms may be able to negotiate ownership stakes and recoup some of their investment.

Some Chinese businessmen have joked about “One Road, One Trap,”²⁸ and Sri Lanka’s recent history reads like a dramatic warning. The country owes close to $8 billion in Chinese loans and unpaid interest related to construction of the Hambantota Deep Sea Port, Mattala Airport, and an ambitious Colombo Port City built on reclaimed land.³² Domestic concerns about Chinese involvement were high enough that a new government came to power in 2015, campaigning on the promise to cancel construction on Colombo Port City and wipe away loans. Eventually, this new government came to realize that the country was too reliant on Chinese investment and aid to cut off ties, and reinstated project construction.³³

In the process, China Merchants Port Holdings obtained a 99-year lease on the strategic Hambantota Port in a controversial debt-for-equity exchange.³⁴ Another Chinese SOE, China Harbour Engineering Company, obtained a 99-year lease over large parts of Colombo Port City land in return for its original investment.³⁵ As for the projects themselves, many do not seem to have justified Sri Lanka’s original gamble. Mattala Airport today is known as “the world’s emptiest international airport” where a busy day comprises two flights. And the newly developed Hambantota, which had previously been better known for its jungle wild life, has so far failed to attract the hoped-for business activity.³⁵

This case is concerning as B&R’s current roster includes projects in some of the poorest countries in Central and Southeast Asia, as illustrated in Figure 5. In Laos, for example, not only does the planned $6 billion in railway projects represent 38% of 2016 GDP, but the economy is also heavily dependent on potash, a fertilizer commodity with a volatile price.

To be fair, both sides share in credit risk. A Chinese bank that has been saddled with non-performing loans cannot recycle capital into fresh loans, and the illiquidity is a drain on the domestic economy. If the loans are kept afloat through government infusions and financed by Chinese taxpayers, investors may feel emboldened to make more bad investments. As China is counting on outside investors to share in B&R financing opportunities, maintaining confidence in the initiative’s viability seems critically important.

On the lender side, a country that cannot repay its loans will ultimately pay in other ways. Typically, defaulting countries suffer from currency devaluations and capital flight as panicked citizens rush to remove their savings from the banking system. And as shown from Sri Lanka’s case, a country with its back to the wall could end up ceding its land or other valuable resources.

China’s project partners are undoubtedly aware of these risks, but may feel they have no other option. For a country like Laos - landlocked, crippled by unreliable roads and power, and largely left behind by the rest of the world - China’s investments could appear to be the only way out.

Finally, to keep things in context, China’s outbound investments extend beyond the Belt and Road region to embrace a variety of projects, as shown in Figure ⁶.

The Long View

At this point, we can revisit some of the financial questions we first set out to address:

Sources of Cash

Much of the initial seed funding came from China’s foreign reserves, but project-level participation is spread across multiple layers of funding institutions that include policy banks, state-owned banks, multilateral development banks, and private commercial banks. In the future, private Chinese citizens may also participate if B&R projects go public.

International participation is critical for B&R. Policy banks often work directly with local governments to reduce credit risk. The Asian Infrastructure Investment Bank (AIIB) was set up in part to facilitate global investment, and foreign countries’ participation in its capital has grown to 70%.⁵⁴

Uses of Cash

Despite China’s centralized political system, B&R project generation and funding has been extremely de-centralized. Chinese firms and recipient countries have strong incentives to brand their infrastructure plans as B&R.

The majority of investments are structured as loans with modest yields, even for some projects with high credit risk. Many of these loans do not appear attractive from a strictly commercial standpoint, but banks are also motivated by policy mandates. Project participation for Chinese construction companies can entail more upside, with some projects leading to asset operating rights, land access, or partial asset ownership. And as seen with Africa, investments often precede accelerating trade activity between China and its partner countries.

Distribution of Risk and Upside

Borrower countries can stand to gain from new credit avenues. Assuming that project scope is contained and completed projects generate reasonable returns, B&R investment can be a substantial boon for the borrowers.

However, risk-sharing tends to be asymmetrical, and lenders are in a much stronger negotiating position if repayments fall through.

Considering the unprecedented scale and time frame of B&R’s implementation - with the ultimate goal of building up a Eurasian economic network around China - outsiders may wonder how one country can plan on such a scale. Chinese leaders have a history of long-term planning. Economic reforms initiated by former President Deng Xiaoping in 1977 continued for decades after his death in 1997 under the watch of his like-minded successors. During his life, Deng frequently proclaimed that China was prepared to wait 100 years to reunify with Taiwan.⁵⁵

This sort of patience is critical for B&R, as individual projects can take 10 years to complete, and economic relationships with neighboring countries may not pay off for decades, if ever. Finally, the year 2049 carries a symbolic milestone to China as the 100^th anniversary of the formation of People’s Republic of China. All of this suggests that President Xi’s party is willing to weather near-term losses, criticism, and uncertainty for the sake of China’s long-term positioning.

Xi’s foreign minister, Wang Yi, has said that the initiative is Mr. Xi’s most important foreign policy.²⁸ Considering the efforts President Xi undertook to solidify his power base leading up to the 19^th Communist Party Congress in 2017, it is unlikely that continuation of his prestige project will be in doubt.

Over the next fifty years, Belt and Road initiatives have the potential to dramatically shift the fortunes of the economies and companies involved. Not everyone can wait decades to assess the outcomes, but there are still several indicators that investors can monitor:

• How are insolvent loans accounted for on bank ledgers? Which institutions incur the ultimate risk of failed loans?
• How do Chinese banks manage their growing exposure to diverse and challenging B&R economies?
• Can China’s project partners realistically afford to pay off their loans? What happens when a poorer nation cannot meet its payments?
• Do infrastructure projects bring in sufficient revenue for their host countries? Does project construction create employment opportunities for local workers?
• Do the resulting trade deals between China and Eurasian partners appear fair and politically sustainable?

In the end, China’s leadership should be applauded for their risk-taking in the name of long-term growth and willingness to work with nations that have been sidelined by global financial institutions. The hope is that China’s banks and smaller business partners are given adequate protections in the process.

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The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of December 31, 2017 the Seafarer Funds had no economic interest in the entities referenced in this commentary.