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SHANTANU BASU | 20 OCTOBER, 2016

China: Strategic Panda Astride the Business Tiger


The China-Pakistan Economic Corridor (CPEC) has excited large adverse opinion in India over its strategic implications in the past few months. Just what is the CPEC all about?

In Dec. 2014, China (PRC) sensibly established the Silk Road Fund (SRF) as a fund management company to extend investment and financing support to CPEC projects and to promote industrial cooperation with Pakistan.

The SRF is a consortium of leading Chinese banks, including the China Exim Bank and the China Development Bank. It had an initial corpus of $10 billion that was subsequently raised to $40 billion. For CPEC projects, all SRF-financed loans will be insured by the China Export and Credit Insurance Corporation (Sinosure) against non-payment risks while the security of loans is guaranteed by the host state.

There is no grant-in-aid component, unlike American handouts to Pakistan in the past, and PRC’s financing and implementing agencies will hold proportionate equity in the Pakistani host entity – strategic advantage profitably piggybacking on great business.

What projects does the CPEC cover? All 49 CPEC projects would be executed with the financial and logistical participation of the federal and state governments and private sector of Pakistan on joint venture (JV) basis.

CPEC two main components, viz. developing a new trade and transport route from Kashgar in China to the Gwadar Port in Balochistan and special economic zones along the route including power and motorway projects. The first-phase projects will receive $45.69 billion in concessionary and commercial loans, for which financial facilitation to PRC companies is being arranged by SRF. These include $33.79 billion for energy projects, $5.9 billion for roads, $3.69 billion for railway network, $1.6 billion for Lahore Mass Transit, $66 million for Gwadar Port and a fibre optic project worth $4 million.

How is PRC financing such gargantuan expenditure? Although PRC has had its fair share of bad bank loans, distressed stock market and a sagging renminbi, yet $1.22 trillion in US Treasury Bonds (as of July, 2016) is no mean amount of a total of $4 trillion investments in the US alone in mid-2015.

As of Sep 30, 2016, the average interest rate on US Treasury Bonds was 4.429%, down from 4.673% a year earlier. Against this, a conservative annual return (interest and return on investment) @ 30-35% per annum makes a positive difference of about $300-350 million/annum to PRC entities for every billion dollars invested over US Treasury Bonds. Included in this is a conservative 10% mark-up in prices of capital equipment (that is normal globally), debt servicing costs (excluding interest) of about 7% and return of investment of about 30-35%, all per annum!

For $67 billion CPEC funds (Pakistan & Bangladesh), PRC could potentially earn about $20-23 billion per annum with average payback period in a remarkable 3-5 years. The Bank of China reports a low prime lending rate of 4.35% as of Sep, 2016 that has not changed in the last year, so the cost of domestic and repatriated capital is low.

Just how expensive will SRF finance be for Pakistan?
A framework agreement for energy projects under CPEC was recently signed between Sinosure and the water and power ministry of Pakistan to provide sovereign guarantees. Sinosure is charging a fee of 7% for debt servicing added to the project’s capital cost. Such add-on of $63.90 million for debt servicing and financing fees and charges of another $21 million would raise the capital cost of the Port Qasim 660MW power project from $767.90 million to $956.10 million.

Interestingly, interest during construction will be at the rate of 33.33% each for the first and second years, 13.33% for the third and 20% for the fourth year. In addition, 27.20% return on equity is guaranteed, post-commissioning. Power is therefore least likely to be affordable, so will be substantial upward tariff revision meet with popular dissent as for motorway tolls.

Pakistan’s Finance Ministry has already exempted a few motorway projects from customs duties and taxes. Pakistan’s Federal Board of Revenue (FBR) has, so far, also granted exemption on withholding and sales tax to two Chinese firms on import of motor vehicles for CPEC motorway projects.

States too are pitching in. The Punjab government has leased 4,500 acres of land to PRC companies for the second phase of the Quaid-e-Azam Solar Park of 900MW, probably gratis. Similarly, the Gwadar Port Authority (GPA) has assigned or will be very shortly assigning 923 hectares (2300 acres) of tax and cost-exempt land to China Overseas Port Holding Company (COPHC) on a 43-year lease. None of these costs will be borne by the PRC and will add to the cost of CPEC’s implementation. This is in addition to the $248 million PRC has already spent on establishing Gwadar Port in 2007, also as loans.

What agencies would undertake joint implementation for the PRC? Three Gorges Corporation for hydropower projects, Shanghai Electric (Group) Corporation, Lucky Electric Power Company, Zonergy Co Ltd, China Construction Company, China State Construction Engineering Company and China Civil Engineering Construction Corporation, Syno Hydro Company, etc., all PRC-owned companies, private and public, are the principal contractors.

Sub-contractors would presumably be Pakistani which is where local corruption will hugely creep in, as in India, and appreciably reduce the value of the loans. Chinese supervisors would also have to be protected against local goons for which the Pakistani army is reported to raising about a division to protect CPEC assets, expenses on which will be on Pakistan’s exchequer.

What additional gains will PRC derive from CPEC-like investments? At a very modest 0.25% annual accretion to PRC’s GDP in 2016 of $10.87 trillion owing to CPEC and similar Non-West transnational investment may potentially add at least another $300-400 billion per annum to PRC’s GDP by 2020. In addition, equipment and building supplies manufacturers, now in distress, would not only generate new jobs but also witness appreciable upsurge in their share values and consequently earnings per share for investors, many of them in distress now. Is that why PRC’s SRF is being called the new East India Company?

What is the flip side of CPEC-like PRC investments?
For one, high rates of return on investment are proportionate to the gravest risks involved that all recipients would certainly face in varying measure. The track record of mega corruption in sub-contracting, poor implementation and operation plagues nearly all of PRC’s client countries. As delays mount, so will commitment charges on loans and accumulated rate of return. Similarly, political compulsions in accepting high-tariff tolls for every km of new motorways, willingness to substantially raise power, water and telecom tariffs in a historical subsidy regime, land acquisition hurdles, relief & rehabilitation of the displaced, high maintenance costs (owing to less than average material used and terrain), etc. could add manifold to the Chinese debt of a recipient country.

PRC suppliers and probably limited skilled labour too, at least at the supervisory and foreman levels, could severely dent a recipient’s hopes of generating employment. Corruption is built into the implementing stage that will ensure that less is purchased for more money. The end result may therefore cause decades-long leases of minerals and metals or any other natural resource, perpetual right of overland access, and enhanced cost of securing PRC-built facilities arising from equity participation of PRC entities in the implementing agencies of recipients and extraordinarily long leases on project land such as for Gwadar Port. Quantifying the final figure of dues to PRC entities is thus a complex and frightening prospect.

Another flip side to PRC’s ‘generosity’ is its strategic implications. Trains can theoretically double for ICBM launch pads and carriers (satellite imaging though is a deterrent) while tanks and guns can roll down 4-6 lane motorways and fighter aircraft could use 4-laned motorways for runways. Likewise, airports can receive foreign air force aircraft and carry supplies to armies on the move. Fibre optic links can be commandeered for alien military use. In digitally connected times, telephone exchanges and power plants could be shut off by codes embedded by PRC suppliers in the system software.

Solar and other power and water plants that are connected by Internet these days to one another could be disabled for a recipient country’s non-compliance or violent change of regime. Quality assurance will remain a major flash point and add to costs and delays since the PRC’s credentials on this score are not particularly creditworthy.

PRC investments in infrastructure have additional long-term economic benefits. Every percentage rise in PRC’s current annual exports of $2.28 trillion would annually add $23 billion to its kitty plus several thousand new jobs. Given the magnitude of OBOR, PRC may well end up adding over $300-500 billion to its annual exports by 2025, mostly in new markets in the host countries of their investment, taking advantage of probably cheaper transportation overland bulk transportation, most so to several landlocked hosts and on to Europe.

Since wages paid to domestic PRC workers are in the range of only $239-327/month in 2016, presumably with little or no social security, corporate profits of PRC enterprises arising from transnational investment would shore up the balance sheets of many distressed PRC companies. Overland access would also vastly reduce shipping insurance premium aside from bypassing the volatility of the Persian Gulf, North Africa, South China Sea and the piracy-prone Horn of Africa.

There are gains too for PRC and the recipients of CPEC-like investment. Low-cost PRC imports would flood the recipient country’s markets. These countries would gain by physical infrastructure, somewhat greater low-wage employment and relatively cheaper and deeper access to markets, old and new.

However, repayment defaults could cause concessions for establishing EPZs in recipient countries for PRC manufacturing and distribution hubs that, in turn, would cause a situation akin to indigo cultivation by the English in India in the 18th century.

Access to several ports stretching from Chittagong to Bandar Abbas and Gwadar combined by 4/6-lane network of motorways from port and rail heads and dotted with international airport and tax-free EPZs will no longer remain a pipe dream for PRC and its client countries. Backing PRC’s business pincer movement is the rapidly modernising People’s Liberation Army.

(The author is a senior public policy analyst and commentator.)

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