May 17, 2018

Restoring the Old Silk Road: pipe dream or serious proposition?

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China’s flagship Belt and Road Initiative is promising to restore the ancient Silk Road trading route and provide significant regional economic development. Kevin Smith examines the political and financial challenges of delivering this mammoth programme of infrastructure investment.

WITH the peaks of the Tian Shan mountains looming in the distance, the frontier region of Khorgos on the China-Kazakhstan border has come a long way in the past three years. Rising from desert sands, a bustling dry port now processes Chinese freight trains, transferring containers from standard-gauge to 1520mm-gauge wagons to continue their journey into Kazakhstan, Russia and beyond.

 

Gubler China intermodal2The $US 250m port was built by the Kazakh government and is now 49% held by China’s Cosco Shipping and the Port of Lianyungang. It processed its first TEU in July 2015 and is estimated to have handled around 150,000 TEUs in 2017, or four to five Chinese trains per day.

The port is targeting 550,000 TEUs per year by 2020, with new logistics, manufacturing and warehousing facilities all planned as part of the vast Khorgos Eastern Gate development project. The new town of Nurkent, which is already home to 3000 people, and neighbouring Horgos across the Chinese border, could become a settlement of 300,000 people in the medium-term.

This is China’s Belt and Road Initiative (BRI) in action.

China’s flagship foreign policy initiative was announced by president Mr Xi Jinping in Kazakhstan in 2013 and was formally adopted in 2015. Its core aim is to restore the ancient Silk Road trade route between East and West by improving infrastructure and cross-border connections between up to 70 countries in Asia, Europe and Africa covering up to two-thirds of the world’s population.

As the Belt element of the policy, rail is a major beneficiary. This is already notable in the upsurge in China-Europe intermodal rail freight volumes in recent years, as witnessed at Khorgos. With China heavily subsidising these operations in order to spur their development - by an average of $US 2500 per 40-foot container - an estimated 262,000 containers were transported by rail between 35 Chinese cities and 34 cities in 11 European countries in 2017. This was an increase of 180% compared with 2016 when volumes also grew by 120%.

As well as introducing new routes, work is taking place to optimise and improve the efficiency of freight flows. New technologies such as climate-controlled containers are enabling the transport of products in changing or harsh climatic conditions. Reforms to customs procedures, including single tickets and digitised records, are speeding up border crossings.

Ultimately China is aiming for 20% of exports to reach Europe by land, which compares with 1% at present, and could mean up to 2 million TEUs passing from China to Europe by rail in the long-term. There is also an opportunity to enhance freight flows in the other direction, with a thirst for high-value European goods in eastern China, but east-west rail freight currently outstrips return shipments: 98,000 TEUs were sent from Europe to China by rail in 2017, although this compares with just 1300 in 2010, and is hampered by Russian sanctions on certain European exports, particularly food products.

While the existing Trans-Siberian Railway is a major beneficiary of the increase, China is not limiting itself to existing infrastructure. Four competing land routes are included in China’s National Development and Reform Commission’s “China - Europe Corridor Construction and Development Plan” which was published in 2016: Manchuria-Russia-Belarus; Mongolia-Russia-Belarus; Kazakhstan-Russia-Belarus; and Kyrgyzstan-Uzbekistan-Turkmenistan-Iran-Turkey. More broadly, BRI covers six major corridors:

  • China-Mongolia-Russia Economic Corridor
  • New Eurasian Landbridge Economic Corridor
  • China-Central Asia-West Asia Economic Corridor
  • China-Pakistan Economic Corridor
  • Bangladesh-China-India-Myanmar Economic Corridor, and
  • China-Indochina Peninsula Economic Corridor.

Although precise detail is scarce, which has drawn criticism, investments in infrastructure improvements on these corridors could be worth up to $US 900bn in the initial phase. However, according to Mr Barry Hembling, partner in the construction and engineering team at Fladgate, a London law firm, this demand must be placed within the context of an extensive Asian infrastructure deficit in the past 20-30 years.

A study published by the Asian Development Bank (ADB) in 2017 states that between 2016 and 2020, Asia is set to suffer from a 2.4% infrastructure investment gap of projected GDP, which rises to 5% if China is excluded. Currently $US 881bn is invested annually in infrastructure. However, the study says that Asia will need to invest $US 26 trillion from 2016 to 2030, or $US 1.7 trillion per year, if the region is to maintain its current growth momentum, eradicate poverty, and respond to climate change. Transport is expected to account for $US 8.4 trillion of this investment, with power accounting for $US 14.7 trillion, telecommunications $US 2.3 trillion, and water and sanitation $US 800bn.

“There has been a lack of a coherent infrastructure investment strategy to keep pace with the rapid economic growth experienced in the region,” Hembling says. “BRI should be considered as a means to address this. It covers two-thirds of the world’s population, but this area only accounts for one-third of global GDP. Infrastructure development is key for the economic development of the countries along the route.”

Interest in BRI was reflected in strong attendance at the inaugural Belt and Road Forum for International Cooperation hosted by the Chinese government in Beijing on May 14-15 2017. Heads of state and government leaders from 29 countries attended the forum. Russia’s president, Mr Vladimir Putin, Turkey’s president, Mr Recep Tayyip Erdogan, and the United Nations secretary general, Mr Antonio Guterres, were among those who spoke.

Yet there were some notable absentees. Turkmenistan and Tajikistan, potentially key transit countries in the China-Central Asia-West Asia Economic Corridor, stayed away from the event. India has also been a consistent detractor from BRI, opposing the $US 62bn China-Pakistan Economic Corridor as it would involve construction in the disputed territories of Kashmir and Gilgit-Baltistan. India is also rumoured to be considering an alternative to BRI in cooperation with Japan, Australia and the United States.

Similarly, Sri Lanka’s inability to pay off the onerous debt it owes China for various infrastructure projects conducted in recent years has sparked protests against the government. In Kazakhstan, a vehement supporter of BRI, epitomised by Khorgos, there have been rare protests over proposed legislative changes which could enable the Chinese to purchase agricultural land. Concern has also been raised over the disproportionate award of contracts for BRI schemes to Chinese contractors compared with similar infrastructure schemes financed by ADB and the World Bank.

Downplaying fears

Xi was keen to downplay these geopolitical fears during his opening address to the forum, stating that China has no intention of interfering in other countries’ internal affairs, exporting its own social system, or imposing its own will on others.

“In pursuing the Belt and Road Initiative, we will not resort to outdated geopolitical manoeuvring,” Xi said. “What we hope to achieve is a new model of win-win cooperation.”

However, rhetoric alone is not sufficient. If China is to convince these countries and others that BRI is to their mutual benefit, there must be changes in policy and approach, particularly to alleviate fears of debt distress.

A study by the Center for Global Development published on March 3, identified eight countries at particular risk based on an identified “pipeline of project lending” associated with BRI. The study recommended several steps which China can take to alleviate these concerns.

By promoting increased multilateralism in BRI projects and greater standardisation in lending practices, the study says China and major BRI partners can adopt the disciplines and standards practiced by other major sovereign and multilateral creditors to reduce potential debt risk. It also calls for China to act as a donor, specifically in financing technical legal support to developing country borrowers and suggests offering debt swap in exchange for achieving environmental objectives.

“China should take the lead in establishing and funding an international legal support facility (LSF) that would address potential asymmetries in financial sophistication between BRI creditors (largely Chinese institutions) and BRI borrowers,” the study notes. “Some BRI borrowers may be well informed about markets and financial techniques while others may not enjoy the same level of knowledge. An LSF would allow low-income countries to secure expert counsel to advise them on the negotiation of debt operations.”

Hembling reports that work is underway to define the legal framework for BRI. This includes defining common safety standards and the adoption of “one test one certificate” for inspection and quarantine and resolving future dispute resolution cases.

“The proposal lacks detail and we do not know whether this will be a form of international arbitration of the type operated by Chinese government organisations such as Citeac, or whether this will be a state-run means of dispute resolution,” Hembling says. “If that is the case, participating parties will want comfort that they will receive a fair hearing in the event of a dispute.”

He adds that China could ease these concerns further by clearly recognising a distinction between constructing infrastructure and the consequences of debt finance. “If it is truly to become a global initiative, there must be a wider choice of funding options available for BRI projects,” he says.

China’s efforts to fund BRI have centred on two institutions: the Silk Road Fund, which was founded in December 2014 with an initial contribution of $US 40bn, and which aims to support BRI infrastructure projects; and the Asian Infrastructure Investment Bank (AIIB), which was established in 2016 as a new multilateral bank capable of competing with ADB and the World Bank to provide infrastructure finance in Asia, although not necessarily related to BRI.

AIIB has established partnerships with 84 countries and already provided $US 5bn in finance to infrastructure projects which support its three major objectives of promoting sustainable infrastructure, maximising production capacity, and improving cross-border connectivity. Among the early beneficiaries are metro projects in Bangalore, and energy projects in Indonesia, Egypt, Tajikistan, Azerbaijan and Myanmar.

Mr Janping Thia, principal economist at AIIB, says that following its initial phase of development, the bank is planning to scale up its lending significantly over the next five years. “We are developing cooperative financing arrangements with the ADB and World Bank and are aligning ourselves with projects that boost capacity and improve the flow of goods across borders,” he says.

China has also pushed the diplomatic envelope, signing business and trade commitments with 30 countries during the forum, and reaching an agreement with 27 finance ministries, including from Britain, Malaysia, Russia, Switzerland and Thailand, on a set of principles to guide project financing. However, Germany did not sign the agreement, citing a need for greater transparency.

In addition, Xi confirmed a further $US 100bn pledge to the Silk Road fund and special lending plans at China Development Bank and the Export-Import Bank of China worth Yuan 250bn ($US 39.8bn) and Yuan 130bn respectively to support BRI cooperation on infrastructure, industrial capacity and financing.

Yet there are signs that China’s direct approach to BRI funding is beginning to shift.

After a record-high of $US 170.1bn in Chinese outbound investment in 2016, surpassing inbound investment for the first time, the figure fell by 41% year-on-year to $US 81bn at the end of October 2017. Fears over the rapid decline in China’s foreign exchange reserves and a rise in risky state-owned bank lending were cited for the reduction.

Greater economic pragmatism was also evident in Xi’s keynote speech at the closing meeting of the first session of the 13th National People’s Congress in Beijing on March 20. Xi said that rather than chasing high growth figures, China would increasingly focus on high-quality growth and opening up to the wider world.

In the context of BRI, China is pushing to secure financial support from other sources. The signing of a memorandum of understanding (MoU) during the forum by China’s Ministry of Finance and ADB, AIIB, European Bank for Reconstruction and Development (EBRD), European Investment Bank, New Development Bank, and the World Bank Group, could therefore prove a critical step.

EBRD says it is keen to promote BRI and invest in central Asian economies, touting its expertise and capability to deepen cooperation with the private sector and promote so-called “soft infrastructure” such as policy reform and local know-how. In particular, it says experiences with developing Europe’s TEN-T transport corridor projects and adopting universal standards could be applied to BRI. It also cites work on the EU-China Connectivity Platform, where the EU created a common framework to develop synergies between China’s BRI and EU infrastructure projects, including TEN-T.

As a major contributor to infrastructure development in the region, ADB also looks set to play a leading role. Mr Ayumi Konishi, special senior advisor to ADB’s president, says that in accordance with the MoU, the bank will collaborate on BRI through its country partnership strategies and ADB-supported sub-regional economic cooperation initiatives, such as Central Asia Regional Economic Cooperation Programs (Carec) or Greater Mekong Subregion (GMS) economic cooperation programme.

In the Carec region, a railway strategy was approved in October 2016 and envisages rail taking a leading role in transforming the region from being landlocked to land-linked and “as the mode of choice for trade by 2030.” Priority projects have been identified to develop or modernise 18,000km of rail infrastructure and are estimated to cost $US 38bn with financing coming from multiple sources, including PPPs.

In the GMS region, the recently held Summit in Ha Noi in March reconfirmed a $US 66bn Regional Investment Framework (RIF) for 2013-2022, 85% of which is for transport, including $US 35bn for rail.
Konishi says the 2017 BRI forum shows the strong interest and support for the initiative and Asian infrastructure development in general, and that the world’s second largest economy is leading the push for this level of investment is significant.

Private investment

Yet financial support from the Chinese state and multilateral banks will still fall someway short of the $US 1.7 trillion required for Asian infrastructure development. There is therefore a need for significant private investment in BRI and other infrastructure initiatives in the region.

News in December that former British prime minister, Mr David Cameron, was set to head a $US 1bn BRI investment fund is a sign of willingness from the private sector to engage. However, difficulties in securing support from large banks for the UK-endorsed project reflects the challenges BRI funding faces in an overtly competitive marketplace.

Indeed, Konishi believes there are four major challenges that BRI, and ADB’s Carec and GMS schemes, must overcome if they are to secure the financial support required:

  • ensure that there is a strong ownership of the project by all the concerned governments
  • carefully examine the economic and financial viability of any project
  • understand the economic activities and characteristics of a particular region - if the population is not that large, it may not translate into a bankable project
  • ensure that the highest possible standards of environmental and social safeguarding are met in order for the project to benefit everyone, and
  • observe good governance in project formulation and implementation, including by ensuring adequate procurement arrangements and strong financial management.

“It is not unique to Belt and Road, every infrastructure development programme has to focus on the bankability of the project,” Konishi says. “Any investor in these projects has to have the reassurance that they are going to make an economic and financial return. The project must also have sufficient cash flow to repay the loans.”

Hembling says that there are signs of a growing willingness in the investment community to support infrastructure development, whether through bonds or long-term involvement. An increasing number of BRI projects are also moving from a traditional engineer-procure-construct model to build-transform or build-operate-transform with public-private partnerships (PPPs) becoming more and more common.

However, to attract the level of support required, BRI must prove to its prospective supporters that there are sufficient investable projects.

“Whichever form of private sector finance is used, construction risks must be properly managed,” Hembling says. “Unfortunately, in too many cases large-scale infrastructure projects still take too long from inception to implementation, cost too much to deliver, and are too costly to operate and maintain.

“Without more early wins, the BRI could gain a reputation for an inconsistent delivery record, with high-risk vanity projects on long investment returns presenting major barriers to private investment.”
For rail, reassurance might be offered through improving integration between new and existing networks, particularly across borders.

According to the World Bank, central Asian countries are ranked as some of the most difficult in the world for cross-border trade, with Uzbekistan ranked 168th, Tajikistan 149th, and Kazakhstan 123rd. Improving this capability should be a priority for BRI in its early stages. Arrangements such as joint locomotive leasing, shared cross-border operations, and profit-sharing agreements for the entire corridor rather than the countries where terminals are located would also encourage investors and local governments to support individual projects.

Improving connections with existing infrastructure is also critical. “The development of ‘software elements’ are just as important as big-ticket infrastructure projects,” Konishi says. “Overall management of transnational rail services with “one stop ticketing” and efficient trans-border arrangements for both passengers and freight will be a key. It will provide reassurance that these major projects are part of overall network development.”

This point is not lost on AIIB. Thia says there are significant opportunities to invest in existing rail infrastructure and this is currently a major focus of the bank’s work.

“Electrification has been identified as one area of priority for our bank,” Thia says. “We see a low rate of electrification in southeast Asia and India and a general lack of investment. It is our priority to look for opportunities to upgrade and develop existing rail infrastructure to increase capacity on the lines and it is particularly attractive to us because there are no land acquisition costs involved.”

Yet with many BRI projects centred on parts of the world which are geographically isolated and suffer from political instability and terrorism, the risks may be too much for the investment community. Hembling says that if these projects are to be built, it may be up to China alone to provide the direct finance required.

BRI is not a one-size-fits-all project. To succeed, China must show greater flexibility both to reduce financial risk and address genuine concerns from some of the world’s weakest economies of its intentions. They have a lot to gain. But they also have everything to lose. As president Xi’s pet project, China’s political support for BRI is unlikely to wane. However, only by offering this reassurance will everyone have the opportunity to reap the benefits that BRI, and the new era of “win-win cooperation,” promises.

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