Belt and Road Initiative: China’s new growth model

Hailed by Chinese President Xi Jinping as the project of the century; and perhaps the most important economic and geopolitical stratagem thus far in 2017, The Belt and Road Initiative held its first summit on the 14th of May. China asserts its desire to share growth, development and connectivity with the 65 countries — in Central Asia, Africa, and the EU — that are already involved in the initiative. This proposed region covers more than half of the world’s population, around 30% of the global economy and a proposed long term infrastructure investment of around US$5 trillion.

For a country which remains largely closed to foreign companies, and which has shown interest in demonstrating and exporting its state run economic model, China’s Belt and Road Initiative is an unusual and yet notable move. Jin Liqun, President of the Asian Infrastructure Investment Bank (AIIB) said the following about the initiative: “This is beyond Economics, this is more a strategic, geopolitical issue. It boils down to one single objective: peace and prosperity for people.” The cordial message has received positive attention from most of the participating nations, and from international institutions such as the World Bank and the IMF.

The exquisite splendor of silk was the genesis of centuries of growth and trade for China in the days of the Silk Road. While the cognomen has persisted during the promotion of the Belt and Road Initiative, the only semblance with the old path to Venice is the export based model. However, it’s not silk that China intends to disseminate. The initiative is, at its core, a massive infrastructure investment project, and Chinas 21st Century equivalent of Silk is its construction and engineering capacity. More than just highways and bridges, the initiative aims to cover a spectrum of infrastructure facilities including utilities, pipelines, telecommunications, and power generation. It is designed and marketed as a grand scheme for global connectivity.

Ambitious as the initiative seems, funding will be the sine quo non of any success that it achieves. The IMF stipulates that the annual amount needed to fill the developing world infrastructure gap is at least $1.5 trillion. While it is impractical to assume that a large portion of this requirement will be committed from the onset, China has taken a substantial first step. Through four separate channels — the multilateral AIIB and New Development Bank, the Chinese Ex-Im Bank and the state owned Silk Road Fund — with capitalizations of $100 billion, $50 billion, $55 billion and $40 billion respectively, China has initiated the coalescence of capital required to meet the needs of the Belt and Road Initiative.

To date, PwC has tracked an expenditure of $250 billion on projects associated with the initiative. The $46 billion China-Pakistan corridor, a China-Singapore highway, a train connection between Eastern China and Iran, train links Laos and Thailand, and a high speed rail network in Indonesia are just some of the projects that have already been initiated. And that’s just in Asia. In Europe, the Greek Piraeus harbor has been under Chinese jurisdiction since the China Ocean Shipping Company acquired majority shares of the Port Authority. Chinese investments have been met with some regulatory resistance, but FDI flows into the EU have been increasing dramatically. A large part of this flow is directed toward Eastern and Southern European countries, which — as compared to their Western neighbors — are more amenable and welcoming of these funds.

A majority of these projects are being conducted with the active involvement of Chinese companies, some of which are state owned. The Belt and Road Initiative provides opportunities for non-Chinese companies to partner with their Chinese counterparts, essentially expanding their project engagements. This is also, however, a source of resistance from Western Europe and the US, primarily because non-Chinese firms have had no luck in expanding into China, wherein lie similarly lucrative opportunities. Chinese firms have, through Belt and Road, given themselves access of vast new markets.

Many Chinese companies, and their subsidiaries have the backing of the Chinese government, and can engage in high risk — high payout projects. This introduces significant moral hazard to these firms, who lose all incentive to be aware of market risks. The associated benefit is that even with Chinese firms taking on higher levels of risk, the upsurge of investments in a number of countries, with partnerships with an array of companies, introduces an element of risk sharing into the Chinese foreign investment model.

Chinese growth over the last three decades has been driven by government investments and exports. This model has relied heavily on manufacturing capacity, and on the deliverance of large projects. The success of these strategies made China a global superpower and an economic powerhouse. It also anchored expectations about growth rates at an irrationally high level. It is no secret that China has an abundance of ghost cities, highways with no destination, and infrastructure that has no discernable use. The purpose of these projects was to enable the construction and manufacturing industries to prop up the GDP growth rate. But as an economy grows larger, it becomes harder to maintain previous levels of GDP growth, even if the growth rate is healthy. China has used of a multitude of methods to maintain a consistently high growth rate, but growth remains sluggish, and — as Political Scientist Ian Bremmer has pointed out — Chinese official growth numbers are hardly believable.

The development model on which China has thus far relied — one that emphasizes heavy industry and construction — creates a problem of overcapacity in many of the country’s vital industries. For example, excessive Chinese steel production has flooded the world market, and the ensuing price drop imperiled countries and foreign industries that rely on the robustness of the steel market. As the Chinese economy’s emphasis on manufacturing gradually gives way to a consumption and services based economy, it will be important to let the old juggernaut industries remain active to some capacity, and reduce in size due to natural market forces. The country sees the Belt and Road Initiative as a means to tackle the problem of overcapacity, while simultaneously buttressing high growth, and keeping the manufacturing and construction industries highly active. The initiative is a bid to develop a tertiary economy without sacrificing the current industrial base.

China has, over the last few years, been moving its international reserves from the traditionally reliable US Treasury Bonds to relatively risky and unstable African and Asian countries, in combination with their partnerships in these countries to complete the projects that they have financed.

The emphasis on infrastructure development in participating countries, as well as in China’s landlocked provinces, will help manage excess capacity, and make use of heavy machinery. Simultaneously, the projects will create demand for the services that accompany the planned infrastructure, providing space for China to expand another segment of its economy. With excess capacities ranging from cement to metals, China will have a new market for the export of such goods and commodities. Chinese capabilities in the relevant industries are world-class, and the opportunity cost of capacity export are minimal, while the potential benefits are high.

President Xi Jinping has stated on numerous occasions that the investment of capital in volatile countries that are a part of the Belt and Road Initiative will foster stability in those regions, as well as in China’s inland provinces — which will become conduits to much of the initiatives land based projects. Chinese funding takes the form of preferential debt bonds, thus the recipient countries are receiving funds, but are also taking on substantial debt. The incentives faced by both the investing and the recipient countries are worthy of examination. With government backing, Chinese firms will pour money into projects that might have far more associated risk than a firm would otherwise be willing to take. As discussed earlier, these firms carry with them significant moral hazard. On the receiving end, countries take on loans and investments from Chinese funds and companies at a relatively low risk. The projects undertaken will be finished with Chinese help, and the cost of default on debt obligations will be relatively low depending on the scale of the projects in question.

Any major losses to Chinese firms will be ameliorated due to government backing, thus ensuring a high risk appetite for firms, and for recipients who stand to benefit enormously from these investments. China has been accused of creating a situation that allows for dangerous debt traps in countries which are heavily incentivized to take on Chinese debt and infrastructure, but may not necessarily have the means to repay such obligations. The worst case scenario is a potential Greece-style debt crisis in a Belt and Road country, which may require arduous negotiations and multiple rounds of bailouts. In this hypothetical, the country will be chastised for taking on more debt than it could afford. While the firms involved will likely profit and Chinese growth numbers will benefit with relatively small balance sheet losses, if any.

China’s ability to fund a majority the proposed Belt and Road projects is limited. Since the money that China has already committed and has the ability to commit, only forms a small portion of the total required capitalization. This is further complicated by the huge pile up, and continual ballooning of Chinese debt. Moody’s recently downgraded China’s rating from A1 to Aa3, and the country’s debt burden is expected to reach 40 percent of GDP by the end of 2018. The funding distributed to the recipient countries does take the form of preferred debt obligations to China, it however does not preclude the need for China to have to take on more debt and draw capital from other value streams so as to provide further support to Belt and Road Initiative Projects.

Any further progress on the Belt and Road Initiative, in order for it to meet its stated purpose, requires funding and participation from other countries.

It should be noted that any country that choses to finance projects under Belt and Road can also gain similar advantages, and disadvantages, as would China. However, countries that have the ability to fund such projects are presently unwilling to participate. China’s neighbor to the southwest — India — has refused to participate in the initiative thus far because of China’s involvement with Pakistan, which is poised to benefit greatly from greater economic connection with China. Western countries like Germany and the US are wary of the Chinese economic model, and are unwilling to condone its exportation throughout the world on geopolitical grounds, and due to their interests in supporting their own growth model that has been propagated thus far by the IMF and the World Bank.

In the years after World War 2, the cash starved, and war ravaged nations of Western Europe used funds allocated by the Marshall Plan to grow under the economic model that the US chose to export. The Belt and Road Initiative is already far broader in size and scope than the Marshall Plan ($115 billion CPI adjusted) ever was. Western countries are wary of the spread of the Chinese model through the Belt and Road Initiative. The global economic landscape is presently dominated by the IMF and World Bank models, and China has a good chance at revisionism by meeting the scale of funding currently offered by these two international institutions.

There is a compromise here. As Dambisa Moyo recently wrote, China alone seems to recognize a need for a coherent global economic strategy. China’s growing economic size and scope means that their economy is far too important for global stability to be expendable. In light of China’s debt challenges, and high ambitions, it would be prudent for the US and Western Europe to participate in the initiative as a means of risk sharing and regulatory supervision. The Belt and Road Initiative does not rely on any internationally agreed upon standards and bylaws. It is as important to establish these as it is for other countries and institutions to provide funding to the initiative. International involvement by countries that have thus far refused to participate in the project will require the establishment of guidelines under which countries and companies can operate. For example, environmental regulations such as carbon taxes and emission caps can be established. On an equally broad level, countries can be made to acknowledge the risks of undertaking debt before engaging in projects that may be hard to refinance by posting an appropriate amount of collateral. Companies bidding on projects can be made to do so in a manner that promotes transparency and competition. If connectivity is the end goal of the Belt and Road Initiative, it must involve more countries that are capable financing projects, and not just countries that will be the recipients of capital and infrastructure.

China marketed the Belt and Road Initiative as the harbinger of global connectivity and stability. But perceptions are almost as important as reality in this world. In its current form, the initiative provides significant benefits for China, and for participating countries that are reasonably au fait of their ability to take on debt. It does, however, have the potential of introducing instability and fiscal quandaries in those countries that are oblivious or ignorant of their limitations. The success of the Belt and Road Initiative will lie in increased participation, and in the establishment of a global rulebook. Order is the first step toward connectivity and stability.

Originally published at https://www.linkedin.com on June 24, 2017.