China's Belt and Road Initiative - internationalising the local government debt problem

Three times surely cannot be a coincidence, can it?

Let’s state up front that the right infrastructure can be a boon for developing countries, and I have no problem with China building it for a fair price. That said, China’s Belt and Road Initiative (BRI) is looking increasingly problematic.

First, there was the Hambantota port in Sri Lanka. With some USD 5bn in debt to China, and interest payments bleeding the budget, the new Sri Lankan government pretty much had to accept an equity-debt swap in 2017, handing over control of the port to China Merchants Port (CMP), a large China state-owned enterprise (SOE). As Iain Mallow of Bloomberg reported here the port is real empty. All that shot of the port is missing is the bush-weed.

It’s of course possible that the port does manage to build a trans-shipment business eventually, but the debt is a very real problem today.

A similar situation is in the making in nearby Maldives (here). President Abdulla Yameen’s government has borrowed from USD 2.5bn from China’s Export-Import Bank (Exim) for various big projects. Opposition leader Mohamed Nasheed, currently holed up in Sri Lanka, estimates that debt repayments to China will be some USD 750mn by 2020, some 50% of government revenues.

And now we have the new Malaysian government going through the books and finding some really dodgy deals. Focus last week was on two USD 1bn oil pipelines, but dwarfing these is the East-Coast Rail Link (ECLR), with a total cost estimated at USD 15bn. It winds from Kuala Lumpur on the west coast cross country to the east and then heads up to the Thai border. Construction has already started. At least one other big-ticket infrastructure project that likely would have gone to China contractors has been cancelled.

The projects all went to SOEs from the People’s Republic, which would all be completely fine if they were done transparently with normal project terms. But they weren’t. There are at least four big problems:

1. All the projects were awarded on a no-bid basis (suggesting cost inflation and some hidden motives), to China’s Communication Construction Company (CCCC), here. A subsidiary of CCCC also built the Hambantota port.
2. Payments were not organized on a work-done basis, but on a strict, front-loaded timetable. The pipelines are apparently 13% done, but 90% paid for already. Some USD 4bn has already been drawn-down and paid to CCCC for the ECLR, with hardly any work done. Suggesting someone was a in a real hurry.
3. The loans from Chinas’ Exim Bank which backed these projects went to an entity off the MoF balance sheet. It looks like the new government will recognize these loans as official debt at some point, but under former Prime Minister Najib Razak - who was careful to be finance minister as well - they did not appear there. That’s a nice trick.
4. There’s a 7-year holiday from paying interest on the loans, which seems generous until you realize that interest is still building up - and the budget impact is only delayed, creating fiscal problems for the next government.

You might also worry that the loans are in Renminbi, meaning Kuala Lumpur has to deal with CNY/MYR risk. But I tend to think this is par for the course - a US dollar loan from the World Bank would carry similar risk.

The stink out of Malaysia gets even worse. The funds borrowed by Najib’s government were paid to SOEs in China which then appear to have routed the funds back to Malaysia to help service 1MDB liabilities. (1MDB being the entity Najib established earlier in his term to loot the treasury, it is alleged (here)). If one was being ungenerous, one might wonder if entities in China were colluding with Najib to prevent a big default on the 1MDB liabilities - and getting some benefit in return. A nice infrastructure project and the possibility of a debt-equity swap in the future, for starters?

Bottom line, but it looks like these BRI projects are basically internationalizing China’s local government debt problem. Borrow during your term, park the liability in an off-balance sheet vehicle, build something big and grand, siphon off some funds for friends and family, and leave your successor and the general public with the bill. This is basically what every city mayor and provincial governor has been up to in China for the past decade, ever since the 2008 CNY 4tn “stimulus” package, which turned out to be more like CNY 30tn and mostly financed off-balance sheet. Beijing has attempted to get a grip on its own local government debt, with limited success, in my humble opinion, but its still growing. And now its the turn of China’s BRI partners to take on debt and build.

Hopefully, as light is shone, developing country governments will think twice about taking on these BRI debts. But a free-today loan plus some side-payments are always going to be hard to resist. Which means that over the next decade, they’ll be more debt-equity swaps to come - and, perhaps even some defaults on loans from China. Malaysia’s new prime minister Mahathir made his name decrying predatory western capitalism back in the 1990s. Wonder what he thinks about what Exim and CCCC have been up to on Malaysia’s dime.

Oh, last thing - the folk at the Center for Global Development have a great report putting some of the BRI debt numbers together here.