Zhou Xiaochuan Weighs In on the BRI Debate (Part 2)

History and logic behind BRI financing

To clarify at which level China’s debt financing should be placed, it’s necessary to examine the attributes and economic logic of China’s investment and financing for the BRI. There are two aspects of this worth analyzing.

First, why does China have so much investment and financing in the BRI? Data suggests that both the CDB and the Ex-Im Bank have each issued about $300 billion in BRI financing. Including the private sector, China’s total investment and financing in the BRI could amount to $2 trillion to $3 trillion. These figures may not be accurate and definitions may vary, but they reflect the considerable scale. Some in the West might wonder why China, with its moderate GDP per capita and tight fiscal conditions, is engaging in so much overseas investment and financing. Is it government-led?

It should be noted that China’s investment and financing along the Silk Road has been developing since 2000. After Xi proposed the BRI concept in 2013, the scale and prominence of China’s investment and financing have grown even more. The reason is that China has developed economic advantages in foreign investment and financing, meaning it has comparative advantages that can be utilized for the BRI.

The departure of freight train Tuesday from the eastern Chinese city of Yiwu to Madrid marks the 10th anniversary of the Belt and Road Initiative. Photo: VCG

Sometimes, this comparative advantage is also referred to as excess capacity. In fact, excess capacity and comparative advantage are interconnected. If a production has a comparative advantage, it can produce and export more, indicating supply exceeds domestic demand. So, is that excess capacity? Therefore, the concept of excess capacity can be measured by domestic market capacity, and can be understood as a positive from a globalization perspective. It can also be exploited by others to smear China.

Indeed, China has a clear advantage in infrastructure construction. This significant trend originated in 1998 when the State Council increased investment by hundreds of billions of yuan to bolster infrastructure against the effects of the Asian financial crisis. The second wave originated from the impact of the 2008 global financial crisis, leading to China’s 4 trillion yuan economic stimulus plan, which included a large number of infrastructure projects. As China significantly expanded infrastructure construction, its capabilities to design, build and operate such projects improved. China is strong in the construction of roads, railways, ports, airports, power grids, and other infrastructure, as well as in the manufacturing of complete sets of equipment for power generation, reflecting cost advantages and competitive strength.

Many Chinese private enterprises also have similar advantages in infrastructure and manufacturing. This advantage is not only reflected in broad infrastructure construction but has also expanded to public facilities related to urbanization and commercial and residential real estate. As the opportunities for investment projects in China decrease, companies have begun to explore overseas markets. Despite higher risks, such as unfamiliarity with local policies and languages, many companies eventually find that moving to foreign markets is more profitable than staying domestic. In short, most Chinese enterprises go abroad driven by market conditions and economic interest.

Another significant characteristic of China’s economy is its high savings rate. While a high savings rate has its pros and cons, from the perspective of foreign investment and financing, it is an advantage, equally important as the comparative advantage in construction and equipment manufacturing.

How high is China’s savings rate?

As of 2022, the national savings rate was about 45% of GDP, after hovering around 43% for a few years. This high savings rate phenomenon seems difficult to change in the short term. With it typically in the 40% to 50% range, China’s savings rate is among the highest in the world. And being such a large country, the total amount of funds is quite substantial. When these funds seek an outlet, they compare the advantages and returns of foreign and domestic investment and financing options. One manifestation is that CDB and the Ex-Im Bank of China can issue a large amount of bonds domestically to support BRI projects. Imagine, in a country with a low domestic savings rate, even if a development bank or export-import bank is established, it is very difficult to mobilize a significant amount of savings at a reasonable cost.

Many Chinese companies, including central state-owned enterprises (SOEs), local SOEs, and private businesses, are motivated by economic drivers to actively explore foreign markets, not necessarily at the government’s request or organization.

When these companies go abroad and find good projects, but there may be financing needs, and they often lack the necessary financial strength.

Companies like China Railway Construction Corp. Ltd. may have significant advantages in bridge building and railway design and construction but also need support from financial institutions. They may not be familiar with foreign financial institutions or capable of obtaining funds from international financial markets. Consequently, they focus on domestic sources, trying to convince policy lenders and state-owned commercial banks to provide project financing. It’s easier for these lenders to raise funds via domestic bond issues, and they are also tasked with developing overseas markets, hence their interest in these projects.

Workers stand in front of the Jakarta-Bandung section of the Jakarta-Bandung High-speed Railway in September 2020. Photo: VCG

However, financial institutions are aware that these construction companies generate revenue during the construction process, with most materials and equipment coming from Chinese sources, meaning they often recoup costs and profit before or upon project completion. The lenders ultimately bear the repayment risks after project operation, thus calculating a certain risk premium, which may be higher for some less developed countries.

When the risk premium reaches a relatively high level, debtors may argue that the capital cost is too high and ask China to make it cheaper. Consequently, the lenders have the debtor government borrow or provide government guarantees, quasi-government guarantees, or use future resource revenues for repayment. For some developing countries with poor financial management, they may consider that these sovereign guarantees are acceptable if it means cheaper loans from Chinese financial institutions.

This is also seen as a political achievement to please voters and as a result, some debts that don’t need sovereign guarantees get them anyway.

Do these count as bilateral government loans, as sovereign debt? Should they be included in debt restructuring at this level? Not necessarily.

The apparent government endorsement is also a tricky issue. During the preparation, commencement and construction of projects, if there is a visit by senior leaders from both sides for signing ceremonies to announce agreements and demonstrate cooperation and mutual support between the two countries, relevant departments will collect any projects or agreements available for signing.

For some specific company-level projects, relevant government departments may not necessarily know the background and details in advance, and the entities signing project agreements are often not government officials but companies or banks. Does this imply that these are bilateral government cooperation projects? In fact, such signing events in the company’s name at ceremonies are more of a sign of friendship and mutual support and do not indicate that the project is a government one or necessarily decided by the government. If a thorough analysis is conducted, most of the signed projects are not government-decided, but some in the West looking to smear China will seize on this, saying that since leaders from both sides are present during the signing, it implies they are government projects, and the financing is bilateral sovereign debt. When debt needs restructuring, China should be the first to cut back and bear the cost.

Looking closely at the structures of these projects with sovereign guaranteed-debt, there are large infrastructure projects in which China has a significant production capacity advantage, such as highways, railways, airports, and power projects. There are also a large number of other projects, like general processing industries, mining, urban construction, industrial park construction, and local market development. The latter are numerous and widespread, with a total investment and financing amount that is not small and not less than that for infrastructure project financing. Very few of these, however, actually involve government decision-making and arranged financing.

In summary, the main bodies, motivations, driving forces, and investment conditions of China’s Belt and Road investment and financing are diverse. Based on the available information, a vast array of projects and their financing, from infrastructure to industry, are mainly market-driven, corporate actions, and commercialized financing. When some countries face a crisis in repaying certain types of debt, it is necessary to make a reasonable and clear stratification and classification based on the real attributes of the projects and their financing.

We also need to consider the nature of development and policy bank financing and debt reduction.

What is the business nature of China’s development and policy banks?

China’s policy banks stem from the design of the 14th National Congress of the Communist Party of China and the Third Plenary Session of the 14th Central Committee. Their original intention was to separate policy finance from commercial finance, transforming specialized banks into true commercial banks, no longer segmented by specialty, no longer undertaking government-directed planning, aiming at market competition, and operating fairly. A necessary condition was to divest policy loan business, to be undertaken by newly established policy banks.

In 1994, the CDB and the Ex-Im Bank of China were established as policy banks, and the Agricultural Development Bank of China was also set up to serve the agricultural sector. After these banks helped the specialized banks transition, was it possible for these policy functions to gradually reduce and fade away? At that time, indeed there was such an advocacy, believing that these policy banks could disappear after a period of time. However, the policy banks felt they still had much to contribute.

China Development Bank. Photo: Xinhua　

In the 1990s, China’s fiscal situation was challenging, with tax revenue being just over 10% of GDP, the price system not yet free from distortions, and the fiscal capacity insufficient to support investment and financing in industries with a public nature. Under such circumstances, starting with the CDB, it defined itself as focused on “two basics and one support,” meaning loans were primarily directed towards basic industries, infrastructure, and pillar industries. They gradually explored a path of “developmental finance” that served national strategies, relied on equity credit support, operated without subsidies, operated in the market, independently managed, focused on long-term, guaranteed principal and minimal profit, and financially sustainable. Indeed, this process was marked with continuous exploration and refinement, distinguishing “developmental finance” from “policy finance.”

Initially, the Ex-Im Bank of China mainly supported exports, facing foreign trade and foreign investment, and later also developed overseas project financing under policy guidance, many of which complied with policy directions and were autonomously decided. Government-related projects also continued, especially using “two preferential loans,” namely concessional assistance loans and preferential export buyer’s credits; but some said that “two preferential loans” were not “preferential” enough, meaning the prices were not cheap, and no real price subsidy was obtained.

Additionally, in 2001, China established Sinosure, understood as a policy insurance institution for export credit insurance. Some commented that its premiums were too high, increasing the cost of export credit, making the policy nature less pronounced. It’s understandable that at the time, China’s overall fiscal resources were not abundant (and were particularly strained at some stages), presenting difficulties in deploying fiscal policies due to a lack of resources.

After the successful transformation of the Industrial and Commercial Bank of China, China Construction Bank, and Bank of China into shareholding companies in 2007, there were advocates suggesting that the mission of policy banks was completed, and the CDB and Ex-Im Bank should be converted into commercial banks entirely. This opinion did not prevail at the time, so the two institutions were retained. The preliminary definition of developmental finance proposed at that time specified that its sources should be independent and not rely on subsidies; it should be subject to commercial auditing standards without exceptions; and its capital should be sufficient — the capital adequacy ratio being the core constraint on its balance sheet expansion and health. Hence, it was seen that the CDB and Ex-Im Bank later supplemented some of their capital.

In 2015, the state formally clarified that the CDB is a developmental bank, while the Ex-Im Bank and the Agricultural Development Bank remain policy financial institutions. When international debt restructuring involves governmental credit rights, there is a discrepancy in understanding, both domestically and internationally. Initially, the CDB and Ex-Im Bank were lumped together internationally as government credit institutions, but after repeated explanations, the CDB was dissociated, and its project financing was not considered governmental.

Recently, domestic classifications and verifications of CDB and Ex-Im Bank loans have been made to distinguish which are policy-based and which are proprietary.

Theoretically, the government should underwrite the policy-based loans, i.e., bear the ultimate risk of loss; proprietary loans, however, are not underwritten by the government. But when underwriting is needed, there might not be sufficient fiscal strength to do so. If such divisions are made retroactively, it creates a significant amount of gaming among the players. One side, the ultimate bearer of the loss, does not want to identify too high a proportion of policy-based operations, while the financial institutions themselves hope to identify a higher proportion for an easy write-off.

It’s not hard to imagine that if the CDB and Ex-Im Bank declare how many loans are policy-based, they might inflate the figure. But if other government departments are to assess it, since the government has to underwrite and bear the loss, they would aim to minimize the figure. For the recognized policy-based loans that were indeed mandated by the government, can the finance reimburse them when risk losses occur? If the government underwrites them, and the write-offs are done without affecting the banks’ performance assessments, ratings, or capital.

Similar issues were encountered during commercial bank reforms. For instance, when a bank had undertaken some special task loans and incurred losses and during financial restructuring had to prove whether it was ordered by the government to do so, it would produce evidence such as phone records or IOUs, without any formal documentation to back up the claim. Because the amounts were not considered large at the time, they were acknowledged as having government-backing without further deliberation. Therefore, the post hoc determination of the proportion of policy-based projects is a process of gaming.

In view of this, a good approach would be to establish separate policy-based and proprietary institutions in advance, to prevent shirking responsibility and moral hazard, post-hoc gaming, and make system easier for the international community to understand.

Moreover, from international trends, we can observe similar evolutions.

Firstly, the liabilities of multilateral development organizations such as the World Bank initially relied heavily on public allocations from member countries but later evolved to increasingly rely on their own high credit ratings to issue bonds in the market. Consequently, their debtors are no longer primarily governments, rather their proportion of fiscal contributions has been decreasing. Such institutions highly value their own credit ratings.

Also, multilateral development banks internally categorize their subsidiaries: determining which entities handle concessional business and which handle private capital business.

For example, within the World Bank Group, the International Finance Corporation (IFC) manages private financing, which is required to be profitable and not incur losses. The Inter-American Development Bank, the European Bank for Reconstruction and Development, and others have also established similar internal units. Thus, for institutions like China’s Ex-Im Bank, if there is no institutional distinction and only internal account management and classification accounting, domestic regulatory, fiscal, and development departments may understand what it means in separating policy and commercial operations. However, externally, since it’s under one brand, it’s difficult to explain the distinctions and easy to criticize.

In summary, through concerted efforts, the CDB’s BRI project loans have been clarified to be outside of government business. While the Ex-Im Bank, as a nominal government export credit institution, counts only a portion of its project loans are government business, but that is not yet recognized clearly. There are still many controversies and disputes when some of the bank’s claims involve restructuring and debt relief.

It is necessary to understand that past policy designs that were not well thought out can lead to certain consequences later on, making it difficult to find a good way forward without addressing past issues.

Next stage of BRI

Finally, let’s talk about issues worth noting and studying for future BRI investment and financing.

The ratio of debt to equity in developing countries

Some developing countries have certain issues with financial governance, issuing too much sovereign debt, providing too many sovereign guarantees, or making too many quasi-sovereign commitments, leading to high leverage and excessive debt. It’s necessary to continuously improve financial governance and not create excessive moral hazard.

These existing issues share some similarities with China’s early stage of development, when there was too little internal equity funding, also described by some as a lack of original capital accumulation. With limited equity funding, debt naturally accumulates. It’s necessary to encourage equity financing. In China, during the early stage of development, there were favorable policies to attract foreign investment and establish foreign-funded enterprises to support the entry of equity capital.

After introducing equity financing, another benefit is the reduction of abnormal government intervention and other conditions during the entire construction and financing process.

For example, when building a railway for a country, everything may be well designed, planned, and estimated, but problems can arise during construction. During land acquisition, locals may demand more money, and local officials may shirk responsibility. This can lead to inflated costs and compromised repayment capabilities. On labor, local officials may require hiring more locals, but if skills are substandard, or language barriers impede efficiency, it can also increase costs and prolong construction. Even if the construction is finished, freight and ticket pricing can be problematic, as locals face populist pressures and may set distortedly low prices, turning a well-studied and reasonably profitable project into one with low returns or even long-term losses.

If there is equity investment involved, usually, there are regulations to provide foreign investors and external equity with certain decision-making power and operating conditions, including pricing rights and exemption from red tape, which cannot be changed casually. So, equity investment also has practical benefits.

Equity investment can also be divided into before and after models. The before model decides from the start to involve a certain proportion of equity capital, then the debt-to-equity ratio becomes more rational. The post model refers to initially arranging financing as debt, but later, due to difficulty in repayment or even facing default, while the project itself still has financial potential, opting for debt-to-equity swaps, transferring certain management and operational rights to the other party, and thereby creating a foreign-invested or joint venture company.

The effectiveness of some infrastructure projects largely depends on the surrounding development level. For instance, if a port is built with loans and repayment becomes difficult due to uncontrolled costs, establishing a processing zone nearby can enhance port utilization and repayment capacity. However, this requires subsequent funding, and the challenge is, if the previous debts are unpaid, who would want to join in developing a processing zone? In such cases, if there is an acceptable debt-to-equity swap plan, some of the debt can be converted into direct equity investment, and the equity holders must consider improving management and supplementing with follow-up investment to revitalize the project.

However, due to the current smearing of China in connection with BRI, debt-to-equity swaps are easily described as pre-designed “debt traps,” with the original intention of letting the other party borrow heavily and fail to repay, eventually transferring control. To address this, people design time-limited, phased debt-to-equity swaps, emphasizing that they are only responsible for management and operation within the period, after which redemption occurs.

A similar method is the build-operate-transfer model, where the constructor operates for several years, usually decades, to ensure efficiency and cost control before transferring back control. This has certain similarities to phased equity arrangements and is slightly less susceptible to smear campaigns.

Residential buildings under construction in Egypt’s New Administrative Capital project. Photo: VCG　

Issues with multilateral debt mechanisms

China unequivocally supports multilateralism, but when it comes to debt issues, to what extent are the rules of multilateral mechanisms actually established? In fact, there is quite a gap. Practical cases are constantly changing, and rules are still evolving. Multilateral mechanisms dealing with debt distress still have many unresolved issues, and there is no shortage of criticism and new suggestions. China needs to actively participate in the discussion and creation of these rules in accordance with the spirit of multilateralism, to avoid being passive later due to a lack of initial enthusiasm. Of course, this requires strengthening research on relevant topics.

Expanding the use of bond financing

From China’s perspective, it should learn from new changes in global financing trends, appropriately reduce the use of institutional loans and make more use of the bond issuance. It should also engage more with regional development banks for investment and financing. As long as the project is good, the required financing can come directly from Chinese financial institutions, multilateral financial institutions, and issuing project bonds.

China has a comparative advantage in undertaking projects with low costs and high quality. Thus, the design, construction and equipping of projects are likely to be undertaken by China. Multilateral mechanisms are not simply about complying with rules; they also include the rational use of multilateral rules, which still require in-depth research, discussion and advancement.

Using resources to repay loans is not a bad thing

In reality, various natural resources, including mineral and hydraulic resources, are unevenly distributed across the planet, with some places being more endowed than others. Trade these is both normal and appropriate. Due to its high population density, China, despite exporting a large amount of resources, also needs to import many resources and thus pays attention to investing in certain related industries globally. This is a normal part of globalization, and the exploitation of resources should not be construed as a negative.

Green investment and financing

Looking at the overall trend, a key point of the future will be green investment and financing. China currently has certain strengths in this area, exhibiting leading advantages in manufacturing and construction of solar panels, wind power and nuclear power, and is also forging ahead strongly in electric vehicles and electrochemical energy storage. Xi pledged in 2021 that “China will vigorously support the green and low-carbon development of energy in developing countries and will no longer build new coal power projects abroad,” so, developing green financing for the BRI is very important. Preparations can be made in advance, through design, research and analysis, to make BRI investment and financing greener and more effective than before.

A 100-magawatt solar power plant in Kopolszburg, Hungary, is one of the key projects of cooperation between China and the European country in the field of clean energy. Photo: Xinhua　

Currently, domestic financial institutions seeking high-quality investment and financing opportunities domestically, will inevitably look to the international market, especially along the BRI. While some Westerners clamor about “decoupling” from China, recently changing to “de-risking,” the current external conditions facing Western markets are not so favorable. Thus, even more attention should be paid to the countries along the BRI. There are many opportunities in the BRI, and if China seizes them and leverages its advantages in production capacity and funding capabilities, it can create jobs at home and in BRI countries. Properly addressing and handling debt distress is an aspect of BRI research that cannot be overlooked.