Between the lines: new reports offer a peek into Chinese policy banks

Research teams at Chinese and international institutions collectively shed light on the practices and thinking of CDB and Exim Bank.

In the past few weeks, reports released by teams at UNDP, China Development Bank, the Boao Forum for Asia and NRDC-Tsinghua University open windows into the operation of China’s policy banks when it comes to overseas financing.

None of the reports, even those compiled by China Development Bank itself, are particularly revealing in their description of practices and policies of the state controlled banks, underscoring the general opaqueness of those financial institutions. Most of the information presented in the reports is based on already published materials (policy papers, case studies, news reports etc), and only the Tsinghua University team’s report involved interviews with policy bank executives, providing fresh, first hand information on the banks’ sustainability policies.

Nonetheless, in this desert of accessible information on Chinese state actors, the reports’ compilation of information on the banks’ operations provides some interesting additional insights into how the two policy banks attempt to align their investments with Belt and Road goals and the global sustainability agenda, if you read carefully between the lines. In particular, we get a sneak peek into their differing approaches to environmental and social standards, and how loans for risky but much needed development projects are made secure, at least from the banks’ perspective.

Policy Banks on the Belt and Road

There is already an existing literature on the roles played by China’s main policy banks, China Exim Bank and China Development Bank(CDB), in China’s overseas industrial build-up. It is still worth highlighting, however, the distinctive roles of the two banks, as described in the UNDP-CDB “Harmonizing Investment and Financing Standards towards Sustainable Development along the Belt and Road” report (hereafter as “UNDP-CDB report”). CDB, being the world’s largest national policy bank, offers mainly mid-to-long term non-concessional, commercial loans on the Belt and Road, while China Exim Bank provides mostly concessional loans and export seller’s/buyer’s credit based on market interest rates. According to the UNDP-CDB report, by the end of 2018, CDB had provided financing for over 600 Belt and Road projects with accumulated value of USD 190 billion (USD 105.9 billion still outstanding). The Exim Bank’s Belt and Road portfolio is larger in size, with outstanding loans over 1 trillion RMB (about USD 143 billion) spread across 1800 projects.

A key observation made by the UNDP-CDB report is that loans still occupy a dominant share of Belt and Road financing, as opposed to equity investment. This may be due to the fact that most Chinese financial participants of the Belt and Road Initiative are banks, whose mandate is to provide lending (especially for commercial banks). Nevertheless, the UNDP-CDB report notes that Chinese financing may have also tilted toward loans for their relatively low risk and ability to pool resources for supporting large projects, while equity investment involves longer term exposure to risks over the entire lifecycle of projects and higher transaction costs. But, as a previous blog post on this site has shown, this preference might be changing for some Chinese Belt and Road players as they become more attracted to the higher and sustained return of projects funded through equity investments.

Policy Banks on the Belt and Road
Source of information: UNDP-CDB report

BRI’s heavy infrastructure focus means that the banks’ Belt and Road portfolios tilt heavily towards energy, transportation and construction, with the energy sector the largest recipient of bank financing. The go-to data source for BRI researchers – even for established and connected Chinese research teams, such as at Tsinghua University – Boston University’s Global Economic Governance Initiative shows that coal makes up the majority of the two bank’s BRI financing between 2000 and 2017, followed by oil and gas financing.

Sustainability, Sustainability, Sustainability

One question that observers of the BRI often have is how come Chinese policy banks, despite a domestic emphasis on sustainable development, continues their funding of overseas projects with questionable sustainability, both environmentally and financially. Many analyses approach this question by looking at the banks’ “safeguard policies”, i.e. to what extent can mechanisms at the banks rule out financing “bad” projects. But an interesting insight from the NRDC-Tsinghua report “Research on Green Investment and Financing Standards for Policy Banks in the Belt and Road Initiative” (hereafter as “NRDC-Tsinghua report”) is that domestically, Chinese policy banks, particularly CDB, approach sustainability not so much from a safeguard point of view, but rather from an industrial policy point of view. China’s “green banking” policies are essentially an extension of the central government’s industrial policy. Its central components are sector-specific or client-specific credit guidelines. Through those sector-specific policies, CDB systematically channeled more than RMB 1.6 trillion (about USD 229 billion) into supporting China’s domestic green transformation agenda, which involves the set-up of low-carbon cities and smart cities, pollution control and environmental rehabilitation, renewable energy development and circular economy. In the process, CDB sets up a regular communication channel with the Ministry of Industry and Information Technology (MIIT), a key maker of Chinese industrial policies, to screen and create a pool of bankable industrial energy saving projects.

Without the same level of industrial policy coordination and strategic guidance, Chinese policy banks have a much less clear green mandate when financing overseas, and have to resort to basic safeguards based on host country policies. According to the NRDC-Tsinghua report, this approach has clear limitations. The idea of deferring sustainability standards to host country regulations seems to have been deeply rooted in the thinking of bank executives. The NRDC-Tsinghua team’s interview indicates that those executives are fully aware of the “strictness of environmental and social safeguards developed by the World Bank and Inter-American Development Bank”. But they also believe that strict standards “limit where banks can go in terms of their businesses”, as they require too much on the side of the recipients. These executives nevertheless conceded that when local standards “prove inadequate”, they are willing to bring in Chinese standards (if more robust) as a stopgap. The rationale for applying Chinese standards is to elevate their global acceptance for future technological exports.

The deference approach also applies to grievance mechanisms, where Chinese policy banks demonstrate a clear preference for complaints to be directed to recipient country authorities rather than themselves. Addressing the issue of deference, the UNDP-CDB report recommends governments and financial institutions to assess host country standards and identify countries lacking the ability to implement standards or those lacking standards altogether. Based on such assessment, capability enhancing efforts can be made in the form of technical support or modest grant financing. “Defer to the host country on standards that are already aligned with best-practice standards,” the report prescribes, “but work with the host country to boost implementation, compliance and monitoring capabilities.” This approach can “substitute practices received with limited enthusiasm”, a subtle criticism by report authors of the Bretton Wood institutions’ “conditionality” methods.

Both the NRDC-Tsinghua report and the UNDP-CDB report outline how environmental and social review is embedded in the policy banks’ internal procedurals, with slight differences, as shown in the table below. Before delving into the table, one should note that neither bank currently has dedicated offices or teams to handle environmental and social standards. The safeguard is therefore scattered ( or “embedded)” in bits and pieces across the banks’ due diligence and approval processes without any overarching overseers of how green their lending is. Interviews by the NRDC-Tsinghua team also shows that Chinese bank interviewees have little comprehension of the “Environmental and Social Covenant” approach commonly practiced by international development financial institutions, which would put clients’ environmental and social commitments into loan agreement to become legally binding.

Policy Bank ESS
Source of information: UNDP-CDB report and NRDC-Tsinghua report

The above table might give the impression that safeguards are available and working at the Chinese policy banks, as the banks themselves often argue. But as report writers pointed out, the reliance on recipient country standards mean that in regions with weak governance, such as Southeast Asia, poorly-designed projects might get greenlights. And the lack of a central policy, a dedicated staff and clear project-level standards for environmental and social issues means they are at the risk of being treated as secondary concerns at each of those steps wherein their consideration is supposedly “embedded”.

Green Loan

If the bank’s safeguards seem a bit underwhelming, the Boao Forum for Asia’s “Belt and Road Green Development Case Study” report (hereafter as “Boao report”) brings to the fore interesting details of a solar mill project that CDB financed in Zambia. At Panda Paw Dragon Claw we love graphs and flowcharts that illuminate the workings of Belt and Road actors. The Boao report did a nice job of drawing the below diagram of the parties involved in the CBD solar mill loan:

Zambia Model
Source of diagram: Boao Forum report

Based on the report authors’ description, Zambia’s hydro-powered mills for cornmeal, a staple food for the country, faced curtailed power supply due to a lack of rainfall in 2014, leading to rising food prices. President Edgar Lungu launched the Presidential Solar Milling Initiative to construct 2000 solar mills around the country to ease the pressure on cornmeal supply. The initiative, with a total estimated cost of USD 200 million, was financed through a CDB loan worth USD 170 million. The rest would be paid by Zambia itself.

Despite its green merits – the mills are solar powered and have a public livelihood objectives at its core – the loan also has clear CDB features. Based on the description of the report and news reports from Zambia, the loan appears to be non-concessional (interest rate is unknown), although CDB waived all other fees associated with the loan. It is sovereign guaranteed from Zambia’s Ministry of Finance. A Chinese EPC contractor gets the contract to build the solar mills. And Sinosure, China’s policy insurer, provides mid to long-term insurance for the loan.

Touted as green finance, the loan nonetheless shows both the advantages and limitations of CDB debt financing. Zambia is considered “high risk” in World Bank/IMF’s debt sustainability assessment, and would be advised to avoid or limit non-concessional borrowing. This may restrict the country’s ability to raise funds from international lenders, making CDB’s offering highly attractive. (In cases like this, multilateral development banks would only offer concessional loans with very low or zero interest. And market rate lending will be made to private companies without sovereign guarantee.) While the solar mills may be fulfilling a genuine development need and have a viable future revenue stream (local cooperatives would pay to use the mills), a non-concessional loan inevitably adds to the overall financial stress of a country whose 2018 debt stock stood at USD 10 billion. On the China side, CDB has thoroughly risk-proofed its loan (sovereign guaranteed and Sinosure insured) and the Chinese EPC contractor will reap the benefit of a major construction deal. But Zambia has to figure out how to make the project work in the next 15 years so that the loan can be serviced.

In Zambia, there are already signs of trouble: the President has openly expressed dismay that some of the solar mills have become “white elephants” and is urging provincial officials to take action. Vandalism and theft (of solar panels) also plague the project. “Government borrowed money which has to be paid back with interest,” says Zambia Daily Mail, “Zambia cannot afford to waste resources in that manner (referring to the non-working solar mills).”

If providing financing and construction help get projects like the solar mill initiative off the ground, there is still a distance from a true “win-win” if one side bears a disproportionate risk of project failure while the other side enjoys the safety of near-term benefits.  If the latest reports collectively highlight one thing, it is the disproportional burden Chinese financing is putting on the weak shoulders of its Belt and Road partners, be it environmental governance or debt sustainability. If BRI is to be genuinely “mutually beneficial”, fine tuning that risk-benefit equation would be a first step.

Empty trains on the modern Silk Road: when Belt and Road interests don’t align

China’s provinces are sending empty freight trains to Europe. Chinese media explains why.

China is sending empty freight trains to Europe through one of its key Belt and Road Initiative (BRI) projects: the China-Europe Railway Express. The bizarre phenomenon caught the attention of Depth Paper (等深线), a Chinese online news platform. In a rare move by a Chinese media outlet in today’s media environment, Depth Paper probed critically into one of the BRI’s most visible “connectivity” projects, uncovering the perverse incentives that are luring China’s local governments and companies to create huge “bubbles” of ostensibly flourishing rail routes that run tens of thousands of kilometers across the vast landmass of Eurasia.

The revelation partly confirms what some observers have suspected all along: that China’s central government lacks the ability to keep BRI strategically tight and coordinated. Sub-national stakeholders, as they do in other policy areas, have the incentives to bend the initiative to their own narrowly defined interests and in the process undermine the overarching strategy, if such a strategy indeed exists at all. The curious case uncovers some important dynamics playing out among Belt and Road’s diverse stakeholders.

China Railway Express
Depth Paper uncovered the perverse incentives that are luring China’s local governments and companies to create huge “bubbles” of ostensibly flourishing rail routes that run tens of thousands of kilometers across the vast landmass of Eurasia.

The China-Europe Railway Express

Transporting goods between China and Europe through railroads is not a common choice for traders. Up to now, it only makes up 4.8% of the total bilateral trade volume, far behind commodities moved by sea (68%) and air (19.4%). For many years, the China-Europe rail routes were interrupted by the fragmented customs, quarantine and taxation regimes of countries along the way. As a rail transport agent in west China told Depth Paper, sending cargo to Germany through rail was unimaginable as recently as 1997. “Central Asia was as far as we could go.”

But, according to the report, things changed about a decade ago. Years before the advent of the Belt and Road Initiative, the instigator of this change was in fact the American computer company Hewlett-Packard. In 2009, as the computer giant negotiated a major investment deal with Chongqing, the city on the upstream Yangtze River with no easy access to a sea port, it included a condition that it should be able to transport its products to the European market by train: westbound directly from the city, instead of first going east to the sea. The Chongqing government accepted the condition and after two years, the Chongqing to Duisburg rail route was made navigable, allowing HP to ship to Europe in a relatively low cost (compared to air transport) and speedy way (compared to shipping by sea).

Before 2013, the year when BRI was formally announced, a few other freight rail routes were made possible by such bottom-up commercial interests. The city of Wuhan in central China, a major base for car manufacturing, developed Wuhan to Europe routes upon which half of its car outputs now depend for transportation. Similarly, Yiwu, the light industry powerhouse of Zhejiang province, opened up its own rail route to ship large quantities of small commodities, from garments to needles, to Europe. Ironically, those early trials, mostly developed by landlocked Chinese municipalities, received little central government support around that time. According to Depth Paper, China’s railway administrators even charged a fee for the extra burden those freight lines created. Its attitude toward such initiatives would make a 180 turn after BRI came into being.

2013 saw the creation of BRI and the incorporation of China-Europe rail links under the umbrella of Xi’s signature initiative as a key connectivity component. As China’s 2015 Vision and Strategy document for the BRI declared the intention of building the rail routes into a “brand name service”, the number of routes began to explode. Dozens of Chinese cities, including those on the east coast with easy access to ports, joined the bandwagon of rail transportation.

China Europe train routes
Planned train routes from China to Europe through Central Asia/Russia, source: NDRC

Growing bubble

In 2016, the National Development and Reform Commission (NDRC) laid out a five year plan for the expansion of westbound rail routes. And China’s railway planner published a blueprint document on building up the brand reputation of China Railway Express. China State Railway Group Corporation, which used to be the railway ministry, began to highlight the growth of Europe-bound voyages as a major achievement.

The elevation of the freight service in political importance created powerful incentives for players to “rig the game”. Depth Paper reveals two groups of schemers in the game:

Provincial and local governments: As the number of freight trips to and from Europe become a measurable indicator, local governments, particularly those sitting at key railway hubs, saw a clear opportunity to boost their visibility under the BRI (and probably to the leadership). At their disposal were subsidies to lower the cost of freight services and make them competitive with cargo ships.

The Ministry of Finance provides a guiding subsidy ceiling of 0.8USD/container/kilometer. But ambitious local governments circumvent it by inventing all kinds of additional rewards to lure businesses to their train terminals, sometimes even compensating for the extra mileage of truck transportation to bring containers from thousands of kilometers away. According to a chart collated by Sino Trade and Finance, many municipal government offer around 3000USD per container for a one-way Europe bound trip and a whole train could receive a total of 123,000USD worth of subsidies per trip. These local governments also use tax rebate and land use subsidies to sweeten the deal for freight service companies.

International railway service companies: Competition with each other and pressure from local governments eager for BRI visibility has incentivized the companies who actually run the numerous rail routes to Europe to increase the number of train trips. Every month these companies have to book planned trips from the railway regulators and get what is called a “route slip” that permits them to run those trains. The ratio of actual trips to the applied number is called  “realization rate” that regulators use to monitor rail capacity utilization.

The interplay of these incentives drives both groups to boost indicators that make them look good in this game, creating scenes that are outright bizarre. The government of Xi’an is one of the most active players starting from 2018. The city, 1000 kilometers to the west of Beijing and the former capital of Tang Dynasty more than a millennium ago, considers itself the “starting point of the ancient Silk Road” and strives to restore its glory in the Belt and Road era. With full support from its provincial bosses, it is the most generous with subsidies, dwarfing other provinces by a wide margin. “Subsidized per container transportation price from Xi’an is constantly below RMB 8500, while it costs over 20000 RMB from Shandong,” a trade agent told Depth Paper.

The subsidies are of the scale that they bend the gravity of trade. In the most extreme cases, traders in the far west Xinjiang Autonomous Region, which already borders Central Asia and is itself a Belt and Road rail hub, would move their cargo thousands of kilometers to the east to capitalize on the Xi’an government’s free handouts before transporting west across the Eurasian continent. Similarly, traders in coastal Shandong provinces would truck their goods all the way to Xi’an and load them onto trains, as it is cheaper even after taking into account the 5000 RMB per container transportation cost by truck (for which the Xi’an government also partially remunerates). The result is that Europe-bound freight train trips from Xi’an grew by a whopping 536.6% in just one year from 2017 to 2018.

The railway service companies, on the other hand, blow up their trip numbers even when they have very little to ship. Before Xi’an arrived on the scene in 2018, the competition between Chongqing and Chengdu, two nearby cities, was so fierce that the two cities would refuse to merge cargo loads back from Germany despite neither being able to fill a whole train themselves. When the pressure (and reward) to be the top railway service company facilitating “Belt and Road” trips to Europe becomes huge, the companies simply start loading empty containers to their trains. They must ensure that each train meets the regulator’s 40-container minimum before it leaves the station, but there is no obligation and no ability (for lack of demand) to fill those containers.

In the most extreme case, one train carried 40 empty containers and just one full container all the way to Europe. This makes the China Railway Express’s impressive growth number highly dubious, and most certainly a “bubble”. Even with all their tricks, companies can barely fulfill their promise to regulators: they have overbooked railway resources. In Q2 of 2019, Chongqing’s “realization rate” dipped to as low as 64% for some routes.

BRI undermined

Artificially enabled transportation routes are more of a disruption to than facilitation of trade, as China’s policy makers are slowly but painfully beginning to realize. Subsidies are both unsustainable and capricious: “Sometimes a city changes a Party Secretary and the new boss has other priorities for his budget.” This makes it hard for businesses to make long term plans and build China Railway Express into their logistic strategies.

Heavy subsidies also encourage opportunistic behavior that runs against the original intention of the policy. “[Subsidies] are supposed to help first-time users overcome initial transition difficulties and cultivate user acceptance of freight rail as a reliable means of transportation”, says one anonymous Liaoning provincial official to Depth Paper. “[But] what Xi’an does can hardly nurture real needs. Traders will go back to sea and air as soon as subsidies disappear.” The official also warns that such unpredictability and fluctuation would hurt the China Railway Express’s reputation overseas and permanently scare clients away.

The Ministry of Finance is reportedly determined to pierce the bubble by enforcing a schedule for phased subsidy reduction. Subsidies by local government are to be no more than 40% of a route’s total cost in 2019. The ceiling will be further lowered to 30% in 2020 and zero by 2022. The Ministry is hoping that by then the trains running up and down routes would be completely market driven and China Railway Express will stand on its own two feet.

The episode reveals the fundamental difficulties for China’s central leadership to implement its vision by reducing it to seemingly measurable indicators and supposedly workable incentives that mobilize local players to participate in a central government cause. Distortions and outright undermining of central government agenda happens with GDP numbers, air pollution targets, and other domestic issues. BRI is no exception.

It also calls into question a key underlying assumption of the BRI, that the power and “deep pocket” of the Chinese state can overcome problems that the market cannot solve when left alone. Trade flows, it turns out, are not easily bendable by the sheer will of the state. It is a rare occasion for a Chinese media outlet to so directly call out systemic problems in Xi Jinping’s signature initiative. As China embarks on other overseas adventures that premise on the ability of state capitalism to shift the center of gravity of global trade (through new ports and rail hubs), the troubles of China Railway Express should serve as a cautionary tale of the limits of state power.

Additional food for thought… when personal guanxi is more important than national strategy

CDBCaixin
Caixin’s frontpage story about the corrupt deeds of disgraced former CDB president Hu Huaibang

In another example of Chinese media exposing the “underbelly of BRI” , on August 3, Caixin Media published a frontpage story about the corrupt deeds of China Development Bank’s former President Hu Huaibang, who was recently investigated by the disciplinary arm of the Communist Party. The report, which has since been taken down from Caixin’s website, contains jaw-dropping, mind-boggling details of how recklessly senior officials of China’s largest policy bank (and a major instrument of the BRI) pursued their own interests at the expense of the bank’s financial health.

Hu’s tenure at the CDB (2013-2018) overlaps with the inception of the BRI. But according to Caixin, he was never much into the bank’s international adventures, which got expanded substantially under the leadership of Hu’s predecessor Chen Yuan. Hu reportedly shrank the bank’s international presence by cutting its commercial banking businesses overseas and only involved the bank with overseas financing when directed to by the top leadership (e.g. at deal signing ceremonies during state visits). The revelation somewhat shatters outside impression that CDB has been masterminding China’s BRI financing strategies, as one source told Caixin: “CDB almost never proactively sought overseas financing opportunities under Hu.”

Instead, Hu concentrated his political resources on two major clients: HNA Group and CEFC, both were offered exceptionally generous credit lines from CDB (at least 80 billion RMB for HNA Group, 42 billion RMB for CEFC). In both cases, Hu Huaibang rammed the deals through the bank’s internal risk management and gatekeeping mechanisms. In the face of resistance, he did not hesitate to replace officials who dared to disagree. The payback to his family members and political allies was fat, which, at one point, supported Hu’s unsuccessful bid to take the helm of China’s central bank.

As both companies later got embroiled in scandals in 2018 (CEFC founder Ye Jianming was detained in January and HNA Group’s chairman Wang Jian died in France in July), CDB faced the prospect of tremendous loss. HNA Group is reported to have accumulated 40 billion RMB of overdue loans to the bank, while the exposure to CEFC would cost CDB at least another 20 billion. Whether this will dampen the bank’s appetite for increased BRI involvement is unknown. But the Caixin report opened a rare window into the inner workings of arguably the world’s most powerful policy bank, and what it depicts is troubling.

With Belt and Road a top priority in Chinese foreign policy, space for calling out its flaws and problems is inevitably being curtailed. That makes reports such as Depth Paper’s and Caixin’s all the more remarkable, and all the more valuable for Belt and Road Watchers.

 

Assessing China’s most comprehensive response to the “debt trap”: the Belt and Road ‘Debt Sustainability Framework’

Ma Xinyue argues that debt financing along the Belt and Road is as much a “trap” for debtors as it is for China

One of the most significant and anticipated outcomes of the second Belt and Road Forum held in Beijing this April, was the Debt Sustainability Framework for Participating Countries of the the Belt and Road Initiative (BRI-DSF) issued by China’s Ministry of Finance (MOF). Developed on the basis of the IMF/World Bank Debt Sustainability Framework for Low Income Countries (LIC-DSF), the framework offered some response to the barrage of accusations of China’s use of “debt diplomacy” along the Belt and Road.

Behind the politicized and moralizing tone of the “debt trap diplomacy” narrative is a question over “debt sustainability”, a question which concerns the economic health of both borrower and lender. Before labeling China’s Belt and Road financial behavior as a “trap,” this complex issue deserves diving into.

This prompts us to ask some sets of questions. Firstly, is China actually creating debt sustainability issues? If so, what’s the scale and nature of the problem? Secondly, how does the BRI-DSF absorb and differentiate from the existing debt sustainability frameworks? How sound is this framework? And lastly, what is the implication of this framework on China’s overseas presence? Will it solve the problem and alleviate risks of debt sustainability? If not, what else does it take?

“Debt trap” or “creditor trap”?

China’s debt financing to other countries in the world have mounted since the end of the financial crisis in 2009. In the energy sector alone, China Development Bank and the Export and Import Bank of China have lent $245 billion to other countries between 2009 and 2018, based on calculation from Global Development Policy Center. A newcomer to the scene of development finance, China indeed brings striking volumes of loans and investment.

The “debt trap diplomacy” narrative interprets China’s overseas finance behaviors as state-driven political leverage to gain influence over other countries by bankrupting its partners and bending them to its will (see for example, John Pomfret’s 2018 opinion piece in the Washington Post). A “snappy phrase invented by an Indian polemicist”, as Chas Freeman, the former U.S. diplomat to China puts it, the narrative has been popularized by media and politicians, especially in the U.S., criticizing the Belt and Road (e.g. Mike Pence, 2018; John Bolton, 2018). The most frequently referred to case is the Hambantota Port project in Sri Lanka, which was handed over to a Chinese company on a 99-year lease. Concerns about Chinese loans have also been raised in regards to the Maldives, Pakistan, Venezuela, and many more.

Such arguments have been refuted by the Chinese government as well as some recipient country governments. Both the Central Bank of Sri Lanka and Government of Pakistan that these two countries’ debt to China are only about 10% of their external debt, a fair share of which are concessional loans lower than market rates. Officials from the Philippines, Uganda, and Sri Lanka – to name a few – have also publicly defended their debt from China. Some scholars have also exposed the narrative.

The Center for Global Development – a Washington D.C.-based think tank – made the first systematic attempt to assess the debt implications of the BRI. Using a list of BRI lending pipeline deals compiled from public sources, they estimated immediate marginal impact of potential BRI projects on countries’ debt to GDP ratio – a “worst-case scenario of future debt,” and identified eight countries where debt to China might push their debt to GDP ratio beyond thresholds of 50-60% of GDP. It also listed a compilation of debt renegotiation and relief given by China since 2000, which were further explored by reports from Rhodium Group and Oxford Africa China Consultancy – even though the debt cancelation is said to have only been for overdue zero-interest loans, which are part of China’s foreign aid program.

The China-Africa Research Institute at Johns Hopkins University (SAIS-CARI) and the Global Development Center at Boston University (BU-GDP Center) published similar but empirical analyses of the debts of Africa and Latin American and the Caribbean countries to China based on their debt profiles and recorded debts to China. These reports found that, in the majority of cases, debt to China takes up a small share of countries’ total public debt, although in a handful of debt troubled African countries (Zambia, Djibouti, for example), debt to China does take up a significant share of their external debt, and they are also among the biggest borrowers from China.

Xinyue Figure 1 v2
Figure 1. Changes in PPG debt by source for Bolivia, Ecuador, Guyana, and Jamaica 2004-2016, Source: Rebecca Ray and Kehan Wang’s calculations using Gallagher and Myers (2019), World Bank IDS and MDB annual reports

The shared conclusion from these reports is that BRI will not likely be plagued with widescale debt sustainability problems, even though it is also unlikely that the initiative will avoid any instances of debt problems among its participating countries. A more recent working paper published by the World Bank also attempted to evaluate the long term debt dynamics impact of China’s loans, taking BRI investment related growth into account. Availability of credible data remains a constraint for these papers. Yet of the 30 countries included in their long-term debt dynamic simulations, in only in 2 countries BRI debt financing would result in increasing debt vulnerability.

Worth noting, however, is that debt relief and restructuring is both relatively common (recorded instance of relief so far reach $9.8 billion) and tends to favor the borrower country. In this light, the “debt trap” might seem more of a “creditor trap” for China than for the borrowing countries, as Stephen Kaplan puts it when analyzing the case of Venezuela. Indeed, from a geopolitical perspective, it is strategic for China to hold leverage in security choke points in case of fundamental disruption of global stability or an outbreak of war. However, financial leverages do not automatically translate into political leverages. Venturing to confiscate its debt-financed assets would mean risking all credibility and reputation for any other international engagement.

On the contrary, China faces more risks giving away debts in financially vulnerable countries. In cases of real financial distress such as Venezuela, China’s debt renegotiation might come with more loans issued in the same country in the hope of generating revenue and recovering the previous loans. Deutsche Bank was recently reported to have confiscated 20 tons of  gold that backed Venezuelan debt, but we don’t see Chinese financial institutions making similar moves.

The Challenge for Development Finance

Public debt financing is a common practice in all countries across the world, even though typical practice of each country varies by a great deal. For example, according to IMF, as of 2017, the general government debt to GDP ratio ranges from 9% (Estonia) to 238% (Japan). As stated in the Addis Ababa Action Agenda, borrowing is an important tool for financing investments critical to sustainable development and covering short-term imbalances between revenues and expenditures. Government borrowing can also allow fiscal policy to play a countercyclical role over economic cycles.

Nevertheless, whether high debt to GDP ratios have an impact on a country’s economic performance is much-debated. Most economists agree that there are no certain thresholds or ideal levels of debt to GDP. Rather, it is the dynamics of debt that matters more. The simple logic of debt sustainability is that, as long as the rate of public debt increase does not continuously exceed the growth rate of the government fiscal balance, public debt is sustainable and will not affect economic activity in general.

Then comes the dilemma: given the urgent need to address the Sustainable Development Goals, public expenditure has to increase, but in many countries, the government’s fiscal space is cramped. Scaling up public expenditure requires debt finance, which in many cases would consume primary balance that could have been used for urgent public investment such as physical and social infrastructure development. But if done right, such financing should serve to strengthen the primary balance by facilitating economic and social development and by increasing tax revenue in the long run.

Debt Sustainability Frameworks for the Belt and Road

To “promote economic and social development of Belt and Road countries while maintaining debt sustainability”, China’s Ministry of Finance published its Debt Sustainability Framework (BRI DSF) at the April Belt and Road Forum. The BRI DSF is almost exactly based on the 2017-reviewed version of the IMF/World Bank framework for debt sustainability analysis.

As part of the IMF’s efforts to better detect, prevent, and resolve potential crises, the Fund introduced a formal DSF in 2002. To guide borrowing activities in low-income countries (LICs) in a more nuanced manner, the World Bank and IMF also launched a joint framework for debt sustainability assessment for LICs in 2005. The World Bank and IMF now jointly produce Debt Sustainability Assessments (DSA) for the applicable countries at least once every calendar year, and provide templates for these exercises. Chinese lenders could therefore use the IMF/World Bank assessments as a baseline to guide their activities.

The IMF/World Bank DSF – to which the BRI DSF is aligned – operationalizes debt sustainability management by assigning different thresholds of multiple debt indicators for groups of countries according to their debt carrying capacities, and provides risk ratings based on evaluations of the baseline projections and stress tests relative to these thresholds combined with indicative rules and staff judgment. The 2017 revision adjusted the thresholds with an effort to eliminate conservative bias. It incorporates more factors into the country classification methodology to estimate countries’ debt-carrying capacities.

All of these improvements are also incorporated in the BRI DSF. The only difference in the BRI DSF is in the stress test element. The BRI DSF includes an additional “new borrowing shock” stress test, adding greater stringency to the test.

Both frameworks adopt the same standards for identifying low income countries (based on their eligibility for concessional financial resources). As of May 31, 2019, 47 of the 131 countries that have officially signed BRI cooperation agreements with China are included in the List of LIC DSAs for PRGT-Eligible Countries. The graph below shows the distribution of debt stress risk ratings of these LICs from low to in distress. In addition, another 11 BRI countries not in risks of debt distress have been assigned suggested debt limits in General Resources Account (GRA) arrangements.

BRI Main map (v2)
Figure 2. Risk Profile of BRI Countries with IMF/WB Debt Sustainability Assessment, Source: IMF

For countries in debt stress or at high risk of debt stress, including some countries with moderate risks of debt stress, IMF and the World Bank would advise them to avoid or limit non-concessional borrowing (NCB) (or only accept in exceptional cases), and provide limits for concessional borrowing to some countries, leaving space for grants. For countries with moderate or low risks of debt distress, borrowing would be advised to be assessed on a loan by loan basis, with the option to request borrowing ceilings.

Of the 39 BRI countries subject to IMF/World Bank Group debt limits conditionality, 15 are subject to zero-NCB limit, 8 are subject to non-zero NCB limits, and another 16 are not subject to debt limits or have targeted debt limits, showing a rather balanced risk distribution. (Note that this does not represent the amount of loan granted to each group country, and thus does not accurately reflect actual risk portfolio of China’s overseas development finance.)

The Future with “Cautious Capital”

The DSF risk assessments already inform lending policies of other creditors including many Multilateral Development Banks (MDBs). With the issuance of the BRI DSF, China seems ready to adopt the mechanism too. For China, this is unequivocally a critical step in risk management for Chinese creditors and constructive response to the debt trap diplomacy theory.

According to very rough estimates using the available second hand compiled databases for the stock of China’s overseas debt finance, about 14% to 18% of China’s overseas development finance in BRI countries goes to LIC countries with debt limits, while the number of these countries (39) account for 30% of the BRI countries, indicating that those countries already receive less finance on average from China than non-LIC countries. Given that these estimates are based on flows of commitment rather than debt outstanding, some of these loans are likely to have already been paid off. Nevertheless, considering the sheer volume of China’s overseas finance, this would have been enough of a risk portfolio for China to manage, and also significant enough debt burdens for the recipient countries as well. Future credit making will require much prudence so as to gradually improve these situations.

Such caution has already been shown in the recent trend of China’s overseas development finance flows (See Figure 2 taking China’s overseas development finance in the energy sector as an example). Observers have witnessed a clear downward trend in China Development Bank and Export-Import Bank of China’s overseas energy finance since the peak in 2016. Where there is relatively reliable data, similar trends are also seen in the cases of all-sector official loans from China to Africa and Latin America. This trend also coincides with recent downward trends over all in the emerging markets and development countries, China’s stagnant FDI flows and overseas contracting activities, as well as strengthening domestic and cross-border financial and capital account regulations.

China overseas finance trend
Figure 3. China’s Annual Overseas Development Finance in the Energy Sector (million$), Source: Boston University, Global Development Policy Center, China’s Global Energy Finance Database

While the strengthening risk-management mechanism demonstrates China’s willingness for responsible engagement with the Belt and Road countries and better alignment with multilateral efforts, this trend also further stresses the inherent challenge of development finance, which carries the crucial function of correcting market failures and providing countercyclical financial resources while maintaining the ability to provide financial resources sustainability. As global financial regulation mechanisms such as the Basel Accords and credit rating agencies step up their scrutiny over development finance in the same way as commercial finance, it seems to be increasingly hard to channel sufficient financial resources to places and in times that need them the most – places where risks are also often higher.

Meanwhile, there is probably no perfect framework for debt sustainability analysis. As the effort of a DSF is to provide judgements about future macroeconomic dynamics in a scenario of debt stress, estimates of the discount factor and feedback effects of fiscal policies would inevitably be subjective, even if empirical analysis of historical data is full incorporated.

Moreover, a framework alone is far from enough. At the end of the day, what sustainable debt positions and sustainable development in general requires is nothing but soundness and sustainability of projects – financially, socially and environmentally. Risk management mechanisms cannot ignore project and social risks, as well as potential physical and policy impacts of climate change, which pose substantial risks to a bank’s carbon intensive energy portfolio

Instead of hindering the scaling up of development finance, risk management should enable development finance to strengthen vulnerable economies and generate multiplier effects over the long term to improve the status of public finance, and insure timely debt repayment. This is by no means an easy task, and requires coordination and trust between governments and the private sector.

Even though debt to China remains a relatively small share in the public debt portfolio of most countries, China has emerged as an important international creditor as the Belt and Road Initiative unfolds, and deserves to be part of the multilateral engagement in debt sustainability control. Meanwhile, given the challenges and imperfect nature of development finance risk management, a diversity of approaches could create healthy competition to get it right.

Xinyue (Helen) Ma is the China Research and Project Leader at the Global Development Policy Center (GDP Center) at Boston University. Ma has experience researching different aspects of China’s international investment with China’s National Development and Reforms Commission (NDRC), Control Risks, and China Daily. She received her Bachelor’s degree in International Politics and History from Peking University, Beijing, and her M.A. in International Economics and Energy, Resources and Environment from Johns Hopkins University, School of Advanced International Studies (SAIS), with a specialization in Infrastructure Policy and Finance.