24 Oct 2017
Unique Belt and Road considerations - Repaving the ancient Silk Routes
Whilst the opportunities for foreign companies to participate in B&R projects are numerous and diverse, such projects are frequently developed under conditions which are complex and often beyond a company’s control. Particularly in the growth markets in which most of the B&R projects are planned, institutional voids can prove to be very disruptive to project completion.
Foreign companies may well find their usual project management evaluation and approach inadequate amidst the institutional voids which characterise many of the countries along the B&R routes, such as inconsistency in regulatory regimes and underdeveloped credit markets.
Regulatory regime inconsistencies
Inconsistency in regulatory regimes affects many B&R projects, as many such projects are involved in monopoly sectors (e.g. power grids), or operate assets of national security interest (e.g. oil refinery and storage tanks) which require close regulations to avoid abuse of monopoly power or compromise of national interest. The investor returns are also closely tied to public subsidies for projects such as public transportation, therefore posing a direct impact on the firm’s ability to make revenue and service the loans. Given the direct and substantial impact of regulatory regimes on the projects, any inconsistency in the policy development and implementation could cause problems in project operations.
Underdeveloped credit markets
Even though China is committed to financing the B&R projects, many private investors are still concerned about the underdeveloped credit markets in many of these countries. Limited visibility for fund monitoring and the weak enforcement of contracts which is typical in a developing market can be amplified if the company gets involved in a large-scale B&R project which involves the management of a complicated and constantly-changing network of contractors and subcontractors. If not managed properly, companies risk getting trapped in a labyrinth of financial turmoil, which could eventually lead to cost overrun or even unbankability.
Therefore, acknowledging that these voids exist in a variety of forms depending on the specific growth market, it is important for companies to proactively identify, evaluate and manage the different types and scale of risks they might face when participating in B&R projects.
In this section, we will be highlighting three pertinent risks – geopolitical, funding and operational – which are most
associated with B&R projects, and how they manifest themselves.
Geopolitical dynamics have a significant influence on regulations, which play a central role in many infrastructure projects. In addition, the long gestation periods that outlast political cycles, the significance to bilateral relationships and the cross-territorial involvement of B&R projects further heighten geopolitical risks.
Long gestation period
Infrastructure projects usually take a number of years to complete and they often outlast political mandates, exposing the project to potential policy changes under different administrations. With a long asset lifetime and contractual relationship, as well as the payback beyond political terms, companies need to be assured that the government currently in power meets the commitments so that their investments will not be adversely affected by future administrations. Therefore companies need to get a good grasp not only of the regional, but also the local political goals. The positions of the opposition parties are also critical, especially in understanding what they will support and block and their goals if successful in gaining power.
It takes consistent political will with sustained focus and a positive relationship with China to see the project through. Yet political will and sustained focus remain a greater challenge for many B&R projects, which are inevitably influenced by the changing local political dynamics in the host country. Governments need to assert their efforts against adversary consistently to ensure the progress of B&R projects.
Significance to bilateral relationships
Many B&R projects play a significant role in bilateral government relationships as they are often keynote projects pivotal to the economic development of the host countries. One such example is the Standard Gauge Railway project in Kenya. The US$3.8bn project, with China Road and Bridge Corporation as the prime contractor, plans to connect the relatively large economy with a port of East African importance to a number of landlocked economies, unlocking intra-Africa trade opportunities. In another instance, Laos will be embarking on a US$6.8bn high-speed railway project as part of the B&R initiative, which represents more than half of the impoverished country’s GDP. The B&R initiative projects are therefore regarded as a much-needed investment and economic stimulus to economies distressed by depressed energy prices and weak global demand.
As China’s B&R investment addresses critical developmental bottlenecks in host countries, it is often perceived as an affirmation of the political ties between the two countries. However, these ties cannot be taken as guarantees of success. As such, these government to government agreements can potentially draw reactions from opposition parties and private sector bodies.
Aside from typical bilateral government relationship factors, the geographically expansive nature of the B&R initiative raises geopolitical concerns. Some countries have expressed concerns as to the dominant foreign ownership and presence across the different trade routes. Connectivity, the concept that the B&R initiative expounds on, was identified by India’s Foreign Secretary Subrahmanyam Jaishankar as having ‘emerged as a theatre of present-day geopolitics’. It is also noteworthy that the countries where B&R projects are planned and the nations which have concerns suffer from varying degrees of vulnerability from the lack of developed institutions and political stability.
B&R projects tend to straddle multiple territories, with the eventual objective of establishing a connection across large stretches of land and sea, and some of these projects are in the middle of cross-territorial disputes such as the Amu Darya River between Tajikistan and Uzbekistan. Therefore, given the projects’ influence on both internal political dynamics and unilateral relations, companies might see themselves in the nexus of greater geopolitical currents as the B&R projects reflect China’s relationship with the host country and its region.
Large infrastructure projects often hold a high financial risk. The high capital intensity of these projects leads to a high debt service ratio, long pay-off periods, and uncertainty of forecast demand. The challenges are often exacerbated in cross-border projects where the structuring of finance needs to take into account different currencies and national financial capacities.
Financial risk takes on a different facet in B&R projects. There are typically three main sources of global financing for B&R infrastructure – the Chinese government (mainly policydriven state funding), the host government and private institutions. Multilateral banks such as the World Bank, Asian Development Bank, and the AIIB also contribute some funds to B&R projects amongst other mandates.
To date, the Chinese government has taken on the lead financing role as many developing countries have limited means to fund the B&R projects in their country. Projects also vary in their ability to provide profitable returns.
Private funding is also still limited as many companies are concerned about the transparency of fund management, the effectiveness of the cross-border regulatory framework and the bankability of some of the projects. This funding gap therefore creates the most pertinent financial risk which needs to be addressed for B&R projects to take off.
Chinese government taking the lead
To date the Chinese government has taken the lead on B&R projects. Until 2016, there was at least US$186bn worth of investments or loans into B&R countries, of which a significant portion originates from China. However it only makes up a fraction of the potential infrastructure demand in the developing markets. PwC’s Strategy& estimates the potential infrastructure demand in the developing markets to be around US$10tn from 2015 to 2025, of which the main sources of financing identified only constitute about 2% of the financing needed to fulfil the infrastructure demand. While China might potentially increase its funding, it is unlikely to finance the B&R initiative entirely.
Host countries’ ability to pay
The host countries’ varied ability to pay is another concern. The B&R initiative is a debt-financed infrastructure development strategy. In contrast to aid packages or foreign direct investments, China’s lending plans place greater ownership of the financial risk on the recipients of the investment, most of which are developing countries with varied ability to finance them. Sixteen of the 65 countries on the B&R initiative are not rated on a sovereign basis. And of those that are rated, the countries’ creditworthiness ranges
from AAA down to B-.
The host countries’ varied ability to repay could also potentially lead to a network of interdependence guided by the exchange of resources and asset ownership. Some African countries are already approaching China to reschedule, freeze debt repayments or to pay back with resources for previous infrastructure projects.
Private funding cautiousness
Given that China is unlikely to fund the B&R initiative entirely, and host countries have varied ability to finance the projects, private capital is much needed to close the funding gap. However, the bankability of the B&R projects remains a pressing concern to the private investors. Many investors are still adopting a wait and see approach to see how the state capital will be deployed, and whether the initial investments will deliver their benefits. Private investors need to gain assurance in the transparency of fund management and the effectiveness of the cross-border regulatory framework supported by market principles to support a business case for business returns. China also needs to allay concerns that institutions might get entangled in projects where commercial logic and demand for public transportation are perceived to be secondary to political considerations. Until then, companies need to be mindful of the financial risk in many B&R projects.
Large-scale infrastructure projects are vulnerable to going off track whilst being executed with many suppliers and contractors over several years. The different legal frameworks, volatility of exchange rates, potential incompatibility of technical specifications, differences in trading terms and greater likelihood of political interference further exacerbate the challenges in multi-territorial projects. Many of these lead to risks of delay, cost overrun or even un-bankability of the projects.
These risks may be compounded in B&R projects where key stakeholders are still gaining experience in infrastructure development and international projects of the complexity of the B&R initiative. These struggles are prevalent across different phases of the project life cycles: before starting, during project delivery and after construction.
As an unprecedented endeavour that covers multiple underdeveloped territories, the B&R initiative brings many projects into new markets. It is therefore critical to appreciate how labour resourcing, construction equipment, logistics and scheduling in multi-country projects can be affected by the culture, traditions, labour productivity and technical proficiency in the host country before a project begins. However, these are often learned in retrospect. It becomes even more challenging in some B&R projects, where assessment of economic viability and project governance sometimes play a supplementary role in the larger context of the high-profile government-to-government negotiations that are taking place.
During project delivery
As many B&R projects are being built in developing markets, companies have to contend with the fluidity of business in developing markets, such as a reduced sensitivity to timelines, having agreed positions re-opened, suggested recourse at every hurdle or sudden retraction of credit lines during project delivery. The gap in international experience could potentially make it even more challenging as the Chinese SOEs and the host countries work on improving their project controls, resources allocation and communication with stakeholders during project delivery. As a result, much of a firm’s finances and capabilities can risk getting caught in myriad project lapses.
Operational risks also go beyond the capability of defining and delivering the project. In many instances, it is not possible to extract the long-term value of the investments due to gaps in the development of consistent policies and supporting institutional arrangements in developing countries, which most B&R countries are. Without the establishment of a sound strategy which prioritises catalyst projects that set the economic activities in motion, or the development of supporting facilities and local competencies to maintain the asset, the project could easily descend from hyped expectations into a debt burden.
In summary, a B&R infrastructure project is not a one-time investment. Companies need to consider whether a cohesive programme of initiatives is planned to support the project during the evaluation, or they will face greater headwinds in operating profitably. It is therefore critical for companies to remain vigilant in operational planning, because without proper management of operational risks, even strong policy and financial support will not guarantee success.
B&R holds rich promise but has associated risks. The nature of B&R projects also further accentuates the geopolitical, funding and operational risks. Only with a clear understanding of the potential risks that B&R projects operate in, can companies find the best ways to manage them.
This article was first published in the PwC report “Repaving the ancient Silk Routes” June 2017 issue. Please click to read the full article.