Belt and Road Explained: South Asia The Belt and Road in Pakistan
With USD62 billion of projects scheduled along the China-Pakistan Economic Corridor (CPEC) – equivalent to 21 per cent of Pakistan’s GDP – China’s Belt & Road (B&R) initiative stands to have a dramatic long-term impact on Pakistan’s domestic economy and businesses.
CPEC, the principal B&R initiative in Pakistan, stands to be much more than a corridor or transit route for Chinese exports and imports. It includes a range of infrastructure projects and proposed special economic zones along the route from Kashgar, China’s westernmost city, through central Pakistan to Gwadar port on Pakistan’s southwest coast. Together these could transform Pakistan’s economy.
Powering a stronger economy
Trade routes and developing Gwadar Port are focus points of CPEC, thanks to Pakistan’s geographic position at the epicentre of trade corridors from Western China to the Middle East, Africa and Europe, which in theory could make it the nexus of some USD2.5 trillion of trade flows. But it also encompasses a range of infrastructure investments to bolster the business environment, including power generation.
Shortages of power have long bedevilled business in Pakistan. Around two-thirds of the scheduled CPEC investment will be in 21 power plants,3 in a bid to end a supply deficit of around 5,000MW. Although plans to end load-shedding by 2018 haven’t come to pass, scheduled outages in main cities have halved in recent years as new capacity has come online: by the middle of this year an additional 9,000MW is scheduled to have been added, increasing capacity by 50 per cent.
Much more is being financed, built and operated by or with Chinese support. The state-owned Three Gorges Corporation (CTG), for instance, is planning three hydropower projects in north-eastern Pakistan with a combined investment of USD5.7 billion and a planned total capacity of 1,118MW. The first of these – the Kohala hydropower project – will come online in 2020.
The economic boost from additional power capacity is a clear benefit. “There are various estimates of the impact on GDP but we expect at least a 1.5-2 per cent improvement if the power shortage is addressed,” says Arslan Nayeem, Standard Chartered Head of Global Banking in Pakistan. “Three to five years ago, a lack of power was one of corporates’ prime concerns; now that’s being addressed to a great degree with enough projects coming online.”
Concerns have been raised about the nature of Chinese investment and the debt loads incurred in concessional loans to finance construction. But a shift in the nature of Chinese involvement in such projects suggests the partnership is focused on long-term success.
In the past, the role of Chinese firms in overseas infrastructure might have been restricted to engineering, procurement and construction (EPC). Belt and Road, and the CPEC as its flagship initiative, is different: Chinese companies are major equity stakeholders in many projects (as CTG is in the Kohala plants) under a build-own-operate-transfer model, giving them a vested interest in their long-term success. Kohala is due to be transferred to Pakistan after 30 years of operation.
In the short term, Chinese equity commitments also have an impact on financing terms. “When Chinese firms take large equity stakes, the funding becomes altogether different in terms of pricing, appetite, structure, timelines and so on,” says Abbas Hussein, Managing Director and Head of Project and Export finance for the Middle East, North Africa and Pakistan at Standard Chartered. “When you have a Chinese sponsor and when that sponsor is pressurising Chinese relationship banks – because at the end of the day they benefit as well – they get more aggressive financing, there is a higher probability of their being awarded projects, and it has a direct impact on the equity internal rate of return (IRR). So equity does make a massive difference.”
Creating new in-roads
CPEC’s infrastructure phase isn’t just about power: it includes five road-construction and three rail-sector projects, upgrading many routes that have received scant investment since Pakistan gained independence. The expansion and reconstruction of the 1,830km-long ML-1 rail line is the largest of these, with an estimated cost of USD8.2 billion.
“These investments have positive externalities far beyond the projects themselves,” explains Standard Chartered Senior Economist Bilal Khan, in particular by improving connectivity within the country. “A lot of domestic cargo, on routes like Karachi to cities in Punjab, is currently transported by road, far less efficiently than by freight car. That infrastructure gap is a supply side constraint that stands to be resolved.”
Though many infrastructure projects are still on the drawing board, those that are in the construction phase have already boosted ancillary business in Pakistan such as cement and steel. Pakistan was the world’s fastest-growing steel producer in 2017, with crude steel output up nearly 40 per cent from 2016. Cement production has also been rising steadily and was up 14.7 per cent year-on-year by end-March 2018. “Our clients in the steel and cement industries are contemplating expansion because they see the opportunity for growth,” Nayeem says.
New zones, new hopes
From Pakistan’s perspective, CPEC is the gateway to far greater integration into the global economy and hopefully a means to break out of a cycle of financial instability that has led to successive balance-of-payments crises. Key to this is making the country a more attractive investment environment and ultimately boosting export earnings. In the longer term, Special Economic Zones (SEZs) along the CPEC route will be instrumental.
Currently nine SEZs have been identified, all of which are at the feasibility study stage. The hope is that with the improved connectivity and stable power supply, together with tax and investment incentives in the SEZs, Pakistan can attract some of the manufacturing that is becoming increasingly expensive in China, as well as investment to unlock Pakistan’s own natural resources, from minerals to agriculture.
Given its lower labour costs, there is “an opportunity for Pakistan to attract some of the investment associated with the mass movement of jobs out of China” in the coming years, says Nayeem. Potential investors could also see the benefits in Pakistan’s domestic economy, with a growing base of young consumers: around 55 per cent of the country’s 205 million people are under the age of 25. If the economic growth of recent years can be maintained, the consumption potential of a growing middle class could be enticing.
Some Chinese firms are already banking on Pakistan as a growth market. China Mobile established its first overseas subsidiary in the country in 2008, buying local mobile network operator Zong. Since CPEC was announced, the M&A flurry has increased: a Chinese-led consortium took a stake in the Pakistan Stock Exchange and Shanghai Electric Power acquired one of the country’s biggest energy distributors, K-Electric, for USD1.8 billion. The deals are not just infrastructure related. Alibaba, the Chinese e-commerce giant, invested in and recently acquired Daraz, a Pakistan online store. Alibaba’s payments affiliate, Ant Financial, also struck a strategic partnership in early 2018 that will see Ant investing over USD180 million in Pakistan’s Telenor Microfinance Bank.
Climbing over hurdles
It is fair to say that the most significant transformational benefits for Pakistan are long-term and a matter of CPEC reaching its full potential. There will be challenges to surmount along the way, such as the fact that the initial infrastructure construction phase requires importing a large amount of capital equipment, which puts Pakistan’s limited forex reserves under pressure, as does local liquidity project financing. “In the short term, deficits will increase and certain [local] banks will hit sector exposure caps,” warns Hussein, necessitating a greater role for export credit agencies, government-to-government loans and multilaterals.
Aside from the implications of greater levels of foreign debt, there is the issue of servicing the return requirements of Chinese asset owners when the projects are up and running. “In the first 10 years, it will be about servicing debt; beyond that guaranteed return-on-equity [contracts] means operators will also be sending dividends and profits back to China,” Khan says. “Pakistan will have to make foreign exchange available for that, at the rate of between USD1 billion-2.5 billion per year depending on how much capacity comes online.” For the power sector, there is also the question of how problems with distribution and utilisation can be addressed, even as capacity is increased.
Nevertheless, CPEC is a tremendous vote of confidence in the future of business in Pakistan, focused both on its domestic economy and for exports.
“Does Pakistan just become a transit route? No, we want to take advantage of the trade corridor and develop industries that create employment and forex reserves and make the economy sustainable,” says Shazad Dada, Standard Chartered CEO in Pakistan. “We aspire to achieve what China has accomplished in the past four decades: consistently grow the economy at 5 per cent-plus per annum, grow the middle class while taking millions out of poverty, and seize the opportunity to integrate with Belt and Road trade flows worth over USD2.5 trillion.”
If China’s Belt and Road initiative is executed properly, because Pakistan is at the forefront it has the opportunity to follow a similar development path.