Thursday 5 December 2013

Book Review: The China Development Bank: Debt, Oil and Influence

The China Development Bank (CDB), in 2010 held $687 Billion in loans. Over twice as much as the World Bank. And I knew almost anything about it prior to reading this book by Henry Sanderson and Michael Forsythe:

China's Superbank: Debt, Oil and Influence - How China Development Bank is Rewriting the Rules of Finance

My main interest was loan-for-oil financing. This is a topic I've been following over the last few months. Info is hard to come by, but as this post outlined, China has been securing oil supply as repayment for debt. Sometimes via the NOC's, but sometimes it's the Export-Import Bank (EXIM) and other times it's the CDB. But these deals are everywhere.

Getting a glimpse behind the CDB history and logic really illuminated an interesting viewpoint that I think is difficult for us westerns, who grew up in our developed western economies to grasp.

When infrastructure and economic development are at extremely low levels, the return on investment beyond direct monetary returns, via appreciated land value and positive externalities, are so significant and that a standard Internal Rate of Return (IRR) or Net Present Value (NPV) are inadequate.

This is the secret sauce that CPC princeling Chen Yuan leveraged to push the CDB from a marginal bureaucratic loss making institute into China's growth engine and the global financial player it is today.

After getting cut off by the central government in Zhu Rongji's 1994 reforms, local Chinese governments had to run balanced budgets; their funds were allocated to them, they couldn't asses new taxes, issues bonds, or run deficits. Did they sit on their hands and make due with what they were given? Of course not.

The need for funds resulted in the establishment of the local government financing vehicles (LGFV) that are now often cited as the shadow debt that could bring on a huge debt collapse in China.

It started off simply enough: Savers deposit > Commercial Banks take those funds and purchase CDB Bonds > CDB would then lend to government affiliated (but not official) LGFV's > the LGFV would then invest in whatever the governments wanted. Once these LGFV's were capitalized they were free to act as commercial entities. The key linkage there, is that the newly established LGFV's had no merit to make a commercial case for funding.

Chen Yuan's key insight: urbanization would lead to increasing land and property values via their presence and the network externality effects that they would bring.

Using land as collateral, a city would build infrastructure. Even if this infrastructure could not service their CDB obligations out of cash-flow, the increased productivity created by the infrastructure investment would increase the land CDB held as collateral. Cash flow would then be obtained from additional land sales when needed, or mitigated by the increasing equity of the collateral, and the cycle would continue.

Conveniently for the government they happened to own all of this land. While compensation and relocation would have to be paid to those living on the land, the difference between the pre-infrastructure land value and the post-infrastructure land value was huge. Add in some controversial valuations and questionable compensation, and this incredible cash stream has been sufficient to mobilize the local governments to build the China we see today.

While one might argue that this cycle has gone a bit too far and these LGFVs are holding way to much debt, it's hard to argue against the notion that this policy had an extremely successful run. We would expect the returns on infrastructure (and the increasing value of land collateral) to asymptote at some point. Has that point been reached in China? How much variance across the country? Heady questions indeed.

Next, the CDB transitioned, as the central government began pushing their domestic companies to "go outward', to funding domestic companies like Chery Auto, Huawei, and Lenovo in their attempt to gain market share internationally; A similar to the policies (outlined in this post) utilized by South Korea and Japan during their development.

From outsized credit facility, favourable vendor financing terms, and the benefits of an implicit government backing Chinese companies have had a great deal of success, while drawing considerable heat from all corners of the globe.

This outward approach has led to my initial area of interest and the focus of this blog: the energy sector.

During the financial crisis, Chen, reflecting on his failed purchase of Barclays Bank in 2007 and the collapsing financial system of the west, quoting from the book:
"The quality of Wall Street assets is very bad; they have many problems. We should think about what China really needs." China needs natural gas and oil and should take the opportunity to buy overseas resource assets...
And in a separate interview:
"When we buy oil we don't need to go to Chicago and New York futures exchanges, and to buy minerals and metals we don't need to go to the London metals exchanges; we can negotiate directly, and directly cooperate. This kind of cooperation has better results."
The result? China increased foreign direct investment from by over 300% from 2007 to 2008 hitting $54 Billion.

In 2009 CNPC got a $30 Billion five your loan at "discounted rates" to fund overseas acquisitions, on top of $12 Billion that China had already spent on oilfields and refining assets.

The book sketches out the ideal scenario for how the CDB functions, from the Chinese perspective: Venezuela.
$40 Billion and counting since 2008...Venezuela is using the loan proceeds to go on a buying spree in China. It acquired phone networks from ZTE Corp., railroads and housing complexes from CITIC Group, power stations from Sinohydro Group, and of course, oil refineries and pipelines from China National Petroleum Corp. (CNPC and China Petroleum & Chemical Corp., better known as Sinopec.
CNPC was pupmping 200,000 barrels a day in Venezuela by 2012 and planned to increase that to 800,000 barrels a day by 2017. A leaked memo from the state-run oil company shows that Venezuela must sell China 430,000 barrels of oil a day merely to service its debt
The most disappointing part of this book was that an offhand reference to oil-for-loans financing that Japan and China had agreed to in the 1980s (when China was a net exporter of oil) that I wish it had explored a bit further. Information on this was hard to come by, but I did find this page which included this paragraph:
In February 1978, a long-term private trade agreement led to an arrangement by which trade between Japan and China would increase to a level of US$20 billion by 1985, through exports from Japan of plants and equipment, technology, construction materials, and machine parts in return for coal and crude oil.
It goes on to say that China had to scale back commitments and we aren't given much insight into how much technology was transferred or how much oil was returned, but by my read of recent Chinese history, it is quite likely that this arrangement, seen as a benefit to both countries would have had some part in inspiring the current oil-for-loan set up.
It is as if China and Western institutions are using different baselines; China is looking at the enormous growth that its own economy has produced while Western institutions are more likely to consider Africa's recent history.
The authors describe the added benefit in taking oil as collateral as being the consistency with which it pumps, regardless of political conditions. I'd suggest viewing it from the same angle described in the preceding paragraph: It's not just the direct monetary benefit of the oil, but the indirect economic return on that oil that the CDB is considering.

Given the consistent increase in oil consumption through the price increases of the 2000s I think it's safe to say that the marginal barrel of consumption still yields significantly higher return then the market price. Currently, China sells most of the oil on the market; essentially hedging it's own consumption. The real benefit would be if there is a physical shortage in the future. Having the ability to control the destination of crude would have huge benefits.

If that consideration is taken into account, CDB would then be investing in projects based on the estimated direct returns on the project (as western institutes would) PLUS the potential positive economic externalities that the project would generate for the country that they are investing in. The return, is then judged based on the direct monetary cash flow from the resources (as western institutes would) PLUS the return based on the potential positive economic externalities that those resources would generate for China.

A judgement of this sort would explain what seems like an incredibly aggressive appetite for risk.

Going forward, I honestly believe the CDB has an important and incredibly useful role to play as a development bank. While the actual terms of these loans are not made public, the general sense seems to be that the CDB does take a pretty hard line on the terms of these loans. As long as they can funnel as much of those funds to productive means then this set up should be encouraged.

A poor country, providing very poor countries with loans and/or infrastructure expertise to the benefit of both, in a sustainable manner has the potential to have a very positive impact world.

The concerns, to me, are both real and plenty:

1. The CDB must encourage the technological transfer that they, and other successful east Asian countries, employed in their economic development.
2. The CDB and recipient countries need to find the right balance of employing foreign expertise while building domestic markets.
3. Over exposure from CDB overreach might create adverse political conditions from other financial institutes (particularly in the developed world)
4. Managing PR in foreign markets to ensure that regime change does not lead to nationalization or reneging on CDB deals.
5. Over reach taking CDB away from it's core competencies (development via infrastructure investment) might inhibit it's ability to perform these core competencies; which I hold as it's greatest value added function for the world.

Ultimately, no Country has the track record and the ability to handle the first two concerns better then China. It's the last three that concern me most. This book outlines the central role the CDB has played in the greatest feat of economic, and what I'd call human welfare, progress in human history. Time will tell if it can play that same role on the international stage.

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