May 25, 2017

Ahead of 'Modern Silk Road' build, China credit downgrade worrisome


The recent announcement that Moody’s Investors Service, one of the leading global credit ratings agencies, downgraded China’s credit rating, contradicts the official narrative promoted by China that things are great, and its economy is on solid footing. Chinese policymakers have consistently justified the high debt-to-GDP level arguing that its economic model can both safely and reliably service such large amounts of debt, so long as the economy continues growing at a healthy pace.

For Moody’s, the assumptions on which China is predicating its growth has it most concerned. For roughly the past 10 years, China’s growth has come by way of two areas — investment in infrastructure, commercial and residential real estate and exports of manufactured goods.

With regard to the former, since 2008, China has embarked on a building spree unlike anything witnessed in world history. In fact, more concrete was poured in China from 2011 to 2013 than all concrete poured in the United States during the 20th Century. The building of roads, tunnels, bridges and high-rise buildings has put a lot of people to work and kept factories humming with construction-related materials.


Regarding exports, it is apparent that China has been very successful in manufacturing products of all kinds and selling them in the world’s most important consumer markets, such as the United States and the EU.

The challenge China is confronting is the sustainability of its growth model and its ability to continue its reliance on investment- and construction-driven growth, as well as diminishing competitiveness in its manufacturing sector.

On the construction side, all funding came by way of debt. Chinese corporations and local governments borrowed heavily to construct state-of-the-art highways, transportation facilities, shopping malls and residential towers. The problem is, what if the projects fail to meet revenue expectations and, if so, how will the debt be repaid? 

On the export side, China is also getting squeezed — the cost of manufacturing in China is going up. The cost of labor and inputs have all risen, making it increasingly difficult to compete against places like Vietnam and Sri Lanka. To address this, Chinese factories have been heavily investing in automation and robotics to offset the rising cost of labor. 

At the same time, global demand for manufactured goods has been less than the global increase in manufacturing productivity, leading to a glut of supply and not enough demand to absorb all of the built-up capacity within China.

Realizing that China’s go-go days of growth may be behind it and that it’s mountain of debt casts a shadow on its future prospects, its policymakers are looking to revive its fortunes through the One Belt One Road (OBOR) initiative. In fact, OBOR is the centerpiece of President Xi Jinping’s blueprint for China’s economic future. 

In a nutshell, under OBOR, China wishes to link the entire Eurasian continent by way of an extensive land (rail) and sea (sea ports) network that will represent the modern recreation of the ancient Silk Road connecting East with West. The intended benefit would be to facilitate long-term multilateral trade between China and all of the nations that OBOR will traverse.

China envisions the unification of the Eurasian continent, from Western Europe, through Central Asia and Russia, all the way to China and South Asia. It represents one of the most ambitious and massive infrastructure projects ever conceived, covering a distance equivalent to three United States, end-to-end. 

To fund this undertaking, China has created its own policy bank, the Asian Infrastructure Investment Bank, and bankrolled it with an initial capital worth $50 billion. It has been estimated that the total cost of building OBOR may exceed $3 trillion, meaning China will have to rely on global capital markets to answer the need.

Given the staggering amount of capital to build out OBOR, the $50 billion allocated is but a drop in the bucket. China is particularly incensed that the United States has stayed on the sidelines regarding OBOR.

Given the massive infrastructure needs within the United States, capital providers would have a hard time justifying investing in OBOR and funding China’s ambitions when there is such glaring need at home. The OBOR is more than just an “If we build it, they will come” project. The OBOR entails a multitude of risks — security, operational, geopolitical and economic.

The risks call into question whether or not OBOR will be economically viable and whether or not the intended benefits of OBOR will materialize as assumed. Moreover, Moody’s downgrade will only make borrowing costs in China rise as the perceived risks become more apparent. 

Arthur Dong is a professor of strategy and economics at Georgetown University’s McDonough School of Business. He specializes in legal and business engagements between China and the United States

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