Fears of unsustainable indebtedness among many of the countries that are partnering in China’s Belt and Road Initiative (BRI) set the backdrop for a two-day meeting last week in Beijing. The $1 trillion initiative includes projects in transportation, energy and infrastructure in more than 70 countries across Asia, Europe, Africa and Oceania such as ports, railways, oil and gas pipelines, and power grids, along with plans for new economic corridors.

Facing a slowing economy at home made worse by a trade war with the U.S., and increasingly strident opposition to the BRI from the U.S. and European countries, China’s president Xi Jinping was compelled to acknowledge the concerns that BRI is a debt trap for participating countries. He committed to creating a “debt-sustainability framework” for the initiative, compliance with international infrastructure contracting standards, and measures to curb corruption and to ensure environmental sustainability, according to a Wall Street Journal report. Xi also urged foreign and private-sector partners to contribute more funding to BRI projects. The BRI meeting saw attendance by 37 countries, but the U.S. and India were among those that did not attend.

Ensuring funding for BRI projects was the key theme during last week’s meeting. “In the language that came out of the Belt and Road meeting, I picked up one word repeatedly – rehabilitation,” said Marshall W. Meyer, Wharton emeritus professor of management and a China expert. “What’s got to be rehabilitated here is not the concept that China is going to recreate the Silk Route, but the underlying financials.”

Meyer noted that unlike U.S. foreign aid or the Marshall Plan to rebuild economies after World War II, the BRI is “Chinese investment that expects a return.” Chinese financial institutions lend money for BRI projects in partner countries, and the construction contracts are awarded to mostly Chinese firms, he said. “A Chinese company [thus] receives much of the proceeds of the loan, but the host country has got the debt. If the [return on investment] isn’t sufficient to pay off the debt, China will repossess [the project, and it] becomes a debt-for-equity swap.”

“What’s got to be rehabilitated here is not the concept that China is going to recreate the Silk Route, but the underlying financials.” –Marshall W. Meyer

On their own, many of the BRI projects would not produce sufficient returns on investment, and that explains why private investors are not attracted to them, said Wharton management professor Minyuan Zhao. “China is hoping that by coordinating all these projects – by connecting all the railways, connecting the waterways with the railways — every single project will generate more return in the aggregate.” In that context, China’s state sponsorship of BRI makes sense, she added. “With state sponsorship, you create enough externality to make every single investment, which would otherwise be un-investible, a good project.” She noted that many of the projects are in some of the “most challenging geographic areas and institutional environments,” and the key is to generate “enough momentum for a coordinated effort.”

Meyer and Zhao discussed the road ahead for China’s BRI ambitions on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Problems on Multiple Fronts

Meanwhile, concerns are spreading over debt problems associated with BRI projects. Flagship BRI investment projects have suffered delays or cancellations; Chinese lending has come under increased scrutiny amid debt-servicing and corruption concerns; and the U.S. has become more vocal in flagging its worries about the project, notes a report from The Economist Intelligence Unit.

According to a study last March by the Washington, D.C.-based Center for Global Development, “eight countries are at particular risk of debt distress based on an identified pipeline of project lending associated with BRI.”

“Now in its second phase, the Belt and Road Initiative is seeing a lot of pushback from various countries – Malaysia, Sri Lanka, Zambia and even Pakistan,” said Tanvi Madan, a fellow in the Project on International Order and Strategy in the Foreign Policy program at the Brookings Institution, and director of The India Project. She spoke at an event hosted earlier this month by the University of Pennsylvania’s Center for the Advanced Study of India in Philadelphia.

The pressure China faces over resistance to BRI-related debt has forced it to renegotiate contracts with reduced project size and financial outlays. Malaysia had originally canceled a rail link that was part of BRI and would have connected its east and west coasts. China earlier this month renegotiated that and brought down the price by a third from the original estimate of Malaysian ringgit 65.5 billion ($16 billion) to 44 billion ringgit ($11 billion).

The project had been suspended after construction began and Malaysia’s finance ministry estimated that cost overruns would increase the project size to 81 billion ringgit ($20 billion), according to a Bloomberg report. Myanmar, too, has downsized a BRI-related port project from $7.5 billion to $1.3 billion, on grounds that “it didn’t want to repeat the experience of other countries and build infrastructure without sufficient demand,” according to another Bloomberg report.

Pakistan also faces huge debt challenges arising out of its participation in the Belt and Road Initiative, on top of its own budgetary challenges. It is now “putting the brakes on new building, with less than half of $62 billion of Chinese projects carried out,” noted a Wall Street Journal report. The Chinese infrastructure, all built by Chinese state-owned companies, required the Pakistani government to guarantee repayments to Beijing, the Journal said. Pakistan has asked China for $1 billion in development aid and the establishment of factories from the Chinese private sector in the country.

“China is hoping that by coordinating all these projects … every single project will generate more return in the aggregate.” –Minyuan Zhao

The most high-profile of the BRI ventures in Pakistan is the Gwadar Port project, which will have nine new multipurpose berths. It is a main feature of the $54 billion China-Pakistan Economic Corridor (CPEC) and is key to the Belt and Road Initiative, according to a South China Morning Post report. The CPEC is a road link between Pakistan’s Gwadar port near Karachi to Xinjiang in China, and a stretch of it passes through the Gilgit-Baltistan region that is disputed by India and Pakistan. The first phase of the project was completed in 2006, and the second phase is underway.

“India is looking now like it had foresight,” said Madan. “India cannot join Belt and Road because it would mean accepting that parts of Kashmir that Pakistan controls is essentially Pakistan because that is where some of the projects are.”

Wake-up Calls

The earliest warning signals of how badly planned BRI projects could backfire came from the case of Sri Lanka’s Hambantota port. In December 2017, Sri Lanka handed over the port to China on a 99-year lease after it couldn’t service debts of more than $8 billion it owed Chinese firms involved in its construction. Beneficiary countries have to sign on construction companies that Beijing suggests — “a typical demand of China for its projects around the world, rather than allowing an open bidding process,” said a New York Times report. The handover of Hambantota port erased about $1 billion of Sri Lanka’s debt to Chinese firms, but it alerted other countries to how BRI projects could imperil their finances and possibly their sovereignty as well.

In much the same way, Djibouti in East Africa is set to lose control of a container terminal built as part of BRI projects, after it was saddled with debt equivalent to 88% of its GDP of $1.72 billion.

Venezuela was another wakeup call. China had struck a series of oil-for-loans agreements with Venezuela in 2007, but “a political crisis in that country … is threatening China’s payout and drawing Beijing into a proxy standoff as it supports a Venezuelan leader the U.S. is intent on toppling (Nicolas Maduro, Venezuela’s president),” according to a Wall Street Journal report. Venezuela owes Beijing around $20 billion, according to estimates by China’s Commerce Ministry, the report added.

Along with the debt piling up at BRI beneficiary countries, China, too, is facing constraints in investing in the projects. China’s plan was to use at least $400 billion in funding from government-run banks, but the program has ballooned beyond infrastructure construction.

“BRI lending by major [Chinese]banks has dropped by 89% since 2015, and lending by commercial banks — who are dealing with their own financial issues domestically — has ceased almost entirely,” according to a report last August by The Jamestown Foundation. “Policy banks have also scaled back, despite their status as arms of government policy.”

“It appears that China is extending its influence economically and even militarily way beyond its national borders and beyond its traditional peripheral tributary states.” –Marshall W. Meyer

Growing Security Concerns

Another increasing concern – raised especially by the U.S. — is the potential use of the BRI as a vehicle to extend China’s military presence beyond permissible limits. “It appears that China is extending its influence economically and even militarily way beyond its national borders and beyond its traditional peripheral tributary states,” said Meyer.

Many Americans fear that the Belt and Road Initiative is an extension of efforts by the Chinese Communist Party (CCP) to undermine the security and economic architecture of the international order, according to an article last December in Foreign Policy magazine titled “One Belt, One Road, One Big Mistake.”

Meyer pointed to China’s plan to assume management control of Haifa port in Israel. While it would bring commercial advantages for Israel, “it also means that the U.S. Mediterranean fleet cannot call on the port of Haifa,” he said. China also plans to build a rail line connecting Haifa with the Red Sea as an alternative to the Suez Canal, he added.

Europe May Seek Volume Discounts

Meanwhile, BRI continues to add partner countries. Italy is the latest, which signed up in March. A total of 29 deals amounting to €2.5bn ($2.8 billion) were signed during Xi’s visit to Rome, according to a BBC report.

But China could face tough negotiations elsewhere in Europe, Meyer predicted. “European countries, unlike Italy, are not going to go singly to China,” he said. “They will go as a group, probably led by Germany, and again try to negotiate volume discounts. At the end of the day there’s the possibility that the winners of this will be the host countries and not China. Let’s see the terms of trade, then we’ll know.” Australia, Japan, and the U.S. have already formed their own trilateral investment initiative to help meet infrastructure needs in the Indo-Pacific.

A Brand and a Compulsion

“This is China’s global brand,” said Meyer regarding why the BRI is important to China. BRI is also personally important for Xi. “It has his signature on that, and it has to show some degree of success,” said Zhao. “Any slowdown means failure.”

“The recent events [of excessive debt] are enough to be a wakeup call for policymakers to be more cautious of the risks … and to have more coordinated effort.” –Minyuan Zhao

China’s slowing economy means it may not have sufficient resources to invest in overseas projects, Zhao noted. On the other hand, BRI projects help use up China’s excess capacity, and help divert attention from the slowing economy, she added. One concern Zhao raised is whether China “will lump projects that would have been going on anyway into the Belt and Road Initiative.” She noted that by labeling projects as part of the BRI, it would be easier to get funding and government support.

BRI also “brilliantly masks China’s external dependencies for the foreseeable future,” said Meyer. He noted that China will remain dependent on imported energy, especially liquefied natural gas “because it’s cleaner than oil.”

Meyer also pointed to an epidemic of African swine flu that China is facing. “That’s likely to wipe out half the pigs in China, and this means they’re going to be dependent not just on imported soybeans to feed their pigs but imported pork [as well]. These pressures and tensions give a slightly different coloration to Belt and Road Initiative. It’s not so much China going external to make investments. It’s China going out to supply its domestic needs.”

All the negative reports on BRI projects could result in a “self-fulfilling prophecy,” according to Zhao. “It’s self-fulfilling in the sense that pessimism leads to lack of participation, lack of commitment and lack of long-term cooperation,” she said. “And that itself could lead to failure.”

One pre-requisite for BRI projects to succeed is the presence of stable institutions backing the projects at beneficiary countries, said Zhao. “If you don’t have a stable institutions behind all these investments, no return can be expected,” she said, adding that even the principal amounts are at risk. “The recent events [of excessive debt] are enough to be a wakeup call for policymakers to be more cautious of the risks … and to have more coordinated effort.”

Meyer wondered why China is not exporting its capabilities in electronic commerce, which he rates as its best effort in recent times. “Well, in order to do that, you need internet, and all the [related] infrastructure to connect people,” Zhao said. “And guess what? Once the railroad is there you can ship equipment — and the next thing you will see are Huawei towers.”