The Gwadar port in southern Pakistan is part of the China-Pakistan Economic Corridor and will serve as China's trade center. Photo by: umairadeeb / CC BY

ISLAMABAD — Early last year, the Pakistani government sent USAID officials in Islamabad a mystifying letter via snail mail: please stop doing feasibility studies for Diamer Basha Dam.

Pakistan had been lobbying the U.S. Agency for International Development and the Asian Development Bank since 2010 to complete the dam. A USAID assessment found that it would have “monumental” development impacts in terms of power generation, agriculture and flood control, making it “more beneficial for the national economy than any other project.” The problem was the equally monumental cost of construction. Even if the U.S. government dedicated its entire $7.5 billion, five-year planned development assistance budget (the second largest in the world after Afghanistan) to the project, it would build only half the dam.

The Rise of Chinese Aid series As China continues to grow as a global power, so too does its footprint on the development sector. Its rise comes at a moment when the status quo is shifting in the aid industry. Traditional standard bearers such as the U.S. and EU may still drive the majority of funds and set the agenda, but protectionist policies and changing domestic priorities are setting in motion significant changes. In this six-week special series, Devex examines China's expanding role in aid and development across the globe. From tensions in Ghana to projects in Pakistan, from climate financing to donor partnerships, from individual philanthropy to state-financed investment, this series traces the past, present and future of Chinese aid and development. Join the conversation on our Facebook discussion forum.

It took three years for USAID to work out a compromise. The agency would put $20 million into feasibility studies so that international lending agencies such as the ADB would feel more confident funding the project.

When USAID got the letter in 2016, they suspected that Pakistan had found funding with the Chinese. They were right. (USAID eventually got permission to continue the studies, but the ADB turned down the project anyway.)

In May 2017 Pakistan and China signed a $50 billion agreement that included full funding for Diamer Basha and four other dams.

Although enormous, the new agreement hardly merited coverage in Pakistan. China already captured headlines and public imagination in 2013 when the two countries signed memorandums of understanding worth $46 billion to build the China-Pakistan Economic Corridor. CPEC has since quietly grown to a $62 billion investment.

The latest $50 billion in memorandums now brings Chinese loans and investments in Pakistan to well over $100 billion. A senior member of the CPEC team at Pakistan’s Ministry for Planning, Development, and Reform predicts that figure will ultimately grow to $150 billion. If the dams face cost overruns — which are 96 percent on average — then that will be a conservative estimate.

The financing is coming to a country that is starved for cash, fatigued with western donors, and led by a political party that believes infrastructure is key to re-election.

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“It takes many years to have any project approved by international financial institutions,” says a recently retired senior Pakistani official, who did not want to be quoted by name when commenting on donors, especially Chinese financing. “You want to borrow a billion dollars from the World Bank? It would take 20 delegations and 15 consultants coming in and making reports.”

“The Chinese model is very much bricks and mortar, because they think bricks and mortar has a much greater trickle-down effect compared to the Bretton Woods model,” says a CPEC team official, referring to the western model of assistance where loans are given out on the condition that recipient governments make policy changes. The official — who also asked not to be named — reviews Chinese and other donor projects and referred to the Pakistani government as “skittish about upsetting the Chinese.”

“The Bretton Woods model is to give technical assistance, but that technical assistance is $15 million that we have to pay back,” he continues. “And then there are consultants that make $20,000 or $30,000 a month. Frankly speaking, the quality is pretty poor. If you really hold their feet to the fire, by corporate standards, there are very few people [who are worth it].”

“In terms of financing, there’s no issue [with the Chinese]. It’s like Santa Claus has come to town; you can ask for whatever you wish for. But one day it will all need to be paid back.” — Jamil Masud, director at Hagler Bailly Pakistan

China’s involvement in Pakistan, however, is also expensive. Interest rates as high as 5 percent are closer to commercial rates and higher than what the World Bank and International Monetary Fund offer. Unlike U.S. and other bilateral assistance, there is little free money. Rather, Chinese companies expect high returns on their investments after Pakistan pays back the multibillion dollar loans that these companies have taken from Chinese banks.

Whether Pakistan can pay depends on if the massive new infrastructure stimulates economic growth. There is a risk that the potential for development impact is fuelled by hope and may be overstated.

Roads and rails

Highways and railways are what come to mind when one thinks of the China-Pakistan Economic Corridor. CPEC is one of six land routes envisioned under China’s Belt and Road Initiative. BRI is intended to intensify trade connections across Asia, Europe and the Middle East. Confusingly, “belt” refers to roads and “road” refers to maritime routes.

But roads and rail are actually a small part of Chinese money in Pakistan — less than $11 billion of the original $46 billion agreement. It’s small because, contrary to popular perceptions, much of the CPEC route is actually financed by Pakistan.

“Much of the roads being built are being built by our money,” says Miftah Ismail, who was Pakistan’s minister for investment until late last month, when the cabinet was dissolved because the Supreme Court voted to remove the prime minister on grounds of corruption.

What Ismail estimates Pakistan will take on in Chinese projects this year — $4 billion in loans and investments — equals what the Pakistani federal and provincial governments have allocated for roads and highways in their own annual budgets.

China is also financing the expansion and improvement of Pakistan’s neglected railway system, doubling its speed from 60 to 120 kilometers per hour.

CPEC roads will connect landlocked Xinjiang province in western China through a new port city that it is building on Pakistan’s coast, Gwadar. China needs these roads to transport goods out, but it is hard to think of what will go in the other direction. China’s exports to Pakistan account for two-thirds of Pakistan’s trade deficit.

“There are two dynamics,” explains Ali Salman, founder and executive director of the Policy Research Institute of Market Economy. “One is the trade-related dynamic, which is how Pakistan might use the CPEC corridor once the roads are established. For example, will Pakistani industries be able to export more to China than they are exporting right now? The second question is, will there be more industries in the [special] industrial zones being set up? If the answers are yes, that will be a very good thing for Pakistan. But I suspect the answer will be no.”

Pakistan will, at least, collect tolls on the roads. “If out of 10 Chinese containers that move out of Gwadar, one is from Pakistan, then we should consider ourselves successful. Otherwise, we will be reduced to toll collectors,” says the recently retired official.

Current officials, however, argue that Pakistan can be an attractive destination for Chinese companies to relocate to.

“In China, the wage growth is exponential, so the Chinese now want to move some of their light manufacturing to western China and overseas to Vietnam, Myanmar, Cambodia,” says the senior official on the CPEC team. He cites an estimate of 80 million surplus jobs that will be moved overseas. “We’re going to try and grab some of those — 5 or 10 million; whatever we can. That’s part of the puzzle for us.”

Ismail has the same idea, saying that rising wages means that some industries in China are becoming uncompetitive. He suggests that China can produce raw materials, and workers in Pakistan can stitch or assemble them.

Officials also expect investors from other countries to follow China into Pakistan.

“We are already getting interest from all the European countries — the U.K., Italy, Austria, Poland, Belarus. They all want to get on the CPEC bandwagon with us,” says the current official at the Planning Commission. “So for us it’s an opportunity to rebrand the country, make it an attractive [investment] destination.”

Pakistan’s Board of Investment plans to set up nine special economic zones, or SEZs, around the route that will host Chinese factories and be linked to trade flows. But Ismail defers that to “phase 2” of CPEC. Salman points out that “most of our SEZs are very underutilized.”

“A lot more is needed to jack up exports than just infrastructure,” argues Salman. “Real confidence is required to get entrepreneurs and investors to establish these factories. Our taxation policies and business regulations are not that business friendly. Not much is happening on that front. They are just spending heavily on infrastructure. But China has done this in many parts of the world, and big infrastructure ultimately has not translated into business gains.”

“We haven’t really made a lot of progress on that,” concedes Ismail, referring to making the business environment more competitive and conducive. “And that’s something that we would really like to see done in Pakistan.”

Energy and industry

Without energy, however, there can be no industry. In recent months, Pakistan has achieved on its own what USAID and many other donors have tried to do for many years: dramatically reduce power blackouts that have debilitated the economy. This summer, major cities that once lost power every other hour are losing electricity intermittently for just three to four hours a day. The current government promises to fulfill its campaign promise of completely ending blackouts by the time elections are held in 2018.

The problem is that Chinese companies are cutting corners on plants in Pakistan, even though they are charging a lot for them. —

The government reduced blackouts by constructing several new power plants, cutting a deal with Qatar for liquefied natural gas, and driving a hard bargain with General Electric for their most advanced new turbines that use technology that has set a Guinness World Record for efficiency. Pakistan financed three such large gas-fired projects, although a Chinese company won the bid to construct the plants — and did it in record time.

“It’s an example of how you could leverage China’s interest in Pakistan smartly to get additional value per dollar,” says Jamil Masud, director at Hagler Bailly Pakistan, an energy and environmental consultancy firm.

The majority — $35 billion — of CPEC investments is for power plants. The agreements for what Pakistan will pay for each plant are surprisingly transparent and are posted on the website for the National Electric Power Regulatory Authority. The CPEC website lists projects, costs and progress.

While there are some wind, solar and hydro projects, they are “nothing to write home about yet,” according to Ismail. Most of the projects are coal.

Not all experts are concerned that Pakistan is moving to coal, as it helps the country shift its energy mix away from expensive furnace oil. Since Pakistan is coming to coal so late — less than 1 percent of the country’s power currently comes from coal, compared to 34 percent in the U.S. and 75 percent in India — the country can leapfrog ahead in terms of cleaner coal technology to control emissions. Today, new plants either use less coal or have pollution controls that many countries, including the United States and China, are going back to install in their existing plants. The problem is that Chinese companies are cutting corners on plants in Pakistan, even though they are charging a lot for them.

“The Chinese rate is 8.50 rupees per kilowatt hour of coal,” says the retired official. “An efficient rate would have been 5 rupees. In India, it’s about 4 rupees. One would expect a good environmental package with their [high] rate. But they are not putting in the required controls.”

“One would expect a good environmental package with their [high] rate. But they are not putting in the required controls.” — Recently retired senior Pakistani official

Building large power plants without controls for sulphur, nitrogen, mercury and particulate matter emissions can be disastrous, especially for people living near them in Karachi and Sahiwal. More than 100,000 people die prematurely each year in India due to coal-fired plants, costing the country $4.6 billion, according to a report by the Mumbai-based Conservative Action Trust. Besides health problems, emissions can trigger acid rain that destroys agriculture.

The energy projects are treated as investments by Chinese companies, but they are actually loans plus fixed returns to equity. Once constructed, Pakistan will buy what the plants produce at the 8.50 rupee rate. The rate pays back the loan that the Chinese company took from a Chinese bank to build the plant; a commercial 5 percent interest rate; a one-time payment equal to 7 percent of the cost of the project as insurance against default (even though Pakistan has offered sovereign guarantees); and a 15 to 20 percent return on equity. The rate of return is high but standard across similar projects that fall under the country’s policy for independent power producers.

What Pakistan owes for the next 30 years will be calculated in dollars frozen at the 2013 exchange rate of 97.10 rupees to $1. (The current exchange rate is 105 rupees to $1.)

“NEPRA is not competent enough to be able to independently determine tariffs. It is influenced by the rates that are conveyed to them through informal and formal channels. The policy is in a way done independently by NEPRA, but it is in many ways influenced by China. In theory it should be totally independent. But [China] has an influence,” says the retired official.

The assumption is that increasing power production will ultimately add 2 to 2.5 percent to Pakistan’s gross domestic product — which is what the country loses each year due to blackouts. But such returns will not be automatic, if they materialize at all.

“The problem we face now is getting too much power too quickly,” says Masud. “It takes time for the economy to respond and absorb the additional supply. If people don’t have blackouts, will they consume more or will they be constrained by the higher monthly energy bills that result? If they consume more, will they leverage consumption into just buying appliances, or expanding businesses as well? How quickly will growth take off? It will be interesting to see how electricity demand increases and how the economy responds to surplus power.”

Without strong economic growth, Pakistan would not be in a position to pay for a sharp increase in electricity. The country already suffers from persistent circular debt, which means that Pakistan pays plants to produce energy but does not recover the cost through energy bills, due to theft, which is as high as 30 percent in some places. This ages transmission infrastructure and subsidies. Producing more power will mean more debt, although some costs may be balanced as Pakistan moves to a cheaper energy mix.

Finally, one-third of Pakistanis live off the power grid or get very limited electricity. Many of them live in remote areas outside the reach of distribution networks. The nation’s existing power grid also needs to be updated to carry the huge influx of energy that China’s plants will produce.

“There has been little attention to necessary reforms. Planning has so far been largely reactive and short term,” says Masud. “The government's thought-process is only now being jogged by the flurry of new activity, largely thanks to CPEC. Little thought has been given to the transmission and distribution bottlenecks that increased power production will have to overcome,” says Masud. “Our approach must now shift to resolving lingering issues, such as the circular debt, and letting the market guide investments.”

Can Pakistan pay?

“In terms of financing, there’s no issue [with the Chinese]. It’s like Santa Claus has come to town; you can ask for whatever you wish for. But one day it will all need to be paid back,” warns Masud.

“Chinese officials privately admit that they expect to lose up to 80 percent of their investment in Pakistan.” — Tom Miller, author of “China’s Asian Dream”

The payback period for China-Pakistan Economic Corridor projects and loans will unfold over the next 30 years.

“The Finance Ministry has done a projection for the first five years. They’re perfectly okay for the next five years,” says Ismail.

“It’s going to be tough until about 2020,” says the CPEC team official. After that, economic growth is expected to kick in.

He continues: “Yes, there’s a problem of returning the money and we might overextend ourselves. Is the U.S. government not over-extended? Isn’t everyone in debt? But what are our options? Even if we default, how many times has Argentina defaulted? It’s definitely not what we want, but it’s a part of the game. It’s a reality in business.”

Tom Miller, author of “China’s Asian Dream,” has said that Chinese officials privately admit that they expect to lose up to 80 percent of their investment in Pakistan.

Salman argues that Chinese financing is driven by their own need to deploy excess human, financial and technical resources. “China has surplus industrial capacity and surplus capital. They are rich on foreign reserves. And they have engineers who need employment,” he says.

What they offer coincides with the interests of politicians who are looking for short-term gains — much like Pakistan’s current government, which is in a rush to conclude agreements and get projects off the ground during its term, which started in 2013 and will end with elections in 2018.

But beyond infrastructure, China cannot overshadow what Pakistan can do on its own.

“The Chinese contribution to economic growth right now is overstated. A lot of the growth we’ve achieved is because of our own internal things,” says Ismail. “The great control in loadshedding has also been because of other initiatives that the government of Pakistan has taken outside of CPEC. That said, if we are able to parlay CPEC into what the [former] prime minister wants it to be then in the years to come, CPEC will help our growth.”

Update, August 25, 2017: An earlier version of this story misattributed a pull quote about a lack of environmental controls. The correct source of the quote is a recently retired senior Pakistani official who spoke on the condition of anonymity.

In this six-week special series, Devex examines China's expanding role in aid and development across the globe. From tensions in Ghana to projects in Pakistan, from climate financing to donor partnerships, from individual philanthropy to state-financed investment, this series traces the past, present and future of Chinese aid and development. Join the conversation on our Facebook discussion forum.