China has been a building contractor and creditor all over the developing world in recent years. From Southeast Asia to Africa and Latin America, the world’s second-largest economy invests heavily in infrastructure projects. State-owned construction companies build roads, railroads, and ports, financed with loans from state-owned banks.
That’s why China has become the most significant external creditor in the developing world.
While such loans briefly stimulate economic growth, creating jobs and income while they last (as a multiplier effect), the dark side is that many of these projects aren’t economically viable, for several reasons. One is that they are built at inflated costs, mainly by Chinese state construction companies in partnership with local contractors rather than by private contractors under transparent international bidding.
Another reason is that the investment decisions are based on political rather than economic criteria to serve Beijing’s political ambitions to dominate the developing world rather than address the needs of the local markets. As a result, they don’t have a lasting effect on economic growth (effectively an accelerator effect) and end up wasting precious local resources.
That’s a problem with Chinese investors at home, too, a legacy of the Soviet-style planning whereby economic activity begins with the supply side of the economy, with central planners who are in command of society’s resources rather than with the demand side, consumers, and their needs.
The third problem is that these investments leave host countries heavily indebted to Beijing because China’s state-owned banks finance them.
China’s investment in Pakistan to build the China–Pakistan Economic Corridor (CPEC), which stretches from western China to the Indian Ocean, is like those made in Sri Lanka. The country’s external debt took off shortly after CPEC was launched, and Pakistan went to the International Monetary Fund for a $6 billion loan to cope with the situation.
Still, there’s one more issue with China’s investments in low-income countries: They make them less creditworthy in international markets.
“Investors also may worry that, if loan amounts or pricing are determined on the basis of political and strategic rather than economic considerations, borrowing governments may accumulate more debt than they can be expected to service,” Qi Liu and Layna Mosley state.
“Additionally, some types of sovereign creditors may be viewed as more likely to reschedule debt or offer new financing in the case of crises. Hence, the identification of creditors may play a role in assessing overall sovereign risk.”
Because of their higher risk assessment, these countries receive a lower debt credit rating from credit agencies and must pay more (a higher coupon) to raise funds in the bond market.
“Our empirical analyses, based on a text analysis of statements from one of the three main sovereign credit ratings agencies, as well as event studies of sovereign risk premium changes in responses to Chinese loan announcements, largely support our expectations,” Qi Liu and Layna Mosley said.
“Announcements of new loans generate larger spreads for emerging and frontier market countries, suggesting that bondholders are concerned with the potential negative implications of additional debt obligations, or with the specific features associated with Chinese loans.”
