by Haroun Sharif

The buzzword in Pakistan is China. It is the exciting new frontier for both the Pakistani public and private sectors. The reality is though, that in Pakistan China is seriously misunderstood. On the one hand, China is at the center of the current administration’s economic policy, while on the other, opposition parties and popular public commentators are highly critical of Chinese investment in Pakistan.

Many of these Pakistani commentators are simply parroting Western prejudice against China’s investments in Africa without any firsthand knowledge of the facts.  While lively public debate on national policy is important, both policy makers and their critics base their views on deeply misunderstood or inaccurate facts. This in turn affects the quality of discussion and leads ultimately to missed opportunities for Pakistan, a nation that has the most to gain from China’s rise. Most importantly, what is lacking in both policy making and the subsequent debate is a clear understanding of Pakistan’s relatively bad image in the minds of global investors and the knowledge that only a limited number of fiscal strategies are available to the nation. Indeed, China’s increasing involvement in Pakistan should force Pakistan to rethink its archaic multi-national development bank (MDB) focused on economic policy, and ask itself why it has only managed to attract a relatively paltry amount of investment from China despite its close ties. An analysis of recent investment into Pakistan will find that Pakistan is failing to attract high quality investment in volume because of its reliance on preferential loans, and that Pakistan has lessons to learn from developing countries in Africa and Central Asia.

China’s interaction with Pakistan spans several decades, Henry Kissinger first flew to Beijing from Islamabad. Pakistan has been the one country to support China unconditionally, since the time of Chairman Mao. Indeed, China refers to Pakistan as its “iron brother”, an all weather friend. So naturally, when China began its “Go Out” policy of exporting capital to the world in 1999, which has only recently come to fruition, Pakistan was to be a major beneficiary. China has the world’s largest foreign reserves at over $4 trillion, followed by Japan at $1.2 trillion. Since 2005, Pakistan has received at least $12 billion in some kind of investment from China, according to The Heritage Foundation, which tracks Chinese investment abroad. This figure alone only represents a portion of the Chinese financial commitment to Pakistan as key figures, such as military aid or even short-term foreign exchange facilities to bolster Pakistan’s finances have not been counted.

Any figure on foreign currency flows must be viewed in perspective. Pakistan’s image as an investment destination is fairly poor (and not just because of the internal security situation), and any Chinese investment has happened despite this poor perception. In fact, Chinese investment alone is greater than World Bank and ADB contributions to Pakistan combined at least in the last 9 years. The World Bank has disbursed almost $6 billion to Pakistan since 2008 and the ADB $6.65 billion since 2006. Commitments (as opposed to disbursements) show that the ADB and WB have committed more than China has invested. But, though it is difficult to track Chinese commitments as not all are public, it is easy to see how Chinese commitments will soon match those of the development banks. This trend is likely to grow given that the next generations of development banks are backed by China (Asian Infrastructure and Investment Bank or AIIB and the BRICS Bank officially known as the New Development Bank). In any case, these figures illustrate the fact that the Chinese financial commitment to Pakistan matches Chinese rhetoric, that Pakistan is its key ally.

No doubt critics will argue that the majority of China’s financial commitment is in the form of loans and that the ADB and World Bank provide much cheaper loans. Of that there is no doubt, but multi-national development banks can never match the lending power of the Chinese war chest and in this day and age, these institutions cannot be relied on as the sole source of capital (and neither do they want to play this role). The ADB estimates that $800 billion is needed for infrastructure development in Asia and MDBs can barely provide 5 percent of that requirement. Furthermore, the opportunity cost of not building a project sooner rather than later because of a marginally higher interest rate far outweighs the benefits of a lower interest rate (where the project may only be realised years or decades later). To give the reader perspective, Chinese commercial loans to Pakistan are possible at about 4.5 percent per year, with durations of 15+ years and even the possibility of a grace period during construction. Chinese preferential loans are agreed at much lower rates of around 2 percent (the vast majority of Chinese loans to Pakistan) and for much longer periods. Pakistan’s sovereign borrowing rates on the international markets are well into double digits, and even the much-hallowed Pakistani bond by the present government was issued at 8 percent. Chinese loans are in this context much cheaper and plentiful.

Indeed, Pakistan’s addiction to preferential loans from multi-national development banks is a large part of the problem with capitalising on the opportunity that an abundance of Chinese capital offers. The fact is that for the past five decades Pakistan’s core economic policy has been to rely on MDB lending as part of public spending to build infrastructure and drive growth. While the IMF, ADB and World Bank have made huge contributions to the development of Pakistan, Pakistan’s complete reliance on the Bretton-Woods institutions has hamstrung its ability to generate the type of organic growth China or even the US in its early days so effectively nurtured. Chinese planners identified this in the 1980s, when they felt that the MDB suggestion to liberalise prices all at once and implement austerity would be disastrous without strong institutions. MDB funding is the crutch that has weakened Pakistan’s ability to nurture indigenous and organic growth. Specifically, the Pakistani bureaucracy and policy making machine has become too comfortable with its role as simply a conduit for development funding. It is simply not adept at developing indigenous capacity and resources, or nimble enough to work with the private sector in the national interest. Nowhere is this clearer than in the field of infrastructure development, and nowhere is this more obvious than in the present situation when Pakistan desperately needs new sources of funding if it is to advance economically.

The vast majority of investment into Pakistan, whether from MDBs, national development banks (like Korea or Japanese EXIM banks) or China is in the form of preferential loans to Pakistan against sovereign guarantees. The issue is not that Pakistan gravitates to the cheapest form of capital, but that it tends to rely solely on it and suffers from its many restrictions. Chiefly, the phenomenon of the “tender” (most commonly seen in the form of EPC (Engineer Procurement and Construction, contracts for large infrastructure projects) has become the standard for Pakistani infrastructure development. There are many benefits to tendering, namely that in developed economies they really can encourage competition and decrease price. However, these are priorities for developed economies, not for developing economies like Pakistan’s. Instead, for a country like Pakistan, every project is an opportunity to develop indigenous capacity, retain earnings at home and drive growth. The problem with tendering is that somehow, our policy makers have convinced themselves that only foreign companies are competent and should be given the opportunity to compete for Pakistan’s high value contracts. Requirements for participating in these contracts are stupendously high, and are unlikely to be fulfilled by any contractor in Pakistan. In fact these requirements are very much tailored to foreign contractors. China took a very different approach to its infrastructure development while working closely with MDBs and foreign aid. For most of China’s major projects, the executing agency (with the aid of a competent foreign consultant) would divide contracts up and distribute them to local companies (mainly state owned). In this way they were able to develop indigenous capacity, so that now with over 50 years of building in China, Chinese companies are leaders in building hydropower, rail and roads.

Though beyond the scope of this article, it is worth thinking about the institutions that fostered the development of these companies. Institutions such as state-owned banks, which took risks on newly formed construction companies with limited experience. The beauty of state capitalism is that it will take risks, where the private sector never can. It’s important to point out that state capitalism is hardly a Chinese phenomenon; in fact it could be argued that it was pioneered in the USA. Of course, Pakistan’s experience with state run banks and financial institutions has been terrible with politically motivated loans that bankrupted these financial institutions. However, we need to seriously think if Pakistan has not thrown out the baby with the bath water in entirely giving up on development financing? Is it time to revisit this policy, perhaps through public private partnerships arrangements that address the chronic governance issues that led to the fall of such institutions in the past?

Pakistan needs to look to the experience of Africa and South America, where Chinese investment has made a significant impact on the fortunes of some of the poorest countries in the world. Take the Congo for example, a country with an economy a fraction of the size of Pakistan’s. In 2011, the Chinese Development Bank (CDB) signed a deal that would improve the rail and road networks as well as the mining, energy and manufacturing industries. This type of package loan has the effect of decreasing cash flow pressure and spreading the risk of the loan to several projects. In fact the premise of this package loan is integration. Loans do not need to rely entirely on a sovereign guarantee (indeed for poor countries to give such a large guarantee would be difficult, as it is for Pakistan), but on collateralising unexploited natural resources. Far from mortgaging the ‘family silver’ as some critics have called it, this method allows poor countries access to the large volume of cash needed for rapid development. A similar approach has been taken by China with Russia, Brazil and Ghana, where the CDB has provided loans against the sale of future oil shipments. These kinds of loans can be taken while simultaneously investing in the sector against which guarantees are provided, maximizing use of resources. Pakistan has an abundance of natural resources that could be exploited to fuel growth in a country struggling to generate high quality growth. Even apart from natural resources, China has channeled investment into manufacturing in countries like Ethiopia. As China loses the advantage of cheap labour (and manufacturers in China face stricter environmental regulation) it is now moving manufacturing abroad while investing in bankable projects. Pakistani policy makers and politicians alike have to take a serious look at the alternative models of financing available to them. As Pakistan still reels from an ongoing insurgency and even worse a terrible international image as an unstable and insurgency prone country, it has to take the opportunities available to it. Pakistan’s relationship with China, and China’s push to export capital and manufacturing abroad offers Pakistan an enormous opportunity to economically leap ahead.

To fully grasp this opportunity, Pakistan’s policy makers will need to reform. They will need to use scarce MDB loans for visceral non-revenue generating infrastructure while figuring out how to use new sources of capital to leverage domestic and foreign capital into infrastructure and investment projects in Pakistan. Without this the much-lauded China-Pak Economic Corridor (CPEC) will remain nothing more than a pipedream. With lofty ambitions of bringing in over $46.5 billion of projects to Pakistan, this new “silk-road” may be a non-starter. Fundamentally, the entire concept is bottlenecked by Pakistani policy makers’ inability to conceive of these projects except through a sovereign loan modality. Pakistan’s ability to take sovereign loans is not infinite. In any due diligence both the IMF, MDBs and Chinese banks will need to pay attention to what level of debt Pakistan can reasonably service. By definition Pakistan will have a limited scope for taking on sovereign loans even with Chinese banks keen to lend. . There may genuinely be a $46.5 billion pipeline of projects under CPEC. However, only a fraction of the sea per year may be sanctioned based on traditional sovereign lending, and BOT projects are no panacea as in the Pakistan context they invariably rely on sovereign guarantees to cover various risks. IMF views such sovereign guarantees as contingent liabilities against Pakistan’s capacity to borrow. Also, it will not come as news to industry insiders that any equity invested in BOT projects (the only part of CPEC that can count as anything other than debt) by Chinese companies are usually the result of fancy accounting. Not to say that there is fraud but that this equity is rarely hard cash.

Critics may argue on the marginal benefits of Pakistan’s current approach, but one thing is perfectly clear: Pakistan is way behind the curve when it comes to leveraging foreign capital for growth. To realise the full potential of CPEC and indeed other Chinese investments into Pakistan, our policy makers will have to move beyond their addiction to precious but inadequate MDB or other concessional sovereign loans. We need more innovative financing to leverage in domestic and foreign capital. Not all is lost, as  Pakistan has the fundamentals to dramatically change its fortunes. The question is whether policy makers will have the will to make it happen.