abc Building on China s overseas investment Two birds, one stone Global Research Macro China and Asia Economics 8 August 2014

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1 Global Research Building on China s overseas investment Two birds, one stone China will soon be investing more capital abroad than it receives in foreign direct investment This will make better use of its foreign reserves and support exports, jobs and the RMB s internationalisation The China-led Asian Infrastructure Investment Bank will offer another source of funding in the region China is going global: its consumers are travelling abroad, its companies are buying resources from all over the world, and the government is finding new places to invest the country s USD4trn of foreign reserves. As these trends continue, we think the next big thing will be China s export of capital, especially to infrastructure investment projects in Asia and further afield. 8 August 214 John Zhu Economist The Hongkong and Shanghai Banking Corporation Limited john.zhu@hsbc.com.hk Ronald Man Economist The Hongkong and Shanghai Banking Corporation Limited ronaldman@hsbc.com.hk Qu Hongbin Chief Economist, Greater China; Co-Head of Asian Economics Research The Hongkong and Shanghai Banking Corporation Limited hongbinqu@hsbc.com.hk View HSBC Global Research at: Issuer of report: The Hongkong and Shanghai Banking Corporation Limited Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it China s infrastructure boom in recent years has created an economy well suited to designing, building and servicing large infrastructure projects. Although we have argued that there is still plenty of room for China to keep investing in its domestic infrastructure (see Rebalancing a dangerous obsession, 2 June 214), the peak may have already passed. As such, it makes sense for China to look to overseas markets to put all that capacity to use. It may not have to look far. We estimate that Asia needs to invest USD11trn in urban infrastructure by 23. In this report, we update our Asian Infrastructure Measure, and find that while infrastructure development in the region has increased, it is still far below US levels. At the same time, funding gaps have emerged, especially in Indonesia, India and Thailand. To fill them, Asia may have to rely more on external funding as domestic sources become scarce. With a proposed USD1bn capital base, the China-led Asian Infrastructure Investment Bank (AIIB) offers an alternative source of funding for infrastructure in the region. Spending on infrastructure is essential for growth, so there is potential for a win-win situation: China helps to narrow Asia s funding gap and in the process achieves its own policy objectives, including the internationalisation of the renminbi.

2 8 August 214 Tides turning China s direct investment abroad is set to eclipse inward foreign investment, supporting exports and jobs Overseas direct investment makes better use of reserves, creates a larger export market, supports jobs and absorbs spare capacity Recipient countries can tap a new major source of funding and benefit from technological transfer, especially in infrastructure It is one of the lesser-known achievements of China s development in the decades since it opened up the economy: China has maintained or increased its openness to global trade and capital through both good and bad times. We think China s integration with the global economy will continue through a new phase of greater investment overseas, especially in infrastructure projects. China s outward direct investment (ODI) is on track to overtake inflows of foreign direct investment, with major implications for China s balance of payments and for countries receiving ODI (chart 1). China s recent infrastructure boom means many parts of its economy have specialised knowledge in this area; however, the peak in terms of domestic growth may be in the past (chart 2). Looking for overseas markets to put this capacity and expertise to good use would make sense. Will there be demand? We argue yes: emerging market economies in Asia and further afield still have pressing infrastructure investment needs. The problem is one of funding, but this also presents a potential win-win situation as China needs to better invest its excess savings overseas. The creation of the Asian Infrastructure Investment Bank (AIIB) could solve both problems. 1. Direct investment outflows soon to overtake inflows 2. Domestic fixed investment in China has slowed USD bn China, FDI v s ODI % ODI non-financial FDI utilised ODI/FDI (RHS) Source: Ministry of Commerce % China, Fixed Asset Inv estment, YTD YoY, 3mma % Secondary Tiertiary Source: NBS

3 8 August 214 Table 1. Comparison between AIIB, ADB, and AIF Asian Infrastructure Investment Bank (AIIB) Asian Development Bank (ADB) ASEAN Infrastructure Fund (AIF)* Capital base (USDm) 1, (proposed) 16, 48 Date of establishment TBD Headquarter location TBD Philippines Malaysia Total financing in 213 (USDm) TBD 21,2 2 Members (Voting rights, %) TBD Japan (12.8) Malaysia (3.9) United States (12.7) ADB (3.9) China (.) Indonesia (24.7) India (.4) Philippines (3.1) Australia (4.9) Singapore (3.1) Canada (4.) Thailand (3.1) Indonesia (4.4) Brunei (2.1) South Korea (4.3) Vietnam (2.1) Germany (3.8) Cambodia (.) Malaysia (2.) Laos (.) Source: HSBC, ADB, AIF. Note that the ten members with the largest voting rights are shown for the Asian Development Bank. The ADB has 67 member countries. *AIF-financed projects are also co-financed by ADB funds. The voting rights for the AIF correspond to the capital contribution. First proposed by Beijing on 2 October 213, according to a statement issued by China s Finance Ministry on 7 March 214, the AIIB will have a mandate to fund infrastructure projects in Asia on commercial terms and complement the work of similar entities, such as the Asian Development Bank (ADB). The proposed capital base of the AIIB is USD1bn, to be financed by its members. This makes the AIIB s capital base roughly two-thirds the size of the Asian Development Bank (see table 1 for details). At the time of writing, the voting structure of the AIIB has yet to be decided. However, the voting rights of each country are expected to be proportional to their stake in the AIIB. As of 24 June 214, 22 countries in Asia and the Middle East have expressed interest in joining the AIIB, which is expected to be established by year-end 214. A receding tide of capital The loose and unconventional monetary policies in response to the 27-8 financial crisis would have led one to expect the world to be awash with ODI. However, the level of ODI has actually decreased since the financial crisis (chart 3). There are many explanations why the extra liquidity has not yet resulted in a flood of ODI flowing abroad. Risk-averse investors probably focused more on deleveraging after the crisis. In addition, the uncertain and (still) fragile nature of the global economic recovery has dampened risk appetites. Whatever the reason, the retreat in global ODI flows has not been helpful for smaller and poorer countries with significant and pressing investment needs, especially in infrastructure. From a historical perspective, despite several decades of globalisation, capital flows are still far below the levels of their heyday in the late 19 th and early 2 th century before the First World War. Back then, for example, Britain regularly exported over % of its GDP every year. This raises intriguing questions: can China play a similar role as its own economy develops, and will it want to? 3. China ODI has grown rapidly despite global retrenchment USDbn FDI outflow s, China vs World total USDbn 2, 2, 1, 1, Source: Unctad World (LHS) China (RHS)

4 8 August 214 China, going against the current? While ODI flows have fallen on a global level in the years since the financial crisis, Chinese ODI has accelerated over the past decade. It is still attracting a significant share of total world FDI net inflows, but it is the upward trend in its share of outflows that is most striking. 4. China is still a large recipient of FDI, but the US still leads %w orld Share of global direct inv estment flows %w orld 4 4 Demand, meet supply Global capital flows create a much larger pool of funding, allowing governments to run larger budget deficits. For example, the US has been able to invest, despite saving little, precisely because of its ability to draw in foreign capital. Developing countries rely even more heavily on FDI to fund domestic investment (chart ).. Other countries use of FDI in investment have increased % FDI inflow s as share of gross fixed capital formation % China Inflows China Outflows US Inflows US Outflows Source: Unctad Still, it is important to put things into perspective: the majority of FDI flows are between rich countries. The US still receives a large, if diminishing, share of global inflows (chart 4). Developing countries (excluding China) pull in 43% of total global net FDI, which is still below the peak of 4% reached in the early 198s. That inflows to developing countries are not larger (and rich countries still draw the majority of capital inflows) has long puzzled economists, since poorer countries have less capital and so should in theory offer better returns. Of course, some developing countries have done better than others in attracting FDI inflows, and China is a good example of how opening up to global trade and capital, if successfully managed, can bring many benefits. Moreover, China is now well positioned to use its past experience to make a positive contribution to global FDI flows, which should be good for countries in need of capital China Developing countries ex. China US Source: Unctad The arrival of China s significant stocks of excess savings (much of which has been accumulated in the form of USD4trn of foreign reserves) would represent a significant increase in the amount of funding available. As of the end of 213, China s annual non-financial ODI flows totalled just over USD9bn, or 2.4% of its total foreign reserves. In terms of flow, USD9bn of total annual ODI outflows is still only 18% of the USD1bn growth in China s stock of foreign reserves in 213. And, as the Federal Reserve eventually moves to normalise its monetary policy, China s ODI growth can also act as a stabilising force on global capital flows. We now look at the costs and benefits for China associated with the rapid growth of ODI, the impact of FDI on recipient countries, and case studies of three countries, where infrastructure investment needs are well-aligned to the likely future trend of Chinese ODI. 4

5 8 August 214 The benefits for China Foreign investment should create a larger market for Chinese exports of both goods and services Increasing ODI would allow China to make better use of its large stock of foreign reserves Strengthening trade and investment links between China and recipient countries can help the RMB s internationalisation process Time to invest differently China has run a current account surplus for many years, although this has fallen from high single digits to 2.4% of GDP in 213. While the surplus is mainly due to China s positive balance in trade in goods, this has been partially offset by an increasing deficit in the income component of the current account. The deficit on its investment income part of the current account ran to USD6bn in 213 (chart 6). Indeed, China pays out a larger and increasing amount to foreign investors in Chinese firms than Chinese firms are repatriating from overseas. This is an unusual situation for a developing country, which China still is on per capita GDP terms. It does not need to import foreign capital, given that it still has excess savings, which it invests abroad in lower yielding assets such as US treasuries. We think a shift towards China investing and/or funding infrastructure projects overseas will allow Beijing to generate better returns (chart 7), gradually rebalance demand externally and absorbing spare capacity, to boost trade and to help internationalise China s currency, the renminbi (RMB). 6. China earns less from its foreign investment income 7. China s outward contract work is becoming more lucrative USD bn Source: SAFE China, income balance of payments USD bn Balance Payments Receipts - USDm Value of completed outw ard contracts USDm 16, 14, 12, 1, 8, 6, 4, 2, Contract value Value/completed Source: Ministry of Commerce 2 1

6 8 August 214 Better use of its reserves On a macro level, one of the most salient aspects of China s economy has been its high investment rate, which is more than matched by an even higher saving rate. This means that China is not fully utilising domestic savings and is instead exporting capital abroad (chart 8). This is unusual for a developing country that still has plenty of scope for useful domestic investment. China has a per capita GDP of less than USD7, 13% of the US average. Yet, instead of fully investing savings domestically, China is sending excess savings abroad to effectively fund the US fiscal deficit, accumulating low-yielding assets in return. 8. China has a persistently high domestic saving rate % China, national savings and investment as share of GDP % Savings Gross capital formation Source: NBS We are not arguing that China should save less (see China Economic Spotlight: Rebalancing a dangerous obsession, 2 June 214), but that it should be possible to find a better way of utilising its excess savings. One such opportunity for both China and countries receiving FDI is infrastructure investment. And not just in poor countries either, but theoretically for any economy running current account deficits and with infrastructure investment needs. What goes around comes around By definition, capital inflows must lead to trade deficits for the receiving country. The influx of money for investment increases demand, which must be met through an increase in imports. On balance, this is likely to be positive for Chinese exporters: Chinese ODI will create demand for China s exports, absorbing excess capacity and helping to sustain economic and employment growth domestically. The majority of studies show that ODI has an overall positive effect on the exports of the sending country. Foreign production can, in theory, replace exports of a single product, but it usually generates demand for the export of other goods, such as capital goods or intermediate goods and services. For example, before ODI, Chinese companies would export finished goods. As this model shifts from exporting finished goods to exporting capital, companies start to export a mix of finished and intermediate goods, with intermediate goods used to make finished goods in the FDI-receiving country. The corresponding increase in the exports of intermediate goods typically outweighs the fall if any in exports of finished goods. Of course, there are also dynamic as well as static gains. Increasing output in the capital-receiving country also means higher incomes and, again, an increase in demand for imports, including from China. Finally, the nature of the investment also makes a difference. It is likely that the ODI/infrastructure investment model will not just involve goods trade, but services too: infrastructure investments also require servicing further down the line, offering another potential growth area export, such as management/maintenance services. 6

7 8 August 214 FDI and trade: in tune There is evidence that countries where China makes outward direct investments do indeed import more from China in return. We looked at a sample of China s 3 top destinations for nonfinancial ODI (excluding tax havens) and found that not only is Chinese export growth to those countries faster on average, but that Chinese exports to these places also gained market share at a faster pace. In the past decade, the average annual growth rate of total Chinese goods exports was 19% y-o-y. However, export growth to the top 3 countries by accumulated Chinese ODI was 2%. Moreover, of the top 3 ODI destinations, the share of their imports from China in total imports is usually greater than the share of Chinese imports in global imports (chart 9). 9. ODI receivers also tend to import more Chinese goods % Imports from China as share of total imports % World US Australia Canada Source: IMF That effectively means in the countries where China has invested the most, its exporters have been able to gain a larger market share on average (17% in 213), relative to what would be expected according to China s total share of world exports (12% in 213). This applies to both developed and emerging market economies (chart 1), near and far with the notable exception of a number of European countries such as the UK, France and Germany Asian countries receive both the most ODI and imports % Imports from China as share of total imports % World Indonesia Korea Japan Source: IMF Which sectors will benefit? Although it is never easy to predict which specific sectors will succeed or fail on the international stage, there are several rules of thumb. One of the most important is that countries trade according to comparative advantage, i.e. they export goods which they are relatively better at producing, taking into account differences in productivity. China has been building up its infrastructure capabilities in recent years and its economy has a ready stock of capital, labour and technology that has increased its capacity to design, build and service large infrastructure projects. Growth in infrastructure-linked ODI would, therefore, be a logical development. While we don t think infrastructure investment in China has reached a saturation point, we believe it would make sense to look for overseas markets to allow productive capacity to be absorbed gradually through more external demand of which there should be plenty, as we will show in a later section. One way of looking at this is through the proportion of Chinese industrial production that is being exported i.e. what is produced and not consumed domestically. Take steel production, for example, an industry where one would expect to see increased global demand

8 8 August More of China s steel production is being exported 12. China s economy is shifting towards services Tons China, steel products, production and exports % Exports less imports Exports/output (RHS) Source: NBS, China Customs % China, GDP by output as share of total GDP % Primary Industry Secondary Industry Tertiary Industry Source: NBS What has happened in steel is a microcosm of the changing nature of China s economic structure. In the 199s, China was still pursuing an export-led growth model, investing a lot in factories and production facilities. These are intensive in raw materials, such as steel, in the initial investment as well as inputs used to produce finished manufactures for export. However, the pattern of investment and growth has changed. China is now capable of producing more for itself. At the same time, it is also exporting an increasing proportion of that output. This was clear during 24-8, before the sharp fall in world trade (chart 11). The upward trend in exports as a share of output has since resumed. Investing, not competing Mirroring the shift from manufacturing to infrastructure investment, a second structural trend is the steady rise of the tertiary sector (i.e. services such as retail, transportation, finance and public administration). This sector now accounts for 46% of GDP (chart 12) and recently overtook the secondary industries (industry, manufacturing, construction and utilities). This shift towards services has also been seen in China s ODI strategy it has mostly been investing abroad to acquire interests in services industries, such as in banking and insurance and retail sectors that not highly traded (chart 13). 13. China has so far mostly invested in services sectors % China outw ard ODI by sector, accumulated stock of investment Agricultural Mining Manufacturing Source: Ministry of Commerce Electricity, Gas & Water Construction Transport, Storage & Postal Service Information Transmission, Wholesale & Retail Accommodation & Catering Banking and Insurance Real Estate Leasing & Commercial Services Scientific Research Water conservation, Environment & Utility Residential & Other Service Education Health Care, Social Security & Welfare Culture, Sport & Recreation Public and Social 8

9 8 August 214 This focus on services means there is relatively little in terms of import-competition hitting workers back home, since services are much less traded than, say, agriculture or manufacturing. Would this change if future ODI is in infrastructure, i.e. the transport and construction sectors? We think this is unlikely, since infrastructure is consumed domestically as well wherever it is, rather than traded, as explained earlier. In practice, it seems that the primary benefit for China in infrastructure investment should outweigh the potential costs. There has so far been little evidence of hollowing out of the manufacturing sector, since much of China s ODI does not go towards manufacturing in the first place. More generally, jobs simply do not follow investment flows out of the country. A likelier outcome would be ODI creating a larger market for Chinese exports instead and supporting jobs in those exporting sectors. RMB internationalisation We have written extensively about the internationalisation of the RMB (see Rise of the Redback III, March 214), and how it will likely be driven first by trade and then capital flows before reaching the convertibility stage. The growth in China s ODI flows is likely to be another step that helps to increase the use of the RMB as an international currency through both investment and trade channels. 14. Trade drives RMB internationalisation RMBbn China goods imports and exports, RMB settled % Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 RMB-settled trade (LHS) % of total trade (RHS) Source: PBoC, IMF Conclusion We have argued that there are good macroeconomic reasons for China s ODI flows to continue to grow, and eventually overtake FDI flows into China. This will likely be driven by the need to earn a better return on China s large stock of foreign reserves, and to export its capabilities in infrastructure investment that have built up over the years. We argue in the following section that at the same time as China s ODI is increasing the global supply of international capital and infrastructure investment capacity, demand for both in other parts of Asia is also substantial. China can meet more of this demand, and in the process achieve its own policy objectives. 2 1 As we have shown earlier, countries where China invests in typically import more from China as well. ODI increases trade links, and the trend in the past couple of years has been increases in both the absolute amount of trade settled in RMB, as well as steady growth in the proportion of trade that is RMB settled (chart 14). 9

10 8 August 214 Implications for Asia Asia will benefit from more infrastructure investment: we update our Asia Infrastructure Measure to gauge the latest developments But funding gaps have emerged as governments consolidate their fiscal balance, especially in Indonesia, India and Thailand The China-led Asian Infrastructure Investment Bank offers an alternative funding source for infrastructure investment in the region A new source of funding Emerging Asia will benefit from more infrastructure investment. Stronger infrastructure raises capital and labour market efficiency, boosting national productivity. This is important, given Asia s urban population is set to rise by 6m between 21 and 23: we estimate that over USD11trn of urban infrastructure investment is required to accommodate this demographic shift (see Bridging the gap, May 213). Despite the low global interest rate environment, capital for infrastructure investment has become scarce and funding gaps have emerged. The publicgood properties of infrastructure present a strong case for the public sector to do most of the heavy lifting; however, policymakers in Asia have prioritised fiscal prudence and the contribution of budget funding is projected to moderate. At the same time, although the private sector was encouraged to contribute to selected projects, the commercial viability remains low, especially through public-private partnerships. The China-led Asian Infrastructure Investment Bank (AIIB) could be a large source of alternative funding. With a proposed capital base of USD1bn, the AIIB plans to provide. ADB disclosed financing to Asia decreased since Disclosed ADB financing to Asia by economy USDbn Philippines 6% Indonesia 7% Sri Lanka % Thailand 1% India 39% ADB financing to Asia* *Asia includes: China, India, Indonesia, Philippines, Sri Lanka, Thailand, and Vietnam. Source: ADB, HSBC Vietnam 21% China 21% Total disclosed ADB financing to Asia* between 1998 and 213: USD68bn *Asia includes: China, India, Indonesia, Philippines, Sri Lanka, Thailand, and Vietnam. Source: ADB, HSBC 1

11 8 August 214 Table 2. Component breakdown of the Asia Infrastructure Measure (AIM) Component Weight Description Source Road Density 6.2% Road density (km of road per 1 km 2 of land area) World Bank Paved 6.2% Roads, paved (% of total roads) World Bank Port 12.% Quality of port infrastructure World Bank Telephone 12.% Fixed telephone lines (per 1 people) World Bank Internet 12.% Fixed broadband Internet subscribers (per 1 people) World Bank Rail 12.% Rail density (total route-km per 1 km 2 ) World Bank Air Air freight 6.2% Air transport, freight (million tonne-km) World Bank Air passenger travel 6.2% Air transport, passengers carried per 1 population World Bank Energy 12.% Electricity production, kwh per population World Bank Water 12.% Access to safe drinking water (% of population) Pacific Institute Source: HSBC, World Bank, Pacific Institute infrastructure loans to its member countries. While the operations of the AIIB draw parallels to those of the Asian Development Bank (ADB), we believe Asia will benefit from more sources of infrastructure funding. The disclosed funding provided by the ADB to Asia peaked at USD9bn in 211 and fell to USD7.3bn in 213, a small fraction of infrastructure investment made in the region (chart ). The majority of disclosed ADB funding into Asia is allocated to India, China, and Vietnam (chart 16). We believe AIIB funding will focus on three key criteria: infrastructure development, trade with China, and the size of the economy. 1. Infrastructure development The lower the level of infrastructure development in an economy, the stronger the case will be for funding support from the AIIB. To measure infrastructure development, we updated our Asia Infrastructure Measure (AIM), which tracks the region s infrastructure development. The AIM is made of eight equally-weighted broad infrastructure components roads, ports, telecom, internet, rail, air links, energy, and access to clean water (table 2). Each component is taken relative to the US equivalent. For example, in 212, China had 12.7 fixed broadband internet subscribers per 1 people, vs 28. in the US. Therefore, China s internet reading in the AIM is 12.7/28. =.4. This gives us a good indication of how infrastructure in emerging Asia compares with the US. The latest value,.68, shows that infrastructure development in emerging Asia was around 68% of that in the world s largest economy in 212 (chart 17). The increase in the AIM shows that infrastructure development rose in Asia but is still far below US levels. 17. Infrastructure development rose further in Infrastructure development by economy AIM value AIM value: by economy (212) Asia Infrastructure Measure (AIM) Singapore Hong Kong Korea Japan United States AIM Sri Lanka Malaysia China India Thailand Vietnam Indonesia Philippines Source: HSBC, World Bank, Pacific Institute Source: HSBC, World Bank, Pacific Institute 11

12 8 August AIM heat-map by economy and component, 212 values. Intensity of red increases for lower values. Road Water Port Telephone Internet Rail Air Energy AIM: Economy China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Sri Lanka Thailand Vietnam AIM: component Source: HSBC, World Bank, Pacific Institute. Note there were no data available from the World Bank for rail in Hong Kong and Singapore. As such, we have omitted their respective readings from the calculations. The relatively high score for road infrastructure should be interpreted with caution as it may not adequately capture the significant differences in quality and degree of urbanisation, especially between India and the US. There are variations at country level. The three economies with the highest infrastructure development level are: Singapore, Hong Kong, and Korea (chart 18). Meanwhile, the lower end of the spectrum is composed of less-developed ASEAN economies. The latest AIM values suggest that infrastructure development in Singapore is 4.7 times greater than in the Philippines. To minimise the inequality of infrastructure development in Asia, investments across different components are required for each economy. Chart 19 shows a heat-map of the 212 AIM readings by economy and component: numbers highlighted in a darker shade of red represent a greater need for infrastructure investment. For example, there is a stronger need for road development in Indonesia than Hong Kong. 2. Trade with China China has a greater incentive to strengthen its ties with its main trade partners. While the Asian Tiger economies are at the upper end of the scale, the differentiation thereafter is more important. From the trade perspective, Malaysia, Thailand, and Indonesia matter more to China because they collectively account for 6% of China s trade, which is twice the combined amount of Sri Lanka, the Philippines, and Vietnam (chart 2). 3. Size of the economy The larger an economy, the greater the incentive China has to strengthen its ties with that economy with the AIIB and increase its influence in the region. Using nominal GDP in US dollars, the top three economies in emerging Asia, excluding China, are India, Korea, and Indonesia (chart 21). 2. China s trade ties across Asia 21. Nominal GDP of emerging Asian economies % Hong Kong Korea Taiwan Malaysia Singapore Thailand Indonesia India Share of China's trade (213) Vietnam Philippines Sri Lanka USDtrn India Korea Indonesia Taiwan Thailand Malaysia Singapore Hong Kong Nominal GDP (213) Philippines Vietnam Sri Lanka Source: CEIC, HSBC Source: CEIC, HSBC 12

13 8 August 214 Our conclusion Based on these three criteria, we summarise our finding in table 3. We rank the 1 economies in emerging Asia, excluding China, in: Ascending order by AIM value. A higher rank indicates lower infrastructure development. Descending order in size of trade with China. A higher rank indicates an economy that accounted for a greater share of China s trade in 213. Descending order in size of nominal GDP. A higher rank indicates a larger economy. The score of each economy is defined as the sum of the three ranks listed above. The scores are then sorted in ascending order (Table 3). We expect the China-led AIIB to have greater interest in economies with a lower score. We believe that Indonesia, India, and Thailand are the three economies the China-led AIIB will have the greatest interest in. While Korea s score is one point above Thailand s score, given the larger size of the Korean economy and its stronger trade links with China, local media Yonhap News reported on 27 July 214 that South Korea is reluctant to join the AIIB. Meanwhile, the ruling National Council for Peace and Order (NCPO) gave approval for Thailand to join the AIIB as a founding member on 22 July 214. Policymakers in Indonesia and India may also be interested in joining the AIIB. This is because funding gaps have emerged in their infrastructure investment plans, which need to be filled by more capital. The rest of this chapter looks into the size of the funding gaps in Indonesia, India and Thailand based on their government s latest infrastructure investment plans and the implications for their economies. Table 3. Ranking of emerging Asian economies (lower score represents a higher likelihood of interest from the AIIB) AIM Trade with China Nominal GDP Score Indonesia India Korea Thailand 4 14 Malaysia Hong Kong Philippines Vietnam Singapore Sri Lanka Source: HSBC, CEIC, IMF, World Bank, Pacific Institute. Note that there is no AIM value for Taiwan and hence it is not included in the ranking system. 13

14 8 August 214 Indonesia: 17% funding gap China first proposed the Asian Infrastructure Investment Bank in Jakarta, October 213 Indonesia s plans infrastructure investment of USD4bn, but more is required Further reforms to increase the commercial viability of infrastructure projects in Indonesia In its Masterplan for Acceleration and Expansion of Indonesia s Economic Development (211-2), also known as the MP3EI, Indonesia s government aims to transform its economy into one of 1 largest in the world. To achieve this, real GDP needs to grow at 7-9% between 211 and 22 and a total of IDR1,786trn (USD4bn) of infrastructure investment is required. We believe this will be insufficient as the Five-Year National Development Plan (21-14) alone included infrastructure investment of IDR1,924trn (USD166bn). History suggests funding risks are prevalent: the National Development Planning Agency (BAPPENAS) estimates the funding gap for planned infrastructure investment is 17% (chart 22). The government has made efforts to cover the funding gap. The Ministry of Finance (MoF) created the Viability Gap Funding Mechanism in 213, which covers up to 4% of costs upfront. Other major entities were established, most notably the 3+1 : Indonesia Infrastructure Guarantee Fund (IIGF), Indonesia Infrastructure Finance (IIF), Sarana Multi Infrastrucktur (PT SMI), and the Indonesia Investment Agency (IIA). The IIA is closely associated with the MoF and is the 1 in the 3+1. That said, the level of financing from the 3 is limited when compared with the infrastructure investment required (chart 23). For the new AIIB to fill this funding gap, the loan conditions need to be politically viable. External borrowing is under greater political scrutiny: the Asian Financial Crisis created a general aversion to foreign loans. It follows that the process must be transparent, as public attention is centred on anti-corruption as evidenced by the victory of the reformist Joko Widodo (Jokowi) in the 9 July presidential elections. More reforms raise the commercial viability of infrastructure projects, such as power and water, where producers face unfavourable tariffs. In May 214, the government started a new round of electricity tariff hikes for industrial consumers to reduce the fiscal burden of related subsidies. A cumulative hike of 38.9% or 64.7% will be imposed by year-end 214, depending on power consumption. As prices become market-driven, private sector interest in Indonesia s infrastructure opportunities is set to rise. 22. Indonesia s infrastructure investment funding 23. Balance sheet of key entities to support infrastructure Funding gap 17% Private 18% SOE 18% Source: BAPPENAS, HSBC Central government 29% Local government 18% Total infrastructure investment: IDR1924trn Balance sheet size (213), IDRtrn SMI IIGF IIF* Balance sheet Source: HSBC, IIGF, PT SMI. *Estimate 14

15 8 August 214 India: 23% funding gap China has invited India to join the Asian Infrastructure Investment Bank India s 12 th Five Year Plan estimates an infrastructure funding gap of USD243bn The Asian Development Bank provided only USD3.bn of financial loans to India in 213 India projects that its infrastructure investment totals INR6trn (USD1trn) in its Twelfth Five Year Plan (FYP) for , roughly twice as much as under the previous FYP. However, officials estimate a funding gap of INRtrn (USD243bn), 23% of planned investment (chart 24). The share of infrastructure funding from the public sector is set to decline from 67% to % over the current FYP. The success of previous publicprivate partnerships (PPPs), such as the Delhi airport and Jhajjar power transmission project in Haryana, strengthened the case for the government to tap into non-public sector resources as the government consolidates its fiscal position. In its FY budget, the government aims to reduce its fiscal deficit from 4.6% of GDP to 4.1%, with substantial investment in infrastructure through the PPPs identified as one of 1 tasks for the future. Therefore, it is clear that there is less public capital available to fill the shortfall in infrastructure investment funding. However, the domestic private sector may not have the capacity to fill this funding gap. The main private sector funding source is commercial banks, most notably public sector banks. Banks rapidly raised their exposure to the infrastructure sector between 27 and 211, and the sector s share of non-food bank credit rose from 8% to 14% (chart 2). The Planning Commission observed that most banks have reached their prudential caps for [the] power sector; other sectors like roads may not be far behind. In the absence of further increases in the banks capital base, the scope for bank credit to drive infrastructure investment has narrowed. International organisations can reduce the funding gap and support infrastructure development in India, which slowed over the past three years, according to our AIM. As a benchmark, the Asian Development Bank provided USD3.bn of disclosed funds to India in 213, close to a historical high. Even assuming this amount was sustained through the current FYP, the ADB will likely provide only USD18bn of funding: a fraction of the estimated USD243bn shortfall. Further financial support will thus be welcomed in India. 24. Funding of infrastructure investment in 12th FYP 2. Share of bank credit to infrastructure in India Funding gap 23% Equity & FDI 7% ECB 1% Insurance 2% Commercial banks NBFCs 6% Budgetary support % 11% Note: Non-banking financial companies = NBFCs, external commercial borrowing = ECB, foreign direct investment = FDI % of non-food credit Total infrastructure investment: INR6trn FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 FY14 Bank credit to infrastructure Source: Planning Commission, HSBC Source: RBI, HSBC

16 8 August 214 Thailand: 43% funding gap The NCPO approved in principle for Thailand to join the Asian Infrastructure Investment Bank Infrastructure development may slow, given the revocation of the THB2trn infrastructure bill Weak infrastructure may weigh on Thailand s aspirations to be ASEAN s transport centre The Infrastructure Development Plan forms the baseline for infrastructure investment in Thailand. The Plan details THB2.3trn (USD72bn) of infrastructure investment to be made by the end of the decade: 6% of the total is earmarked for land transport, which includes high-speed trains and a metropolitan rail system. However, the Asian Development Bank estimated that the country may face up to a 43% funding gap (chart 26). Ambitions for infrastructure investment remain high and a THB2trn infrastructure spending bill was passed by the Cabinet in March 213 to finance new megaprojects. The bill would have doubled the country s infrastructure budget to THB4trn; however, the bill has been placed under review by the National Council for Peace and Order (NCPO). On 29 July 214, the NCPO approved an infrastructure spending plan for 2-22, which includes eight train projects valued at THB867bn (USD27bn). Two of the eight projects will serve as a transport link between Thailand and southern China. Financing plans are due for submission to the government by the end of August 214. Delays to Thailand s infrastructure development weigh on the country s aspirations to use its geographical advantage to be the transport centre of the ASEAN Economic Community (AEC), a regional economic integration project. The clock is ticking: the AEC is scheduled to be in force from 2. Pressure to find funds and raise infrastructure investment is increasing, but domestic funds are scarce. Public aversion to higher and opaque public debt limits government financing. While the government has encouraged greater use of publicprivate partnerships (PPPs), the capacity of these projects to fully fill the funding gap is limited. The AIIB is an alternative funding source for Thailand. Its proposed capital base of USD1bn should give it more capacity to support Thailand s ambitious infrastructure plans, especially when compared with the ASEAN Infrastructure Fund (AIF) (chart 27). On 22 July 214, the NCPO approved in principle for Thailand to join the AIIB as a founding member. This suggests that Thailand s doors to external infrastructure investment funding are open. 26. Thailand s Infrastructure Development Plan funding 27. Capital base of the AIIB and the AIF Funding gap 43% Note: State-owned enterprises = SOEs, public-private partnership = PPP. The 13% (THB3bn) emergency loan degree was for water management. Source: ADB, HSBC PPP 6% Budget 11% SoEs 14% Borrowing 13% Emergency decree 13% Total infrastructure investment: THB2.3trm USDbn USD.bn 2 1 Asian Infrastructure Investment ASEAN Infrastructure Fund Bank Capital base Source: ADB, HSBC 16

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