Overview: The United States seems to be raising the bar for International Development Finance with the proposed BUILD Act. Through the proposed creation of a new U.S. Government institution, the International Development Finance Corporation, the US looks to create a new paradigm for the developing world - in direct response to China's Belt & Road Initiative and China's rising influence globally. Given the purpose and scope of the draft legislation, it behooves Canadian companies to consider ways to capitalize on this new funding source, most likely in collaboration with U.S. companies looking to pursue qualifying projects overseas
In a bid to compete with China's global activity in the infrastructure and development assistance space, the United States is updating its development finance apparatus through the Better Utilization of Investments Leading to Development Act (the "BUILD Act"). The proposed BUILD Act aims to "facilitate the participation of private sector capital and skills in the economic development of countries with low- or lower-middle-income economies." To carry out this mandate, the BUILD Act will create the United States International Development Finance Corporation (the "IDFC"), a development agency committed to the "highest standards of development, transparency, and accountability." The IDFC will consolidate the U.S. Agency for International Development ("USAID") Development Credit Authority and the Overseas Private Investment Corporation ("OPIC") - which will be subsequently terminated - into one institution that will double U.S. foreign development finance capabilities from $29 billion to $60 billion. IDFC will have a 20-year mandate, terminating in 2038 (presumably to be renewed thereafter if all goes well), and will have the authority to provide technical assistance and equity financing, which OPIC currently lacks. Based on the broad bipartisan support it has received from both the House Foreign Affairs and Senate Foreign Relations Committees, the prospects for passage of this legislation are good, despite the otherwise polarized climate in Washington, DC.
The BUILD Act is a direct response to China's Belt and Road Initiative (BRI, also referred to as "one belt, one road"), the most expansive, ambitious, and publicized infrastructure project in modern history. Estimates of the total intended investment in BRI projects range from $1 trillion to $8 trillion dollars -- a range that is difficult to confirm due to China's lack of systematic reporting on overseas lending. Even at a trillion dollars, the BRI dwarfs the U.S. alternative and is the biggest vehicle for foreign direct investment in the world. It is the driving force for Beijing-backed energy and infrastructure projects, as well as trade and transportation agreements across 78 countries that account for more than two-thirds of the world's population.
The bulk of these Chinese-financed developments support a "modern silk road" over land and sea, creating a contiguous trade region that encompasses Asia, stretches from Oceania to Europe and Africa, and places China at its geopolitical and economic center. Beijing's stated motivation is a desire to deeply integrate neighboring markets and to enhance the "connectivity of the Asian, European and African continents and their adjacent seas." However, China's development finance has a far more global impact that extends well beyond this core region, to investment and construction projects in Latin America and the Caribbean. Taken together, the BRI aims to strengthen economic links between China and partner countries that collectively account for "[more than] 30 percent of the global GDP, 62 percent of population, and 75 percent of known energy reserves. China's President, Xi Jinping, has called the BRI the "project of the century" and has promised it will usher in a "golden age of globalisation."
In an effort to have more of a say in global financial institutions and to facilitate the BRI, China also spearheaded the creation of the Asian Infrastructure Investment Bank (the "AIIB") in 2016. The AIIB is a multilateral development bank that prioritizes projects that promote sustainable infrastructure and support to countries making efforts to meet environmental and development goals. To date, it has 86 approved members worldwide, including Canada (noteworthy that the USA is not a member, nor is Japan). While not large enough to facilitate all BRI development, the AIIB aims to fund energy, transportation, and telecommunications projects linking countries in Central, South and South East Asia, and the Middle East. The AIIB funds these projects by mobilizing private capital and encouraging partnerships that stimulate investment, including agreements and partnerships with other multi-lateral development banks, governments, and private financiers.
In concert with other Chinese finance institutions, the AIIB is financing BRI projects in foreign countries. The combined influence of the BRI program and the emergence of the AIIB has resulted in a global rise in Chinese influence. China's trade competitors have become wary. They view the BRI as a Trojan horse for China's military and economic designs fueled by debt trap diplomacy.
The concern of debt trap diplomacy
Debt trap diplomacy is caused by debt that has been incurred by China's BRI partner countries, which such countries simply cannot afford in the long term. When unable to pay, these indebted countries may be forced to sell off state assets to satisfy their debts to Beijing. The most notable case is the Hambantota Port in Sri Lanka, which was ceded in December 2017 in a one-sided lease agreement to the Chinese government in exchange for debt relief.
Given the lending habits that have become characteristic of BRI projects, there is valid cause for concern. These projects tend to be focused in countries with fragile economies that are susceptible to corruption and have the perceived inability to handle the outsized debt that accompanies these big-ticket infrastructure projects. Moody's ranks the median credit rating of these BRI partner countries as Ba2, a "junk" level of default risk. This seems to be by design, since the selected partner countries include many with the world's riskiest economies, according to the Organisation for Economic Co-operation and Development (OECD). Sri Lanka is only one example. BRI projects have also placed the economies of Pakistan, Cambodia, Montenegro, Djibouti, the Maldives, and Laos in risk of immediate debt distress. In Kenya, financial institutions are being forced out of the financing market by an onslaught of Chinese banks who offer far more competitive performance guarantees. As of June 2017, China controlled $4.75 billion (USD) of Kenya's bilateral debt. That figure accounts for 66% of Kenya's total bilateral debt and is more than seven times the debt China held in 2013.
Some countries are pushing back. In Malaysia, $23 billion in BRI projects have been suspended while the Prime Minister reviews the costs and burdens of "unequal treaties." From Tanzania to Hungary, BRI projects are being canceled, renegotiated or delayed due to similar concerns, namely that countries are getting too little out of Chinese backed and built projects. Certain trends in BRI financing are instructive. Chinese funded projects are rarely open to local and international participation. The majority of contractors working in Chinese-funded projects (89 percent) are Chinese companies, and few contractors are local to the project country or foreign-owned (7.6 and 3.4 percent, respectively). In addition to cutting foreign- and locally-owned contractors out of potentially lucrative projects, there is a further problem: the debt problems also exist at the company level.
The double-edged debt sword
The average large state-owned enterprises that are responsible for building, operating, and investing in BRI projects are highly leveraged. As a measure of their extreme indebtedness, the top 10 Chinese construction and engineering contractors that are active outside China are nearly four times more highly leveraged than their non-Chinese counterparts. Many of these companies are state-owned and can amass huge amounts of debt without fear of bankruptcy, for the time being. However, if China continues to heap debt on its partners and its operating companies, it could be steering a growing ship towards a debt crisis.
Further BRI hurdles
Critics cite other potential problems with the massive and rapid growth of the BRI. For some, the environmental risks are far too high. It is estimated that by the middle of the 21st century, the BRI will have spawned over 7,000 projects spanning nearly 80 countries and potentially impacting over 1700 critical and sensitive biodiversity areas. Many of these areas are in developing nations with weak environmental controls where BRI projects are "locking in outdated, dirty, and inefficient technologies" and ignoring potential environmental impacts and alternative sustainable models.
Others suggest different strategic motives behind the BRI. They see the BRI as a veiled means of extending and deepening China's military and intelligence gathering presence in project countries. The Center for Advanced Defense Studies (C4ADS) suggests that the international community should be wary and concerned about the "strategic locations, dual-use development models, notable Communist Party presence, significant financial control and limited transparency and unequal benefits" inherent in many of the project locations. Doing very little to dispel the rumours, China has already announced that it is "ready to provide security guarantees" for BRI partners such as Pakistan and Sri Lanka, project countries struggling to repay their debts to Beijing.
The U.S. is not alone
These concerns about Chinese geopolitical influence and about the nature of BRI projects are not unique to the United States. To contextualize this further, on September 19th, the European Commission adopted a new "Connectivity Strategy", offering a different approach to China's BRI, whereby the EU intends to present candidate countries with a credible and sustainable alternative offer for connectivity financing. The Connectivity Strategy emphasizes sustainability and respect for labor rights, as well as stressing that such development investments should not create political or financial dependencies. It is a reflection, too, of a Spring 2018 report from EU ambassadors in China, which criticized the BRI for, among other things, being economically, environmentally, socially, and financially unsustainable.
The IDFC: The U.S. response to the BRI
The BUILD Act comes at a time when concerns about BRI projects and rising Chinese geopolitical influence are growing. Specifically, one of the BUILD Act's statements of policy is: "to provide countries a robust alternative to state-directed investments by authoritarian governments and United States strategic competitors using high standards of transparency and environmental and social safeguards, and which take into account the debt sustainability of partner countries."
The IDFC will have the ability to:
- make loans or loan guarantees;
- (as a minority investor) acquire equity or financial interests in entities;
- provide insurance or reinsurance to private sector entities and qualifying sovereign entities;
- provide technical assistance;
- administer special projects;
- establish enterprise funds;
- issue obligations; and
- charge service fees.
Of note, "The interest rate for direct loans and interest supplements on guaranteed loans shall be set by reference to a benchmark interest rate (yield) on marketable Treasury securities or other widely recognized or appropriate benchmarks with a similar maturity to the loans being made or guaranteed …"
In practice, the IDFC will be a development finance institution standing in stark contrast to the BRI and AIIB model. It is a clear and direct response to the prevalent criticisms of the BRI, namely its seeming preference for engaging lender (Chinese) country companies and workers, and employing unsustainable loan practices to create debt dependencies with recipient countries. The IDFC looks to expand the tools available to partner countries to aid in economic development, as well as developing sustainable local businesses and job markets without creating the indebtedness inherent to the Chinese model. It further seeks to avoid corruption by curtailing inter-governmental agreements, and engaging a more sustainable private investment model.
In execution, the IDFC will prioritize transparency, oversight, accountability, and responsibility. In scope, it will prioritize developments in less-developed countries, minority and women-owned business, small business, and women's economic empowerment. Its directive is "to achieve clearly defined economic and social development outcomes" guided by "public accountability and transparency" while aiming at "high standards of… environmental and social safeguards."
A Model of transparency and accountability
Built into the IDFC are mechanisms that ensure it sustains its mandate. For example, the IDFC will be co-chaired by the administrator of the U.S. Agency for International Development (USAID), creating a direct link between U.S. foreign aid spending and development finance policies. The four non-government members of the board are required to have private sector expertise, and relevant experience in "the environment, labor organizations, and international development" that create linkages extending as far into the development field as possible.
Oversight of the IDFC resides with the Chief Development Officer (the "CDO"). The CDO is responsible for ensuring that development policies and efforts mesh with other U.S. government agencies and foreign aid missions within partner countries. The CDO is also responsible for co-designing projects with USAID, managing employees, authorizing fund transfers, overseeing performance measurement, evaluating and learning, overseeing the development aspects of the annual report, and engaging with private sector partners. The CDO has the most developed description in the legislation and is ultimately responsible for keeping the IDFC on course.
To assist the CDO, the IDFC proposes a Development Advisory Council comprising up to nine members who are "broadly representative of nongovernmental organizations, think tanks, advocacy organizations, foundations, and other institutions engaged in international development." The Council will advise the board on adhering to the stated impact-focused IDFC development mandate.
Alignment with the UK model
In addition to forward-looking tools, the IDFC proposal includes an Independent Accountability Mechanism that will require annual publicly- available reports on "compliance with environmental, social, labor, human rights, and transparency standards." This independent check on mandate, unique among U.S. government foreign affairs agencies, will align the IDFC with the U.K. Department for International Development, which has an Independent Commission for Aid Impact, and other multilateral development institutions with independent accountability mechanisms.  The annual report will provide details as to the impact of developments and their compatibility with "the development assistance programs of the United States and qualifying sovereign entities." It also will require information be made available on a project-level, providing detailed oversight.
When considering these transparency and accountability mechanisms, one has to wonder whether the BUILD Act is trying to impose standards - by example - on China's BRI and on the behavior of the AIIB, as that institution matures.
Opportunities for Canadian companies?
Section 501(b) of the BUILD Act states that the IDFC will give "preferential consideration to projects sponsored by or involving private sector entities that are United States persons." This suggests that the U.S. Congress will monitor the IDFC portfolio to ensure it demonstrates this preference. However, there is no U.S. ownership or content requirement. So, if other financing agencies are an example, there may be an opportunity for foreign-owned (Canadian) companies to benefit from IDFC support. These opportunities will depend on the agency's investment criteria. So far, the criteria only clearly states prohibitions. Namely, the companies cannot have been found to violate U.S. law, be subject to U.S. sanctions, or engage in monopolistic practices. As the bill moves closer to becoming law, and the IDFC to becoming a reality, it is likely that more questions around its processes and investment criteria will be answered. That said, this new U.S. initiative warrants further consideration by Canadian companies, particularly those that might wish to collaborate with U.S. companies on IDFC-funded projects.
Gowling WLG is watching these developments closely and has the expertise to enable its clients to take advantage of these important advances now and into the future.