Ryan Lam, CFA

Senior Economist

ryancwlam@hangseng.com

April 2015

China’s ‘Belt and Road’Initiative: Assessingthe Opportunities

• Good infrastructure connectivity is just a starting

point for creating a Eurasian economic corridor.

The Chinese leadership will likely use the ‘Belt

and Road’ initiative to push forward with its ‘Go

Global’ strategy.

• We have identified several areas in which Hong

Kong has the potential to capitalise on the

opportunities presented by the initiative.

• Infrastructure revenue bonds are a natural choice

for financing. As the leading offshore renminbi

bond market in the world, Hong Kong has a lot to

offer in terms of supporting renminbi-

denominated bond sales.

• In addition to its role as a trading platform, Hong

Kong can also play a proactive role as a provider

of capital. The newly established Future Fund

could benefit from the stable returns and inflation

protection that infrastructure assets can provide.

• Regardless of the nature of the build-operate-

transfer or build-own-operate agreements put in

place, conflicts of interest often build up between

investors and governments over issues such as

ownership, control and profit sharing. There is a

great deal of room for negotiation in contractual

arrangements. Backed by world-class legal

professional services, Hong Kong could serve as

a convenient location for liaison in terms of

holding conferences and undertaking contract

negotiations.

• With area for improvement in logistics and limited

supply of proper construction materials in host

countries, Chinese developers may choose to hire

external parties to develop project-specific

logistics facilities that will help streamline delivery

of major equipment and building materials from

the Mainland. Hong Kong's logistics and maritime

advantages put the city in a strong position to

seize such opportunities.

2April 2015

Forging a new path

In 2005, then US Fed Chairman Ben Bernanke gave a landmark speech in which

he drew attention to the issue of rising global imbalances. A growing number of

economists have since come out in support of Bernanke’s argument that a “global

savings glut”, emanating in large part from emerging economies, had fuelled the

credit boom and greater risk-taking in advanced economies. Based on this view,

a rebalancing of the global economy requires high-saving countries to spend

more so that advanced economies can rebuild their savings and reduce their

trade deficits.

Parking large amounts of savings into US Treasury securities is no longer an

optimal policy in economic terms. This reality is a major driving force behind the

Chinese Government’s recently announced plans to reallocate its savings away

from financial instruments and towards the development of much-needed

transport and energy infrastructure throughout Eurasia.

The ‘Belt and Road’ (BAR) initiative, which aims to bolster trade with Europe and

build infrastructure across Asia, is comprised of two key elements – a land-based

‘belt’ and a maritime ‘road’. The ‘Silk Road Economic Belt’ encompasses three

routes that will connect mainland China with Central Asia, Russia and Europe; the

Persian Gulf and the Mediterranean Sea through Central and West Asia; and

Southeast Asia, South Asia and Indian Ocean. The ‘21st Century Maritime Silk

Road’ will include two routes that will link the Mainland to Europe through the

South China Sea and the Indian Ocean, and to the South Pacific through the

South China Sea.

There are three distinctive features of the BAR initiative:

• China’s Ministry of Commerce estimates that the countries along these routes

encompass a population of 4.4 billion people and have a collective GDP of

USD21 trillion, an amount equivalent to 29% of the global economy. While

there is currently little information regarding how bilateral negotiations will

proceed, there is a strong commitment on the part of Chinese Government.

• The BAR initiative’s main tool for releasing untapped growth potential in the

region is the development of an array of transport and logistics corridors to

xxxx

3April 2015

draw Central and South Asia into a unified transport network. The focus on

removing transportation bottlenecks is not accidental. Delivering goods on

time and at a low cost has been a crucial part of Emerging Asia’s1 integration

into the global production chain.

• Good infrastructure connectivity is just a starting point for creating a Eurasian

economic cooperation zone. The Chinese leadership likely views this as a

gateway step to facilitate moving forward with its ‘Go Global’ strategy. We

expect more detailed plans focusing on the creation of a Eurasian economic

corridor to be laid out at the provincial level.

A strategy with incentive compatibility

Despite the growing optimism that is being reflected in recent asset prices, there

is no shortage of examples to demonstrate that policies with good intentions often

lead to unexpected or less-than-desirable results. The keys to successful policy

formulation are recognising the constraints of participants and designing an

incentive-compatible strategy. Under the post-World War II Marshall Plan, for

example, the US provided funding for recovery initiatives, but required the

Europeans themselves to be the driving force and assume responsibility for

drafting the reinvigoration plans.

Considering the long lock-up periods and significant up-front capital requirements

of infrastructure investment, the BAR initiative stands little chance of success if

any of the participants suspect that other players will not fulfil their roles. The

good news is that the BAR plan appears to be mostly incentive compatible and is

therefore likely to remain as a keystone of development policy for the long term.

The key points in this respect are as follows:

• The Mainland is currently facing challenges of overcapacity, particularly in the

steel, cement and shipbuilding sectors. For Chinese firms, capacity cut in

these sectors has proved harmful to short-term business performance.

Exporting excess capacity would be a possible way to ease the pain of

adjustment.

• The engineering expertise and risk management skills of Chinese companies1

Emerging Asia as includes most economies in East Asia, Southeast Asia and South Asia, excluding Japan, Hong Kong,Singapore, South Korea and Taiwan

4April 2015

• For the Mainland authorities, the BAR plan promises several significant

benefits. First, enhancing regional transport infrastructure will reduce the

country’s exposure to commodity supply disruptions. Second, stronger ties

between the Mainland’s interior provinces and its western-frontier neighbours

should help narrow regional income disparities. Third, project financing will

enhance the renminbi’s role as an international settlement currency.

Increased overseas use of the yuan will, in turn, force domestic financial

institutions to embrace market forces and facilitate further financial

liberalisation.

BAR riding high on official agenda

The determination of the Chinese Government to push forward with the BAR

initiative is reflected in the rapid pace at which it is rolling out its plans (Exhibit 2).

The vision of a more closely integrated Eurasian continent was first put forth by

President Xi Jinping in September 2013. The BAR initiative was again discussed

in the March 2014 Government Working Report and, just a few months later in

July 2014, the New Development Bank was established with a starting capital of

Exhibit 1: Chinese-led Overseas Railway Projects

Country/Region Project Investment Estimated Completion Date

US California High-Speed Rail USD68.0bn 2030

South America Peru – Brazil Pacific Atlantic railway USD60.0bn 2024

India Delhi-Chennai High Speed Rail Over USD30bn -

Southeast Asia Pan Asia railway USD30.4bn 2025

Russia Moscow – Kazan High-Speed Rail USD25.0bn 2030

Nigeria Nigeria railway USD13.1bn 2025

Southeast Asia Kuala Lumpur – Singapore High Speed Rail USD12.0bn 2022

Kenya Kenya railway USD3.8bn 2020

Eastern Europe Belgrade-Budapest High Speed Rail USD2.9bn -

Source: Hang Seng Bank

could prove valuable tools for host nations looking to play a bigger role as

‘factories’ and ‘granaries’ for the world. Equally important, Chinese operators

are generally aggressive bidders - with prices often as little as half of those of

their global rivals. One indication as to the success of this strategy is provided

in the number of Chinese-led railway projects with multibillion-dollar price tags

that are already underway in many nations (Exhibit 1).

5April 2015

Hong Kong – assessing first-mover advantage

As the initiative is in still in its infancy, conventional wisdom would suggest that

Hong Kong should act promptly and capture first-mover advantage. This

assumed advantage, however, is far from guaranteed. Not every first-mover will

end up setting the tone of the game and much depends on the circumstances in

which any advantage is sought. With this in mind, we have accounted for a

number of region-specific features and characteristics of infrastructure

investment in our identification of several areas in which Hong Kong has the

potential to capture some of the many opportunities presented by the BAR

initiative.

Securing funding

There is much evidence to indicate that infrastructure investment is in high

demand in Asia’s emerging economies. In the 10 years between 2010 and

2020, the Asian Development Bank projects that infrastructure in Emerging Asia

will require investment of over USD800bn a year2 (Exhibit 3). The Mainland has

xxxxxxxx2Infrastructure for a Seamless Asia, Asian Development Bank and Asian Development Bank Institute (2009)

Exhibit 2: Major policy initiatives related to the BAR initiative

Time Details

September 2013President Xi proposes the construction of a ‘Silk Road Economic Belt’ whiledelivering a speech in Kazakhstan

October 2013President Xi calls for creation of a ‘21st Century Maritime Silk Road’ while deliveringa speech in Indonesia

March 2014 Inclusion of BAR initiative in Government Working Report

July 2014 New Development Bank established with starting capital of USD100bn

September 2014 Establishment of first phase of Railway Development Fund

October 2014 Asia Infrastructure Investment Bank co-founded with 56 countries

November 2014 Establishment of Silk Road Fund with USD40bn endowment

March 2015‘Vision and Actions on Jointly Building Silk Road Economic Belt and 21st CenturyMaritime Silk Road’ unveiled

Source: Hang Seng Bank

of USD100bn. Less than a month following the set up of The Asia

Infrastructure Investment Bank (AIIB) in October 2014, President Xi green-lit a

Silk Road Fund with an endowment of USD40bn. This rapid progress

compared with the pace of strictly domestic reforms highlights how much is

riding on the BAR plan in the eyes of the Mainland authorities.

6April 2015

On its own, however, the presence of funding gap does not warrant private

sector participation. Commercial viability is crucial if projects are to attract

private partners. It is important to note that Emerging Asia as a whole has run a

current account surplus since the late 1990s (Exhibit 5). What this essentially

means is that national savings are more than enough to finance domestic

investment needs3. In other words, even in the face of an exceptionally low

funding cost of the US dollar, domestic firms currently feel no need to borrow

abroad.

Exhibit 4: Funds AvailableExhibit 3: Infrastructure Investment Needs(2010-2020, USD billion)

Source: Asian Development Bank, Hang Seng Bank Source: Hang Seng Bank

Registered

capital

Loan to

equity

ratio

Loan

repayment

period

Annually

available

funding

Asian Infrastructure

Investment BankUSD100bn 1.5 8 years USD18.75bn

New Development

BankUSD100bn 1.5 8 years USD18.75bn

Silk Road Fund USD40bn 2.0 8 years USD10bn

Total USD240bn - - USD47.5bn

Exhibit 5: Current Account Balance of Emerging Asia (% of GDP)

Source: IMF, Hang Seng Bank3

Current account balance is equal to national savings minus domestic investment

already committed sizeable sums of capital to found or co-found various

institutions aimed at supporting infrastructure financing, but our estimates

suggest that the funding gap remains significant (Exhibit 4). Closing this gap will

require a greater commitment from the private sector.

7April 2015

4Financial Fragility and Economic Performance, The Quarterly Journal of Economics, 105(1), 87–114, Bernanke and Gertler

(1990)

Perhaps more than any other factor, Asian savers shy away from infrastructure

projects because of the difficulties in risk assessment and diversification. In

many countries in Emerging Asia the financial instruments needed for sound risk

assessment are simply not in place. Because perceptions of risk, not just interest

rates, determine the supply of credit4, a shortage of credit persists amid lingering

concerns over credit risks. The mispricing of risk is an important factor in the

relative backwardness of infrastructure in Asia, in our view.

Hong Kong could play a pivotal role in releasing credit constraints. The city’s

financial system could shape risk perception through pooling risk (aggregating

savings so that each investor shares the risk of infrastructure projects), hedging

risk (creating financial instruments to transfer part of the risk to other interested

parties) and diversifying risk (grouping the infrastructure investment into large

portfolios of assets).

More specifically, financial history suggests that debt obligations are more likely

to be honoured than equity obligations. The infrastructure revenue bonds (IRB)

secured by cash flows of the infrastructure projects would likely receive stronger

market interest. As the leading offshore renminbi bond market in the world, Hong

Kong has a lot to offer in supporting renminbi-denominated IRB sales to fund the

BAR plan.

Of course opportunities do not usually come without challenges. Other AIIB

founding members also aspire to capitalise on the rolling out of the BAR initiative.

London in particular has emerged as a leading centre for project finance and

infrastructure asset management. Over the years, the city has developed well-

integrated trading platforms for insurers and pension funds to assess the risk of

construction delays and cost overruns of infrastructure projects. For the Hong

Kong Government, measures to improve the regulatory and tax framework to

attract alternative investment fund managers looking to relocate deserve specific

attention in this regard.

In addition to its role as a trading platform, it is also worth considering whether

Hong Kong can take a step further and act as a capital provider. In 2014, over

50% of sovereign wealth funds (SWFs) with assets totalling between USD1bn

8April 2015

Seeking local partners

Large-scale infrastructure projects have characteristics of natural monopolies

and are particularly vulnerable to political risks. While public-private partnerships

(PPP) are a popular financing vehicle for mitigating such risks, profit-sharing

arrangements with governments could become a liability if there is regime

change. Even in advanced economies such as Australia and the UK, such

partnerships have been criticised for delivering high returns to foreign investors

without a commensurate delivery of benefits to local users.

An alternative form of financing is to sell debt or equities to local investors in host

countries. Although Dubai and London are currently at the forefront of the

Islamic finance market, Hong Kong’s deep pool of financial professionals and its

extensive experience in creating diversified financial products give the city an

edge in helping Chinese firms to secure overseas funding – but more needs to

be done to strengthen its potential role as the gateway for Islamic finance in East

Asia. One crucial first step is to give meaningful consideration to how Hong

Kong might attract international experts in Islamic finance to help build the

necessary financial infrastructure and advise on religious and regulatory matters.

Exhibit 6: Proportion of SWFs Investing in Infrastructure(by Assets Under Management)

Source: 2014 Preqin Sovereign Wealth Fund Review

and USD9bn included an infrastructure allocation (Exhibit 6). Hong Kong’s public

finances are currently robust enough to support infrastructure spending in the

region. We contend that the newly established Future Fund could benefit from

the stable returns and inflation protection that infrastructure assets can provide.

9April 2015

Contract consultation

Regardless of the nature of the build-operate-transfer (BOT) or build-own-

operate (BOO) agreements that are usually put in place, conflicts of interest

often build up between investors and governments over issues of ownership,

management control and profit sharing. In the ideal scenario, ownership, control

and financial flows should be packaged in ways to satisfy investors’ need for

control while at the same time addressing the political concerns of host

countries. There is a great deal of room for negotiation in the contractual

arrangements that govern infrastructure deals. Backed by world-class legal

professional services, Hong Kong could act as a convenient location for liaison

in terms of holding conferences and undertaking contract negotiations.

Project logistics

Another major opportunity lies in the logistics sector. Chinese infrastructure

developers have traditionally used and managed their own supply chains. In

recent years, however, it has been more common for infrastructure developers

to seek third-party logistics support for their oversea projects. With area for

improvement in logistics and limited supply of proper construction materials in

host countries, Chinese developers may seek to hire external parties to build

project-specific logistics facilities to help streamline the delivery of major

equipment and building materials from the Mainland. Hong Kong‘s logistics and

maritime advantages put the city in a strong position to grasp such opportunities.

The Hong Kong authorities may therefore wish to revisit the city’s port capacity

and facilities to examine whether upgrades or expansion might prove a valuable

investment over the longer term as activity under the BAR initiative picks up

momentum.

10April 2015

Hong Kong Economic Monthly Statistics April 2015

Note: (F) ForecastSource: Census and Statistics Department of HKSAR, Hong Kong Monetary Authority , Rating and ValuationDepartment, Hong Kong Tourism Board, CEIC, Hang Seng Bank

Real growth

yoy (%)

2006 1,503 7.0 7.2 5.7 2,461 9.4 2,600 11.6 -138.8 4.8 2.0

2007 1,651 6.5 12.8 10.1 2,688 9.2 2,868 10.3 -180.5 4.0 2.0

2008 1,707 2.1 10.6 5.0 2,824 5.1 3,025 5.5 -201.1 3.5 4.3

2009 1,659 -2.5 0.6 -0.8 2,469 -12.6 2,692 -11.0 -223.3 5.2 0.5

2010 1,776 6.8 18.3 15.5 3,031 22.8 3,365 25.0 -333.8 4.3 2.4

2011 1,934 4.8 24.8 18.4 3,341 10.1 3,767 11.9 -426.4 3.4 5.3

2012 2,037 1.5 9.8 7.2 3,434 2.9 3,912 3.9 -477.8 3.3 4.1

2013 2,132 2.9 11.0 10.8 3,562 3.6 4,065 3.8 -502.9 3.3 4.3

2014 2,246 2.3 -0.2 0.6 3,675 3.2 4,225 3.9 -550.0 3.2 4.4

2015F 2,360 2.6 5.0 4.0 3,859 5.0 4,479 6.0 -619.8 3.5 3.5

2016F 2,506 3.2 6.0 5.0 4,052 5.0 4,747 6.0 -695.5 3.7 4.0

Q1 2014 532 2.6 4.2 4.0 818 0.7 942 2.1 -124.0 3.1 4.1

Q2 522 1.8 -7.0 -7.2 901 4.8 1,042 4.6 -140.7 3.2 3.7

Q3 580 2.7 1.6 1.6 985 5.9 1,109 5.7 -124.0 3.3 4.8

Q4 612 2.2 0.2 3.5 971 1.2 1,133 3.3 -161.3 3.3 5.1

Q1 2015 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Jan 2014 N/A N/A 14.4 16.7 303 -0.4 323 -2.7 -20.0 3.1 4.6

Feb N/A N/A -2.2 -2.2 213 -1.3 267 6.8 -53.7 3.1 3.9

Mar N/A N/A -1.5 -2.5 302 3.4 352 3.2 -50.4 3.1 3.9

Apr N/A N/A -9.9 -9.6 286 -1.6 341 2.4 -55.3 3.1 3.7

May N/A N/A -3.9 -4.6 306 4.9 348 3.7 -42.4 3.1 3.7

Jun N/A N/A -6.9 -7.5 309 11.4 352 7.6 -43.1 3.2 3.6

Jul N/A N/A -3.2 -4.6 326 6.8 368 7.5 -42.1 3.3 4.0

Aug N/A N/A 3.5 2.8 327 6.4 359 3.4 -31.5 3.3 3.9

Sep N/A N/A 4.8 6.6 332 4.5 382 6.3 -50.4 3.3 6.6

Oct N/A N/A 1.4 4.3 332 2.7 382 5.6 -49.8 3.3 5.2

Nov N/A N/A 4.2 7.6 327 0.4 379 2.4 -52.2 3.3 5.1

Dec N/A N/A -4.0 -1.4 313 0.6 372 1.9 -59.3 3.3 4.9

Jan 2015 N/A N/A -14.5 -13.8 312 2.8 349 7.9 -37.0 3.3 4.1

Feb N/A N/A 14.9 18.3 228 7.2 264 -0.9 -35.9 3.3 4.6

Mar N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

YTD N/A N/A -2.0 -0.3 540 4.6 613 3.9 -72.9 3.3 4.4

HKD bn yoy (%) RMB bn yoy (%) HKD bn yoy (%) yoy (%) ytd (%) ytd (%) '000 yoy (%)

2006 4,757 17.0 23 3.6 2,468 6.7 15.5 4.1 15.0 25,251 8.1

2007 5,869 23.4 33 42.7 2,962 20.0 20.6 25.7 14.6 28,169 11.6

2008 6,060 3.2 56 67.8 3,284 10.9 2.6 -11.1 9.2 29,500 4.7

2009 6,381 5.3 63 11.9 3,289 0.1 5.2 28.5 -9.8 29,590 0.3

2010 6,862 7.5 315 402.2 4,227 28.6 8.0 21.0 12.5 36,030 21.8

2011 7,591 10.6 589 86.9 5,081 20.2 12.9 11.1 15.5 41,921 16.4

2012 8,297 9.3 603 2.5 5,569 9.6 11.0 25.7 7.7 48,615 16.0

2013 9,180 10.7 860 42.7 6,457 16.0 12.4 7.7 7.1 54,299 11.7

2014 10,074 9.7 1,004 16.6 7,276 12.7 9.6 13.3 4.3 60,839 12.0

2015F 11,182 11.0 N/A N/A 8,149 12.0 12.0 0.0 0.0 66,315 9.0

2016F 12,468 11.5 N/A N/A 9,168 12.5 12.5 -3.0 -3.0 71,620 8.0Q1 2014 9,189 10.0 945 41.4 6,826 19.0 12.2 -0.6 1.0 14,698 15.3

Q2 9,612 13.3 926 32.7 7,074 16.0 15.0 2.1 2.3 13,831 9.6Q3 9,920 11.4 944 29.4 7,210 12.7 12.3 8.6 3.8 16,130 11.2Q4 10,074 9.7 1,004 16.6 7,276 12.7 9.6 13.5 4.4 16,180 12.1

1Q 2015 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Jan 2014 9,184 7.6 893 43.2 6,697 17.8 9.6 -0.2 -0.2 5,455 17.8

Feb 9,330 10.6 920 41.2 6,908 21.8 12.9 -0.3 0.4 4,417 9.8

Mar 9,189 10.0 945 41.4 6,826 19.0 12.2 -0.6 1.0 4,825 18.1

Apr 9,392 10.8 960 41.8 6,852 18.1 12.5 0.0 1.3 4,748 10.9

May 9,522 11.0 956 36.8 6,966 18.0 12.7 0.9 2.0 4,591 10.8

Jun 9,612 13.3 926 32.7 7,074 16.0 15.0 2.1 2.3 4,493 6.9

Jul 9,848 14.4 937 34.8 7,141 15.5 16.0 4.6 3.3 5,374 11.2

Aug 9,855 13.9 937 32.0 7,142 14.0 15.4 6.6 3.6 6,010 12.2

Sep 9,920 11.4 944 29.4 7,210 12.7 12.3 8.6 3.9 4,747 10.2

Oct 10,037 11.9 944 20.7 7,282 13.7 12.2 10.4 3.9 5,214 12.6

Nov 10,075 11.1 974 17.8 7,287 12.8 11.2 11.9 4.2 5,300 15.7

Dec 10,074 9.7 1,004 16.6 7,276 12.7 9.6 13.5 4.4 5,666 8.5

Jan 2015 10,186 10.9 981 9.9 7,366 10.0 10.4 2.2 0.3 5,610 2.8

Feb 10,152 8.8 973 5.7 7,365 6.6 8.3 N/A N/A 5,406 22.4

Mar N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

YTD 10,152 8.8 973 5.7 7,366 6.6 8.3 2.2 0.3 11,015 11.6

Total DepositsOffice Rental

Index

GDP

Total Loans

Trade

balance

Money

supply

(Total M3)

yoy (%) HKD bn

Consumer

prices

yoy (%)

Foreign TradeRetail

sales

(volume)

% yoy (%)HKD bn HKD bn

Tourist Arrivals

Imports

RMB Deposits

Unemployment

rate (s.a.)

yoy (%)

Exports

Retail

sales

(value)

Residential

Property

Price Index

yoy (%)HKD bn

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

Source: CEIC, Hang Seng Bank Source: CEIC, Hang Seng Bank

April 2015 11

Hong Kong Retail Sales Volume Hong Kong Unemployment Rate

Hong Kong Exports Volume Hong Kong Total Loans and Deposits

Hong Kong CPI Inflation Hong Kong Property Prices(overall index, 1999 = 100)

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April 2015 12