Infrastructure investment in China

September 2013 | COVER STORY | FINANCE & INVESTMENT

Financier Worldwide Magazine

Infrastructure development remains a top priority for China’s government. In recent years, the government has used substantial infrastructure spending to hedge against flagging economic growth – in late 2012 it gave the green light to a raft of infrastructure projects valued at over £150bn. While the bulk of funding will come from state-owned banks and bond sales, there are also opportunities for foreign private and corporate investment. Furthermore, the stimulus will generate business for the infrastructure sector on a national and international level. Despite the opportunities, however, there are a number of risks for foreign entities investing and doing business in China.

Recent activity

In the past 18 months, the Chinese government has focused on internal development, in line with the country’s 12th Five Year Plan. Approved in November 2011, the Plan marks a turning point in the country’s development, with a focus on sustainable growth. To achieve this, the government must make more efficient use of the country’s resources, stimulate internal demand, speed up urbanisation, and modernise Chinese society. “The rapid growth in economic infrastructure to support the double digit annual GDP growth in the last decade is being balanced by a greater emphasis on quality of life for the general population and long term sustainable growth for the economy as a whole,” says Stephen Ip, Lead Partner of Government & Infrastructure at KPMG Advisory (China) Limited. “Urbanisation is the key opportunity and challenge for infrastructure development in China. The country’s new leadership is seeking to map out an improved model of urbanisation that can address development of the interior and western areas and the massive numbers of people who will move from rural areas to towns and cities in the coming decades.”

Indeed, over half of China’s population – 681 million people – now live in urban areas and, with the UN forecasting further growth of 25 percent by 2050, the country’s cities could be host to well over 900 million inhabitants. As urban areas are developed and cities expand, there is an urgent demand for better infrastructure to cope with this internal migration. Achieving sustainable growth, however, will also rely on China tackling the challenges of pollution, intensive energy use and resource depletion. As such, greener development, environmental protection, clean energy and sustainability are now much higher on the agenda, and the government is striving to reach key targets set out by the 12th Five Year Plan.

In recent years, China’s infrastructure development has also encompassed a seemingly endless stream of outbound activity, with investment increasing tenfold in the decade from 2001 to 2011, rising from approximately $7bn to $74bn. Although the main focus may now be on internal projects, this activity continues unabated. Indeed, outbound investment is a key policy of the Chinese government, explains Terence Wong, a partner at Hogan Lovells. “One interesting trend is that in addition to focusing on infrastructure development inside China, in the last 12 months many Chinese companies, experienced in the Chinese infrastructure market, have been encouraged by the Chinese policy of ‘Going Outside’ to undertake increasing numbers of infrastructure projects in regions across Asia, the Middle East, Africa, South America, and even in developed countries such as the UK, parts of Europe, and in the US.” As China moves closer to becoming the world’s largest economy, growth and development will remain a key concern. To maintain future growth, enhancing infrastructure such as power, water, transport, communications, education and healthcare will prove essential. As well as proving economically lucrative, outbound investment exposes Chinese firms to high quality production facilities and business practices. It also gives firms the opportunity to examine new research and development techniques – particularly pertinent as these firms are keen to advance strategic thinking around product development and retirement cycles.

Key sectors

In September 2012, as part of the 12th Five Year Plan, the National Development and Reform Commission (NDRC) gave approval to 60 major infrastructure projects with a combined value of over $150bn. These included 10 environmental protection projects, of which nine were initiated in Western China; seven port construction and channel reconstruction projects, largely focused on the east of the country; 13 highway construction projects evenly dispersed throughout the country; and 25 rail transit and intercity railway projects, again with a main focus on the east. “Transport infrastructure – roads and railways in particular – is still the biggest area of investment due to the sheer scale of networks being enhanced in rural areas and the continued build-out of the expressway system, linking all major cities,” says Mr Ip. “High speed rail development is recovering following the Wenzhou rail accident in July 2011 and city metro projects are moving ahead nationwide. Water related projects – such as wastewater treatment, water recycling, desalination, and so on – are also key areas of focus given water scarcity issues in China.” The country also continues to develop non-fossil fuel energy generation capacity to counter its overreliance on coal and to reduce carbon dioxide emissions.

In regional terms, given that coastal cities such as Beijing, Shanghai and Shenzhen are reasonably well developed, and that certain inland cities are becoming increasingly developed, the Chinese government has begun to turn its focus toward cities in mid and western China. The government’s ‘Great Western Development Strategy’, for instance, focuses on the improvement of major western cities in the next five to 10 years. In addition, the interior provinces of Inner Mongolia, Shaanxi and Gansu, though rich in natural resources, require the transport links needed to exploit these resources, and environmental protections to counter the effects of their exploitation. Such projects are now being delivered.

Foreign investment

Despite signing off the recent $150bn infrastructure plan, the Chinese government is aware that private sector involvement will deliver a much needed injection of additional cash. Currentpolicy is to attract more domestic and foreign investors as local governments need to diversify their financing sources beyond land sales and bank borrowing. “In June 2012, the Ministry of Housing and Rural Urban Development issued a wide ranging notice encouraging participation of private capital in the investment of municipal public utilities and transport facilities,” Mr Ip points out. “This message has been reinforced in recent days with the government releasing various statements about attracting private capital for urban infrastructure projects and letting market forces take a bigger role.”

European and American companies already have a presence in China’s major coastal cities and provinces, including Beijing and Shanghai. However, very few operate in the secondary markets – inland regions such as Chengdu, Sichuan and Hunan. But as wages and costs rise in the coastal areas, foreign investors are beginning to open facilities inland. China’s large, populous inland cities and provinces all require significant infrastructure investment, and because these markets are not global cities, land prices and wages are lower, making them more attractive to foreign investors. Despite this, given that the market is already very competitive in the lower end, the biggest opportunities lie with companies that enjoy advantages in terms of size, management, technology and other expertise.

In terms of project structures, public-private partnerships (PPPs) are currently being discussed on a regular basis, according to Mr Wong, and this is an emerging theme being tracked at KPMG says Mr Ip. PPPs provide a means for the public sector to make use of funding in the private sector and to tap into theprivate sector’s expertise.However, despite the government’s encouragement of foreign investment, little has been done to ease the challenges that inbound investors face.“China’s recent infrastructure stimulus has opened up new opportunities for foreign investors and business, and although the Chinese government may have promulgated certain policies or incentives to attract foreign investment, one of the biggest hurdles to entering the Chinese market is the need to obtain the requisite qualifications – for example, for engineering design, construction and consultancy – which are quite stringent in the eyes of foreign companies. There is no sign of the government easing up on this front,” says Mr Wong.

Indeed, foreign entities doing business in China face myriad risks and challenges. Typically, these revolve around understanding the local market and the different roles of key players and stakeholders within that market. Any new business to China would be advised to partner with a local company. This is an effective way to navigate differences in the regulatory system, tax laws, contract negotiation, employment practices and corporate culture. Local partners are much better equipped to chart a path through the various issues that foreign firms will face. Finding a partner that understands how to do business in China, but also appreciates the perspective of a foreign party, is extremely beneficial. Foreign firms can also employ the assistance of professional advisers and consultants, who can help to evaluate specific projects and help investors achieve more optimal outcomes while avoiding mistakes along the way.

China’s legal environment is one of the major challenges that foreign companies will face. “The Tendering and Bidding Law, for example, imposes restrictions on members of a consortium, while the Contract Law allows the Courts or Arbitral Tribunal to adjust liquidated damages,” says Mr Wong. “It would be prudent to structure the project in a manner which complies with the law and at the same time meets the commercial objectives. Other challenges, such as protecting intellectual property rights and addressing corruption issues, should also be carefully managed based on advice tailored to the needs of the company.” Foreign businesses must ensure that their operations in China fall in line with the government’s Five Year Plan. However, plans are regularly updated in an effort to meet changing national and global trends. This can cause confusion and delays. More importantly, though the central government creates the laws and regulations that influence development and growth, implementation and enforcement are left to the local branches of the different government agencies, which can result in inconsistencies. Foreign firms hoping to break into the region must also be aware that the introduction of China’s 2008 CIT law stripped away virtually all of the tax incentives offered to new Foreign Invested Enterprises (FIEs) and ended location-specific tax holidays enjoyed by existing FIEs. Tax now applies at a flat rate of 25 percent for all domestic companies and FIEs operating in all of the traditional FDI destinations.

Long term trends

The importance placed on infrastructure development by the Chinese government is clearly demonstrated by the unprecedented scale of investment outlined in the current Five Year Plan. But will its intended aim of boosting long-term economic growth be realised? In theory, it is not such a stretch of the imagination. In reality, however, such plans often encounter unexpected challenges and hurdles along the way. “Achieving economic growth targets of 7.5 percent annually for the foreseeable future looks challenging in the light of current headwinds,” suggests Mr Ip. “However, such growth would definitely not be possible without the spending to enhance basic economic infrastructure – especially inland – and social infrastructure nationwide. Increasing urbanisation, the rate of which only passed 50 percent in China last year, will bring huge challenges and demands on resources, but it will also provide a long term driver to underpin the growth of a domestic rather than export driven economy.”

While the aim of the current infrastructure package is to modernise China and increase its competitiveness on the global stage, it is not without its opponents. The 2008 stimulus package, launched to avert a prolonged recession, had the effect of burdening the country with major debt. While successful in the short term, the stimulus has been blamed for the slowdown of the Chinese economy in recent months. The positive effect of the 2008 package was immediate, with the stock market increasing 80 percent in 2009. The same year also saw the Chinese economy grow by 9.2 percent. While the boom continued through 2012, in January 2013 the economy contracted and April saw zero growth. The Chinese government is eager to avoid the same mistake. “I am cautiously optimistic that China’s increased spending on infrastructure will boost overall economic growth in the long term,” says Mr Wong. “After all, increased spending on infrastructure is recognised as one of the effective means to boost economic growth. Undeniably, the stimulus package in 2008 has resulted in a debt build up. Also, in the five years since 2008, China has become even more international, and its relationship with the rest of the world is closer than ever. As such, economic ups and downs in other parts of the world will have a greater impact on China. In order to mitigate these risks, the Central Chinese Government should monitor the spending in any stimulus package to ensure that maximum benefits can be obtained.”

Financing China’s proposed infrastructure spending is currently top of the government’s agenda, especially in light of concerns about local government debt levels. Finding solutions to develop alternative financing sources beyond tax revenues, land sales and commercial bank debt will be imperative in the next few years. And with private investment expected to be a key component of the country’s drive toward modernisation and growth, opportunities will present themselves to those foreign investors willing to look beyond the obvious options and navigate the unique challenges of doing business in China.

Matt Atkins