Our analysis of fiscal costs related to CPEC reinforces our positive view – We are more comfortable with fiscal risks associated with the China Pakistan Economic Corridor as a result of the analysis presented in this report; this reinforces our positive thesis on Pakistan equities. Our top stock picks are UBL, HBL, BAFL in Banks, INDU, PSMC in Autos, MLCF in Cement, KEL in Utilities.
US$15.5bn worth of “priority” power generation projects – CPEC refers to cUS$54bn of projects, comprised initially of US$46bn of power, port, road, rail and pipeline infrastructure and recently increased by US$8bn of LNG and additional rail. Within this there are US$15.5bn worth of “priority” power projects and within this figure there are US$12bn of projects which have agreed tariffs and achieved financial close. Most of these projects have (1) a debt:equity ratio of 75:25 with the bulk of debt financed by Chinese banks (the foreign currency requirement for machinery imports is generally beyond the capability of local banks which are flush with local, not foreign, currency liquidity); (2) a government guarantee of RoEs of up to c25% in US$ terms; and (3) sufficient revenues to cover debt servicing and repayment over the first decade of operation.
Worst case, a manageable 0.3% added to 2.9% 2018 fiscal deficit – In the absence of resolving (1) electricity network theft and non-payment of bills, and (2) low tax collection (ie insufficient tax compliance as opposed to hiking tax rates on the existing small compliant base), both of which require the political will, generally absent, to challenge vested interests, the risks are that, respectively, (1) “circular debt” fiscal liabilities increase, ie the shortfall in revenue collection relative to guaranteed returns to capital providers, and (2) tax receipts on the incremental GDP growth, resulting from more continuous power supply, are deficient. The overall risk is that the net effect, from a fiscal balance perspective, is that the contingent fiscal costs of meeting government guarantees may significantly outweigh the fiscal revenue benefits of greater tax collection. The chart illustrates different scenarios on network theft, non-payment, GDP growth boost and incremental tax collection rates and suggests that the worst case scenario over the first decade of these “priority” power projects is an annual fiscal liability of US$1bn, which equates to 0.32% of 2018f nominal GDP of at least cUS$315bn and compares to IMF estimates of a 2018 fiscal deficit of 2.9%.
Useful infrastructure not Sri Lanka's Chinese "white elephants" – The list of allprojects under the original US$46bn CPEC umbrella (split 35% priority power generation, 41% other power generation, 14% roads, 8% rail, 2% port) suggests there is useful infrastructure, which should ultimately benefit the wider economy. To us, this looks, in general, like the useful parts of the Chinese financed infrastructure seen in Sri Lanka (the Colombo airport terminal, airport-city motorway and, potentially, the Colombo seaport rather than the redundant airport, port and cricket stadium in Hambantota). The fiscal scenarios above suggest that, at least in the case of the priority energy projects, the fiscal burden should be more manageable, in the worst case scenario, than that seen in Sri Lanka (where expensive debt finance has led to defaults, debt-equity swaps and protracted renegotiation). While CPEC should have positive externalities for wider local economy, once constructed, it remains our view that in its construction phase it will be financed, built and owned largely by Chinese entities, with the exception of local Cementcompanies (irrespective of the claims from most Pakistani corporate management we meet who, in our view, misrepresent the construction of CPEC as a major growth opportunity). In the near term, the most important benefit of CPEC is that it creates an overlapping interest in domestic security between Pakistan’s military and civilian political elite and its key geopolitical sponsor (in contrast to historic relationships with the US and Saudi which arguably cared more for an aligned military than domestic security).