Complexity of #CPEC Cost-Benefit Analysis

Provincial Share (approx.) Under Signed Agreements:-
Punjab ($12.45bn), Sindh ($9.25bn),
KPK ($2.72bn), and Balochistan ($1.21bn)
source: tribune.com.pk

An honest assessment of CPEC must, therefore, carefully evaluate its impact on real economic activity

The transformation which the China-Pakistan Economic Corridor (CPEC) will bring forth may be exaggerated but it surely has expanded the national discourse by introducing elements of economic development to it. Before I proceed, two general points must be made. First, hypothetically speaking, even if CPEC is only a passageway for the Chinese goods, there are significant positive externalities – developmental and geopolitical – associated with trade routes. Second, such projects have long lasting distributional consequences which could be easily managed at the conception stage.

Here I will focus on the effects of the CPEC on the Balance of Payments (BoP) of Pakistan. To fully appreciate the impact which CPEC may have on the BoP, a simple explanation and a brief history is necessary. BoP includes the Current Account (CA). Pakistan’s CA is largely driven by movements in the trade balance and remittances. Any deficit in the CA is mostly financed by foreign investment, State Bank of Pakistan (SBP) reserves and/or loans from the international market – mainly IMF.

Recall that following an increase in commodity prices in the world market, Pakistan’s trade balance worsened from -$13.8bn in fiscal year (FY) 2007 to -$21.4bn in FY2008, according to the SBP data. With no significant change in remittances, CA deficit increased from $6.8bn in FY2007 to $13.8bn in FY2008. Over the same time, foreign investments decreased from $10bn to $8.1bn. With CA deficit higher than total foreign investment, remaining deficit had to be financed from SBP reserves. Consequently, SBP gross reserves decreased from $15bn in FY2007 to $9.5bn in FY2008. Dwindling reserves lead to currency speculation thus forcing the then incoming government to negotiate a $7.6bn bailout package with the IMF in 2008. A similar episode was repeated between FY2011 and FY2013 but also coupled with the repayments of IMF loan. SBP gross reserves fell from the peak of $16.6bn in FY2011 to only $7.2bn in FY2013. Another bailout agreement of $6.6bn was signed with the IMF by the current government in 2013.

Against this backdrop, $46bn of Chinese investment expected over a decade or more under CPEC appears refreshing. It must, however, be noted that $35-37bn of this investment is in the energy sector having a significant import component in the form of power plants and project consultancy. Therefore, the dollar inflow will be significantly less than the size of the total portfolio. Another aspect of the energy projects is also the consequent repatriation of profits. Crude estimates from my discussions with the Planning Commission (PC) sources suggest profit repatriation of $10bn annually once all the energy projects are complete. A cursory analysis of the CPEC, therefore, suggests dollar inflows during the medium term followed by dollar outflows over the longer horizon.

Large dollar inflows during the implementation of the CPEC can also have significant consequences for the CA. It will appreciate the Rupee thus making our exports less competitive in the international market. An honest assessment of CPEC must, therefore, carefully evaluate its impact on real economic activity rather than focusing on its magnitude alone. Given the sheer size of the energy sector in total investment, one would have expected part of the investment to also focus on improving the efficiency of the electricity transmission network. With current line losses – a major cause of the circular debt – at close to 20%, it is intuitive to note that pouring more water in a bucket with a hole is surely not an optimal investment strategy.

It must also be considered how investing billions of dollars in an already established eastern trade route may further contribute towards growth? What are the opportunity costs? Could there have been alternate projects which would improve our trade linkages and open new markets for our exporters? We know that the development of the highway network in Balochistan aimed at linking Gwadar with the Central Asian markets via Quetta as well as with the national trade route via Ratedero faces financial starvation. As per PC documents, at the rate of FY2015 PSDP allocation, N-85 widening & improvement project will take another 4-5 years to complete. Also there is no indication of any work on the 549km Hoshab-Khuzdar section of the M-8. Since PC is expected to meet Pakistan’s part of the financing of CPEC projects, the completion of the above projects may be further delayed especially when tax targets for FY2016 are revised downwards.

Overall, the direct effect of CPEC on the BoP maybe short lived but potential indirect benefits through an improvement in the real economic activity could be substantial. However, much depends on the architecture of CPEC. Is it designed as a set of scattered projects largely intended to achieve immediate political objectives with economic returns as a by-product? Or is each project seen as a part of whole aimed at transforming Pakistan into a regional trade hub? I want to be optimistic.

Understanding key issues in financing infrastructure projects

With increasing cost of construction, frequent occurrence of large-scale natural disasters, and ongoing fight against insurgents, it has become impossible for the government to continue financing infrastructure projects. This can be seen from the recent reductions in the budget of public sector development projects (PSDP). Historically, PSDP has been the main source of finance in addition to foreign loans. Much of the international aid, however, was directed towards social sector projects which were arguably of temporary relief.

To deal with these challenging circumstances, IMF has highlighted some key issues which need to be looked at when undertaking any infrastructure development project. These include: what investments offer the biggest boost to growth? How much investment is needed and by whom? How to finance this investment without taking on too much debt? Without looking at these issues, there remains a much higher probability that the project will get delayed to an extent that it no longer remains needed. If the project does get completed, long delays will push the cost to an extent that the cost-benefit analysis done when the project was conceived is no longer valid. Countries like Pakistan which are very much financially constrained must realise these issues and bring out policies aimed at utilising their full strength.

In answer to the first question, National Trade Corridor Management Unit (NTCMU) was established to come up with projects which help improve trade-related infrastructure facilities with the end goal of making Pakistan a regional trade hub. However, projects are still being approved in isolation with no broader vision of achieving sustainable growth. Ideally, a strategy should have been prepared by now and we should have moved on towards implementation stage.

Similarly, there is a need for improving PC-I with respect to involving private sector in development projects. The entire PC-I documents, expect the project to be fully financed from the PSDP. Instead, it should be made sure that first the project is floated to the private sector for take up with full ownership and if not successful, only then the government is approached for funding. Another section on ‘Public-Private Partnership (PPP) Option Analysis’ in the PC-I document, as suggested by the Infrastructure Management Unit (IMU), can be a good addition.

IMU (2007) has also done an extensive and useful study on constraints to private sector investment in infrastructure. But much needs to be done in removing these constraints. Some of the key constraints highlighted by the study are related to ‘procurement laws’ and ‘procurement processes’. Existing procurement laws do not include a requirement for the public body to consider infrastructure service delivery through the private sector. Procurement processes, on the other hand, are too centralised. All procurement decisions for a value as low as US $4-5 million are made at the highest level of the government. This is the case even for projects which are 100 per cent PPP and will not require any public expenditure.

Despite considerable realisation and wide consensus, Pakistan is still to come up with a detailed yet clear framework on PPP. This is mainly because the direction, content and the responsibility for the PPP framework still remains unsettled. Restriction on local governments against financing development projects through user charges or fees is also a major constraint to PPP at municipal level. Knowing that various amendments are being considered in local government law at provincial levels, these issues can be revisited with the approach of promoting private sector in infrastructure projects. Furthermore, land acquisition laws are currently in conflict with international norms. It is one of the major issues and has often resulted into delays and sometimes abandonment of the project.

National Highway Authority Act, which does not contain any requirement for PPP Option Analysis, also appears to discourage private sector participation.

It does not empower assignment of toll receivables in favour of the private project company executing the project. Another issue is that of competition with public sector construction firms. It is argued by the private construction companies that lucrative projects are always given to public sector corporations in a non-transparent and discriminatory manner. Such attitude discourages growth of private sector firms and hence their ability to undertake projects which are spread thin over the time horizon.

Written by Ahmed Pirzada
& Published in Business and Finance Review (24th Jan, 2011)