It’s been a difficult week for China as leaders from the Asia Pacific region gathered in Port Moresby for the APEC summit. A war of words between Vice-President Mike Pence and President Xi Jinping dominated the summit as Pence took aim at China for what he called “debt diplomacy. Pence warned APEC leaders not to swap sovereignty for investment and loans that will only benefit China in the long run.

In the last decade, more than one hundred mainly developing countries have taken out dollar denominated loans with China. Many of the loans are unique in that they are collateralized against commodities or sovereign assets, often the assets the loans were taken out to build. Most of the loans go unreported by either country but recent developments in Pakistan, Sri Lanka and Tonga indicate that the loans are effectively debt traps that allow China to surreptitiously acquire control of foreign assets to the detriment of the recipient country.

While much as been made of the One Belt One Road initiative, many are sceptical about the funding capacity of China to actually support many of the planned projects. Pakistan, a large recipient of Chinese loans and of immense strategic importance to Beijing, reached out to the IMF recently for a bailout as their foreign reserves began to dwindle under the weight of USD debt. The IMF however has taken a hard line with Pakistan and essentially called China’s bluff by insisting that a bailout would only be available if Pakistan provided full transparency as to its full debt obligations, specifically those opaque loans from China. Obviously, Beijing is very sensitive to having the details of these loans publicized. The message from the IMF clear however, they are not going to fund a proxy bailout of China – if China is committed to funding OBOR then in effect ‘show us the money’.

Worse still for China has been the recent developments in Sri Lanka. Two weeks ago, an intense power struggle erupted in Colombo when President Sirisena suddenly sacked Prime Minister Ranil Wickremesinghe and the appointed the former leader Mr Rajapaksa, a pro-China strongman, in his place. Prime Minister Wickremasinghe has refused to recognize the order and continues to occupy the prime ministerial residence in Colombo, leaving both men claiming to be Prime Minister.

The turmoil began in October when President Sirisena challenged a cabinet decision led by Prime Minister Wickremesinghe to award of an estimated US$1 billion contract for a second foreign-operated container terminal in Colombo to an India-Japan joint venture. The move was seen as a strategic shift away from China and back towards India. The problem is that many of Sri Lanka’s political elites have profited handsomely from Chinese investment in the country, none more than Rajapaksa. While in power from 2005- to 2015, the Rajapaksa-led government was the recipient of large amounts of Chinese military assistance that helped his government defeat Tamil rebels while also being provided political cover by Beijing who blocked a UN Human Rights Council resolution demanding Rajapaksa be investigated for war crimes.

The issue of Indian versus Chinese influence and investment in Sri Lanka has dominated local politics for the past several years but tensions began simmering last year when Colombo was forced to sign a 99-year lease on the strategic Hambantota deep-sea port to Beijing, after it was unable to repay Chinese loans for the $1.4-billion project. The decision sparked riots across Sri Lanka. Anti-Chinese sentiment has risen sharply and many voters in Sri Lanka have been demanding that the deal be cancelled. Despite the upheaval, Beijing persisted in pushing the deal through however. Sri Lanka’s strategic importance to China cannot be over emphasized, as whoever controls Hambantota Port controls the Indian Ocean all the way to Antarctica. This importance has only increased recently with the surprise win of an opposition candidate in the Maldives who campaigned on a promise to reduce China’s role in the Indian Ocean archipelago nation. If projects in the Maldives are cancelled, Sri Lanka would be China’s main Indian Ocean link between Asia and East Africa.

As tensions have continued to rise in the last few days, a number of prominent politicians have been subtly echoing the sentiments of many on the street who are enraged at what they too see as ‘debt diplomacy’ and a breach of their national sovereignty. The growing calls for the Hambantota Port deal to be cancelled is certainly making officials in Beijing nervous according to our sources. While it may be too early to tell if Beijing is facing its first serious case of expropriation it does bring into question the strategy of China’s collateralized debt model and where it might take China.

In 2016 we published a piece called ‘China, the reluctant superpower’ which came out of a red-teaming exercise our team conducted looking at the potential responses of China to a number of theoretical threats to its geo-strategic locations around the world, including expropriation of Chinese assets in Pakistan. The thesis was that while China may not want to wield hegemonic or imperial power in the same ways the world has historically come to expect of superpowers, there may arise certain conditions that draw China into acting in the same way nonetheless.

The Sri Lankan crisis brings to the fore some of the questions China will need to face as more countries inevitably push back on giving up their sovereign assets. Many of you will remember Hedge Fund Billionaire Paul Singer’s seizure of an Argentine Navy Frigate through a Ghanaian court order after Argentina defaulted on bond payments but those bonds were issued in a transparent way through a system that enjoys global buy-in. China’s opaque loans are already being seen as illegitimate and many countries will no doubt follow Sri Lanka into political turmoil as their debt burdens rise and their capacity to pay diminishes. How long is it before we find out just how China will respond to a sovereign expropriation or a refusal to hand over assets? Will we see Chinese frigates in foreign ports with forceful intent? While such a show of hard power in the short term is highly unlikely, this week has certainly been a major shock to China’s soft power – when a small island pacific national like Tonga, heavily dependent on Chinese investment, dares stand up and repudiate Chinese investment strategy, you know you have a reputation problem. Even if Sri Lanka doesn’t turn out to be the canary in the deep, dark “debt diplomacy” coal mine, we can be sure that there is still a long line of canaries waiting their turn, and there’s few indications that China is really ready.

Shorter Term

There are also shorter-term considerations too. Some analysts have viewed China’s debt diplomacy as an adroit purchase of foreign commodities and assets by way of leveraging their three trillion dollars of US reserves. There are a few short term problems with this thesis however because as the examples of Sri Lanka, Tonga and Pakistan have demonstrated, many of these opaque loans appear to be collateralized against either non-productive assets that China sees as being integral to future rather than present capacity. The loans we’ve managed to view show a pattern of investment in assets that facilitate the future movement or extraction of commodities rather than the commodities themselves. We have also seen that while some investments are either operating under capacity and earmarked for future growth, a number are also simply examples of mal-investment to export excess Chinese capacity.

In a rising dollar environment where there is a shortage of dollars and rising servicing costs, loan recipients are finding it impossible to service their debts as their new assets fail to generate the requisite cashflows to do so. Our lead China analyst Yi Lin Tan believes Beijing were well aware that eventually they would have the opportunity to take control, even if indirectly, of many of these investment assets but they were not prepared for issues to arise so quickly and for them arise precisely at a time when China’s capacity to manage them would be so constrained. The main issue for Beijing is that, if we set aside the geopolitical considerations of the capacity for Beijing to effectively seize sovereign assets at this juncture, let’s assume for a minute that China can get away with swapping their leveraged and expensive dollars for sovereign assets, this leaves China with long term strategic assets that, in the short term, will not provide any dollar liquidity or the capacity to generate it. As the US dollar continues to rise and as both China’s current account deficit and stock market sell off worsens, the true aggregate size of these EM loans by China may start to reveal itself. Should this number be as large as we think it is, the probability that China suffers a significant financial malaise in the coming months is rising significantly.

With this in mind, our client main brief this week will be a close up look at the AUD, the ASX and the Australian Real Estate market.