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Will US interest rate rise trigger funding problems for China’s ‘One Belt, One Road’ plan?

China’s ambitious “One Belt, One Road” initiative could face funding problems as a highly likely rate rise from the US Federal Reserve would increase funding costs and China has imposed strict controls on capital outflow lately, an economist said on Friday.

Speaking at South China Morning Post’s China Conference on Friday morning, Alicia García Herrero, chief economist for Asia Pacific from French bank Natixis, said in a panel discussion that it was not sustainable for China to drain its forex reserves to fund large overseas infrastructure projects on the Belt and Road initiative, which left room for Hong Kong to be a alternate source of offshore funding in US dollars.

“Constraints in US dollar financing are very strong in China now. I think China will look for alliances for the belt and road,” Herrero said. “Hong Kong is well positioned because this is a financial centre where you get about a trillion US dollars out every year, which is not minor. If you can redirect a bit of that into the Belt and Road, that is already big enough.”

Since 2014, when the Chinese yuan started depreciating, China has lost more than US$800 billion in its foreign reserves, some of which was used to stabilise the yuan’s exchange rate as it aims at becoming a global reserve currency. This year, the yuan has faced strong depreciation pressure as the US economy rebounds and a rate rise at the end of this year seems almost certain. Strong depreciation expectation on the yuan has provoked capital outflow, leading Beijing to tighten outbound direct investment and the amount of yuan that Chinese companies can remit overseas.

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“That makes it [the funding difficulty] even more so. If China Development Bank raises its funding in Hong Kong, and lends it directly to Russia, that’s not an outflow for China,” Herrero said.

However, co-panellist Hu Yifan, regional chief investment officer of Greater China at UBS, said on the sidelines of the conference that the rising cost of funding overseas infrastructure seemed inevitable as interest rate hikes, such as in the United States, are a trend that is supported by increasing inflation and growth rates globally.

“Cheap funding is likely gone … Relatively speaking, the funding for the belt and road projects that is initiated by policy banks such as China Development Bank is still cheap,” Hu said.

Hu said it was a misconception to think the government would fund all the projects on the Belt and Road because the private sector, including state-owned enterprises, had shown much interest in taking on these projects as well, and these investment opportunities simply outweighed controls on capital outflow, which was “manageable”.

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“Even if we double our forex reserve, the government won’t be able to fund all the projects on the Belt and Road. Capital outflow control is targeted … As long as the Chinese government thinks it’s a good investment it will be easy to get (money) out.”

According to Herrero, Russia and Pakistan are currently the two largest recipients of lending from China for projects on the Belt and Road, and Europe could be the biggest beneficiary of China’s infrastructure investment to date, which could reduce the cost of transportation by up to 50 per cent and increase trade flow.

Both panellists agreed that as the United Kingdom exits the European Union, it would be difficult for it to negotiate new trade deals with the other members of the EU and countries that have trade treaties with the EU in the two-year window period.

“It’s almost a mission impossible,” Hu said.