It was a brief moment of good news for Brazil’s national oil company Petrobras. In February, as it reeled from a combination of low oil prices and the impact of the rolling Lava Jato corruption scandal, it was able to point to a substantial potential influx of new funding.
On 26 February, the then-chief executive officer, Aldemir Bendine, and the president of the China Development Bank (CDB), signed a term sheet for a $10 billion loan in Rio de Janeiro. At the same time, the two also agreed for Petrobras to supply oil to Chinese consumers. This built on a cooperation agreement that Petrobras and China had signed during a visit by China’s premier, Li Keqiang, to Brazil in May 2015.
In one sense, these deals simply extended an existing relationship. CDB had lent Petrobras a similar amount in 2009, alongside a similar set of supply agreements, with the aim of helping Petrobras finance some of its pre-salt exploration and drilling work. But the latest financing finds Brazil in a different place – economically and politically – and the oil industry undergoing severe belt-tightening.
Changing Chinese priorities
It also finds China taking a new approach to projecting its economic influence in Latin America and the wider world. Two new China-inspired development lenders – the New Development Bank (NDB) and the Asian Infrastructure Investment Bank (AIIB) – are now in operation. China has also established three funds – for infrastructure, productive capacity and regional cooperation – focused on the region, notes Margaret Myers, director of the China and Latin America program at the Inter-American Dialogue.
The Dialogue collects data for lending by the China Development Bank and China Export-Import Bank (Chexim), the two most established policy lenders, for its China-Latin America Finance Database. For 2015, it recorded a huge increase in aggregate lending volume by the two banks on 2014, from $10 billion to $24.1 billion, the highest level since 2010. That total includes $10 billion in commitments to Brazil and $5 billion to Venezuela.
For Magdalena Forster, analyst in Deutsche Bank Risk Research’s emerging markets group, the increase in volumes simply highlights the political investment that China has in the region. She comments, “I wasn’t surprised at the increase in 2015. Policy lending involves strategic and structural considerations. It’s linked to policy goals and resources security, and cyclical conditions are less of a concern. The oil price fall on its own did not have a substantial effect. Perhaps in a scenario in which Chinese growth slowed more sharply than expected, you might see a contraction in lending.”
According to Myers, the size of the increase came as something of a surprise, given the slower growth that both China and Latin America have experienced recently. “Chinese policy bank finance in Latin America is supportive of China’s own growth objectives, just as One Belt, One Road initiatives are thought to be.”
China’s president, Xi Jinping, unveiled One Belt One Road (OBOR), in 2013, and it has recently been renamed the Belt and Road Initiative (BRI). According to Henry Tillman, the founder of boutique research and advisory firm Grisons Peak, OBOR/BRI comprises two overland routes through Eurasia, one through Central Asia and Russia, Belarus, Germany and The Netherlands, and one through Iran, Turkey, Greece and the Balkans, that will connect China with Europe, as well as the Maritime Silk Route, which connects parts of East Africa and Southeast Asia to China.
OBOR/BRI includes 60 countries and 4.4 billion people, but not Latin America, though the region has continued to attract policy loans. These loans have been focused on infrastructure, renewable energy, or links to ports, most of which meet the initiative’s green (renewables) and blue (maritime trade) criteria.
“I think you’ll continue to see increased investment in the region, particularly in coastal cities or links to ports”, suggests Tillman. He points to discussions between China Railway Engineering Corporation, the government of the Brazilian state of Bahia and Rede Ferroviária Federal, Sociedade Anônima (RFFSA) about a new line between Bahia Mineração’s proposed Pedra de Ferro iron ore mine and a port facility in the city of Ilhéus.
Tillman suggests that Chinese loans into the region, which were originally focused on oil (such as Venezuela and Brazil), are now increasingly focused on BRI-friendly loans in infrastructure and renewables, or trade finance loans linked to Chinese equipment purchases, mostly in IT. He adds that China has concentrated on strengthening relationships with key countries, including Brazil, Argentina and Ecuador, by elevating these to the status of “strategic partner”, the term that President Xi has used to describe them since 2015.
How strategic are strategic partners?
For all this increased emphasis on infrastructure, energy remains central to China’s involvement in the region. Deutsche Bank’s Forster notes that more than half of all Chinese policy loans to the region have been in the energy sector. The loans can be vital to the recipient economies, with Forster adding that Chinese policy loans over the last ten years would be equivalent to about 15% of Ecuador’s GDP.
But many of these loans, if not most by aggregate volume, are linked to oil sales. Borrowers such as Petrobras and Petróleos de Venezuela (PDVSA) repay loans either with the proceeds of oil sales or directly with oil, with the value of that oil indexed to market prices. The deals, often called prepays, since the loans are essentially downpayments on future oil deliveries, make explicit the link between Chinese financing and its resources security. They give the policy lenders visibility about the source of any loan’s repayment, and diversify the borrowers’ funding sources. They also, notes The Dialogue’s Myers, provide an outlet for China’s foreign currency reserves.
Myers views these financings as part of “a decades-long debate within China’s energy bureaucracy about how best to achieve energy security.” China may wish to take 100% equity stakes in fields to gain physical possession of energy resources, as it has done increasingly in the United Kingdom’s North Sea. Or it may feel that simply increasing the overall global production of oil, and putting pressure on prices, is enough, among other approaches.
The current period of low prices may vindicate the second approach, but it is causing headaches for both the national oil companies that have accessed Chinese funding and the Chinese lenders. The prepays do not expose the lenders to price risk, because delivery volumes simply increase to take account of lower prices. Russia, through state-linked lender Gazprombank, and Japan have also been sources of financing for PDVSA, though not on China’s scale, and Japan has used prepays in the past to acquire natural resources from China, notes Myers.
But, says Forster, “Oil prices are low and have not meaningfully recovered, and for debtors like PDVSA, which repay their loans with oil, they have to use a much larger proportion of production, and therefore revenues, to service this debt. For a country like Venezuela that is heavily dependent on oil for foreign exchange, this presents difficulties. This has led the country to seek talks to renegotiate the terms of the loans.”
Prepays can account for such a high proportion of production that a borrower like PDVSA is left without the ability to service any other obligations, at which point the prepay lender will have to exercise official or unofficial forbearance regardless of the performance of the prepay. The CDB lengthened the maturities and cut oil delivery volume requirement on its loans to PDVSA in early 2015, even as policy lenders sent another $10 billion to Venezuela.
If these loans to national oil companies have become less vital in serving Chinese interests during an oil production glut, they have become crucial to Petrobras and PDVSA during a period when international bond and bank lenders have become progressively more wary. “Chinese financing allows borrowers to diversify their funding sources. For countries with limited – or expensive – access to capital markets, it’s welcome,” notes Forster.
The terms of Chinese policy loans also appear to be converging with commercial norms. Grisons Peak’s Tillman detects an increased interest on the part of policy lenders, and especially the new funds, AIIB, and NDB in being able to sell down debt commitments and exposures on international financial markets, for which market-standard documentation is vital. He points to the experience of China’s new lenders in working alongside international financial institutions like the Asian Development Bank, World Bank and European Bank for Reconstruction and Development, as well as the background of the first chairman of the AIIB, Jin Liqun, who was formerly chairman of China Investment Corporation, which invested in private equity and hedge funds and cultivated relationships with large pension and sovereign wealth funds.
Tillman sees few problems for the policy lenders in coping with the exposures they have to major Latin America oil producers. Managing them can be accomplished by lengthening tenors or lowering the average price per barrel of crude in earlier contracts. Chinese banks are already coping with a spike in defaults at home – from 20 defaults worth $2.5 billion in all of 2015 to 40 defaults worth $4 billion as of August 1, 2016 – and have become adept at working out impaired loans, he argues. In 2015, China Development Bank terminated 50% of a previously agreed $3 billion policy bank loan to Ghana, even though 60% of that loan’s proceeds were allocated to spending with Chinese companies, he notes.
The outlook for policy lending
Policy lending volumes enjoyed a solid start to 2016, with Grisons Peak’s China Investment Research recording $13.5 billion in loans in the region in the first half of this year. That total, however, is dominated by the $10 billion Petrobras loan, and it is likely that 2016 could be quieter overall.
Part of the reason why 2016 may be quieter is that China will wait for new political leadership to assert itself in key Latin American countries. Nicolás Maduro, president of Venezuela since 2013, is facing an increasingly difficult domestic situation. Argentina, an important strategic partner of China’s, with patchy capital markets access, changed administrations in December 2015. The impeachment of Brazilian President Dilma Rousseff, whose definitive removal seems more than likely, and her replacement by her former vice-president Michel Temer, will encourage a more cautious approach on the part of China. Ecuador, says The Dialogue’s Myers, enjoys more political continuity than other recipients.
The Brazilian impeachment drama looks like having a knock-on effect on another China-influenced lender. Brazil has not made all of its promised capital commitments to the NBD. At least one of Brazil’s representatives at the NDB is an ally of Rousseff, and may not be inclined to support Temer’s initiatives, suggests one analyst following the region. Still, in April 2016, before Rousseff’s suspension, the NDB approved a $300 million loan to Brazil’s national development bank, BNDES, to help it finance renewables projects. Brazil is also, alone among Latin American countries, a shareholder in the AIIB.
Whereas in 2015 political realities pointed towards an increase in policy lending even as the economic rationale shifted, 2016 may be the year that politics caught up with economics. But the long-term interest on the part of China in the region will endure. Says Deutsche Bank’s Forster, “I think Chinese policy lending in Latin America is here to stay. Trade levels have been lower since 2013, and China is in the process of rebalancing its economy. But commodities demand would not completely collapse, and may indeed continue to grow, though maybe in a different set of commodities. A growing middle class might lead to greater demand for soft commodities, like soy for animal feed, rather than metals that would be used in heavy industry.”
For Grisons Peak’s Tillman, “agricultural exports could become more important than oil, in fact soybean oil is now a larger export from Brazil than crude oil. Brazil is now China’s biggest beef supplier, and China also imports large quantities of chicken from the region”. He also sees an increasing focus on assets that can support their own debt load or offer underlying security, like toll roads, or renewable energy projects, rather than soft loans to governments for infrastructure projects that may not be self-supporting. He suggests, however, that while policy lenders will want Chinese contractors involved in such projects, which will frequently happen through joint ventures with local firms, these banks are likely to continue to stipulate that at least 50% of loan proceeds be spent on Chinese equipment.
Forster also notes that China’s non-policy bank lenders have also stepped up their engagement. Bank of China, for instance, is considering setting up a branch in Chile, which does not even appear in The Dialogue’s finance database. Industrial and Commercial Bank of China closed a $1 billion sale-leaseback with Petrobras for the P-52 oil platform in March 2016, and has agreed a second transaction of the same size for the P-57 platform.
The combination of commercial and policy bank lenders will ensure that China’s influence in the region remains strong. “There may be a shift in the types of vehicles that China uses to finance priority sectors in Latin America, for instance in the increased use of the China-LAC Cooperation Fund,” says Forster. “So far we can’t see any signs of lower volumes, which points to continued engagement.” LF