The Rise and Fall of the Resource-backed Loan

This two-part series analyzes past, present, and future trends in China’s resource-backed loans. This installment (Part I) looks at why China made frequent use of this tool in the 2000s and early 2010s and why it has since diminished in stature. Part II will turn to how China might change its approach to correct for some of the issues that arose with the older deals, including a look at two recent arrangements with Ghana and Guinea.

Many Chinese international loans are repaid with or collateralized with natural resources. According to my own original data set, somewhere between 29 and 32 percent of loans between 2000 and 2014 were backed by some kind of commodity, usually but not exclusively oil. However, these arrangements lost prominence following a crash in global commodity prices in 2014, and numerous problems have emerged with existing deals. In this article, I treat these developments in four parts. First, I explain the mechanics of how resource-backed loans (henceforth “RBLs”) actually work. Second, I turn to how they can be used to support resource security and exports of industrial goods while lowering risks from recipient-country governance. Third, I explain some of the limitations of the design as originally anticipated by Chinese policymakers. Fourth, I explain some of the unanticipated problems with the model that have prompted policymakers to consider altering their approach.

How Do They Work?

The exact details of how resource-backed loans work vary from case to case. In a few cases, countries have collateralized actual legal title to assets. Notably, Zimbabwe has done so with platinum deposits and even the land underneath Chinese-built waterworks. However, it is much more common to collateralize revenues from commodity production. Typically, this is done via two parallel agreements. A loan agreement establishes terms of financing including collateralization of commodity revenues, which are often placed in an escrow account designated for loan repayment; a purchase agreement then commits a Chinese firm to buy a certain amount of commodities, thereby guaranteeing a stream of revenue for the borrower. The value of the purchase agreement often exceeds that of the loan by a substantial margin, meaning that a minority of commodity export proceeds are pledged toward loan repayment while the borrower country has full discretion over what to do with the majority.

Historically, oil has been far and away the most popular option for collateralization. According to my own data set, approximately 82 percent of resource-backed loans from 2002 to 2014, when both commodity prices and resource-backed loan outflows dropped substantially, were backed with oil; this figure rises to 88 percent when natural gas-backed loans to Turkmenistan are included. Another eight percent went to metals such as copper, cobalt, and platinum; the rest, to a smattering of products ranging from Ghanaian cocoa to Ukrainian wheat and even generalized collateralization of all revenues from exports to China, as was done in Ethiopia and Uruguay.

What Are They For?

Resource-backed loans manage to simultaneously address China’s interests in securing overseas business for its construction firms, access to commodity imports, and protection against loan non-repayment. As the world’s factory floor, China imports large quantities of commodities and re-exports them as manufactured goods. With respect to industrial sectors, the terms of the loans guarantee that at least half, and typically much more, of project value goes to Chinese companies. Chinese firms in sectors such as rail, road, and electrical generation had great success in the 2000s and 2010s building up China’s domestic infrastructure. However, they have become victims of their own success as China’s infrastructure has improved substantially and opportunities for new projects have dwindled. These firms are important to the Chinese economy and employ many workers and the Chinese government is loath to let them significantly downsize. Instead, state-owned banks help them find overseas business, a task otherwise more difficult in the context of a slowing global economy.

The implications for resource security are more obvious. As of 2017, China was the world’s largest importer of crude oil (16.7 percent of global trade), copper ore (43.2 percent), cobalt (43.7 percent), and cereals (5.5 percent); and the third-largest of natural gas (9.7 percent). All of these have been used to repay Chinese loans. These loans can improve Chinese resource security by securing access to commodities at the site of production, by granting Chinese firms opportunities to upgrade their technological and managerial know-how toward the level of major multinationals, and most simply by expanding global output and keeping prices low.

Furthermore, resource-backed loans provide a degree of protection against political risk. The fact that they are “tied” to the use of Chinese contractors means that banks can disburse funds directly to contractors without touching high-risk local bank accounts; it also means that host governments cannot unilaterally expel contractors without also endangering access to funding. Repayment in commodities means that China does not even have to count on governments to remain solvent to repay their loans. China Development Bank officials, for example, were surprisingly forthright in their belief that repayment in Venezuelan oil would shield them from the fate of most others who had lent to the country’s government.

What Aren’t They For?

Given these benefits, it would be tempting to ask why China doesn’t use resource collateralization even more often. The model does have several drawbacks as anticipated by policymakers. Namely, whatever their benefits to commodity production, they do little to address transportation from exporting countries to China. They are also unpopular in most borrower countries and are typically only accepted by governments with few other sources of capital.

Critics point out that resource-backed loans typically do nothing to protect transportation of commodities to the home market. Most of China’s imports come by sea and will be vulnerable to interdiction regardless of any debt arrangements. Notable exceptions exist for oil- and gas-backed loans to be repaid via overland pipelines from Russia and Turkmenistan, respectively. However, both history and more recent events indicate that a more likely (if less dramatic) danger to China’s resource security lies not in interdiction on the high seas but in price shocks due to events in producing regions, especially the Persian Gulf. Despite the region’s centrality to global energy markets, China has not issued a single oil-backed loan to the Middle East. This is partially because many Middle Eastern producers have preexisting relationships with global oil majors and feel no need to mortgage the centerpieces of their economies, but also because China feels overly-reliant on the region and wishes to diversify. Indeed, resource-backed loans tended to go disproportionately to faraway regions: from 2002 to 2014, 43.5 percent went to Latin America, 32.2 percent to Eastern Europe and Central Asia, and 24.3 percent to Africa.

This is surprising if one expects China to focus on places from which it can economically source minerals. In accordance with the economics of transportation costs, much African and Eurasian production is exported to China, but most Latin American commodities are not. In Ecuador, for example, a series of resource-backed loans and purchase orders has led PetroChina and Sinopec to control between 80 and 90 percent of Ecuador’s petroleum output since 2013, but at no point have more than seven percent of Ecuadorian crude exports made their way to China. Hypothetically, the government in Beijing could call on firms to reroute some commodities to Chinese ports, but this is at most an insurance measure against a price shock that has yet to take place. During more normal times, resource-backed loans serve Chinese resource security in more mundane ways: by supporting its firms as they gain global experience, capacity and technical know-how, and global market share, and keeping prices low by expanding supply.

This leads us to the other major limitation of resource-backed loans: they are designed only for certain countries. Using state funds to expand global commodity supply only makes sense in markets where others are unwilling to invest on their own. Resource-backed loans tend to go to countries that are isolated from international capital markets and may not be able to reach their full commodity production capacity. Venezuela, the leading recipient of resource-backed loans, scared away most international investors with a series of nationalizations and a pledge to withdraw from the International Monetary Fund (IMF) and World Bank. Runner-up Russia’s endemic corruption made some investors cautious to enter the country to begin with, and this even before the invasion of Ukraine and Western sanctions. Third-place Angola began to fully exploit its oil reserves following the end of a civil war, at which point China (and several others) used oil as collateral to secure loans in an uncertain environment.

In lower-risk countries with better market reputations, this degree of risk management was neither necessary to Chinese firms nor acceptable to host governments who could find others to invest in their commodities without placing a mortgage tag on mineral deposits or imposing restrictions on their choice of infrastructure contractors. This distinction is clear from a graph of resource-backed loan recipients:

Total Chinese Loans vs. Mean Control of Corruption, 2000-2014

Countries which received resource-backed loans in large print. Countries supplying more than the sample mean value of commodity exports to China in red. Adapted from author’s forthcoming doctoral dissertation, New Types of Financing for a New Financier: A Theory of Chinese Development Finance.

This figure plots total loan disbursements from 2000-2014 against the World Bank’s mean Control of Corruption score over that time period, with higher values meaning less corruption. Resource-backed loan recipients (large print) are concentrated on the left hand side of the chart, meaning countries with worse corruption scores. The list of resource-backed borrowers overlaps partially, but not entirely, with countries in red, which were major suppliers of commodities to China. South Africa (“ZAF”) and Chile (“CHL”), for example, are important exporters to China, but are also popular destinations for international investors and have neither the need nor inclination to mortgage their resource deposits. Ecuador (“ECU”) and Zimbabwe (“ZWE”), on the other hand, are not important exporters to China but are too risky to attract much interest without collateralization. Resource-backed loans were meant to bolster global supply by managing risk in otherwise overlooked markets.

How Did They Go Wrong?

The original assumption behind resource-backed loans was that whatever happens, few if any commodity producers will ever halt extraction or exports. While it is true that few would ever want to stop selling their wares, a number of factors ranging from the sensational (war) to the mundane (price fluctuations) can get in the way. China also did not fully account for problems with the infrastructure-construction side of the equation: a series of perverse incentives in China’s contracting system enable corruption and mismanagement by both Chinese contractors and local governments, sometimes leading to adverse consequences for loan repayment. I address these issues in turn.

War is fortunately not a problem most borrowers have to deal with, but it does happen. China ran into this issue early on in Sudan, where in the 2000s the Export-Import Bank of China lent $1.5 billion toward oil-backed projects. Most of Sudan’s oil was located in the South, away from the ongoing Darfur genocide in the West, and China apparently calculated that risks from Sudan’s longstanding ethnic and religious tensions between the northern majority and southern minority were manageable. This did not turn out to be the case, however, and a civil war and subsequent peace settlement ultimately resulted in South Sudan’s independence in 2011. Having lost most of its oil, Sudan began to repay its debts to China with transit fees from the pipeline connecting landlocked South Sudan to the ocean, but even after a dispute with South Sudan that led to armed conflict and a halt to production, these were simply not enough. In 2012, China granted a five-year moratorium on repayment, but Sudan was still unable to repay the loan. In 2018, China was forced to write off $160 million in debt and further announced $88 million in grants.

Chinese lenders became averse to using resource collateralization in conflict countries after this experience. Following a bout of domestic turmoil and invasion by Russia in 2014, Ukraine fell behind on its payments toward a grain-backed loan, but China had made the deal two years prior and (like most others) did not see these events coming. Worth watching is an agreement with the Democratic Republic of the Congo (DRC) to repay loans with copper and cobalt. The deal was inked in 2008, before the Sudan oil deal collapsed, and bears some parallels to it: the minerals in question are mostly located in the DRC’s South, a region with some conflict but not as much as the troubled East. Finally, a natural disaster could hypothetically play a similar “dark horse” role interrupting commodity production. This has not directly affected Chinese resource-backed loans to date, but hurricanes in the oil-rich Gulf of Mexico and earthquakes in the copper-rich Andes provide an unfortunate proof of concept.

War and disaster are high-impact, low-probability events. In most countries, a more likely risk comes from market prices. Many borrowers have struggled with repayment since a sharp fall in commodity prices in 2014 saw crude oil prices, for example, fall by half. Most deals have been indexed to market prices, meaning that borrowers must now produce more resources to keep up with payments. Currency markets can exacerbate this problem: most international trade and debt agreements are conducted in globally used “hard” currencies such as the dollar and euro, and falling export prices can mean less hard currency coming in to pay for imports and service debt. Not all countries have struggled—Russia, for example, recently repaid an oil-backed loan ahead of schedule—but market trends have not been on borrowers’ sides. Neither does this situation help China, which has reason to wonder how much of its money it will get back and whether the deals can benefit its resource security as much as hoped. Kaplan and Penfold have even called the situation in Venezuela a “creditor trap” in which systematic miscalculation of market price risk by both sides has left China Development Bank facing losses in the tens of billions and PetroChina wondering how much oil it will actually be able to sell.

The Venezuelan case is indicative of a second problem: resource collateralization has not provided nearly as much protection against misappropriation and misconduct as Beijing might have hoped. This has not been an issue in all countries, but where it has emerged, it has been a much less manageable issue than market prices. A kleptocratic, inefficient system in Venezuela led to the waste of billions, meaning that Petroléos de Venezuela (PDVSA), the state oil firm, did not have enough money in the bank to maintain production. One of the worst economic collapses in living memory has ensued. Lesser versions of this story have played out elsewhere. In Ecuador, for example, a former administration is under investigation for the disappearance of billions in funding for oil-related infrastructure. The tying of loan contracts to select Chinese firms has opened the door to different types of malfeasance. First, the opacity surrounding these non-competitive, closed-door deals means that it is fairly easy for Chinese contractors to subcontract to local firms with limited oversight, providing an alternative avenue for corruption in the absence of loans directly to government bank accounts. Corruption and general mismanagement can endanger economic output and thus loan repayment. Then, even where local corruption is not an issue, the lack of competition in the bidding process means that there is limited incentive to do high-quality work. Of six Chinese-built hydroelectric dams in Ecuador, for example, none were completed on time, and many have had serious quality issues, including several thousand cracks and structural flaws in a billion-dollar behemoth at Coca Codo. In many instances, low-quality work will not generate enough economic return to pay back the lender.

Resource-backed loans have begun to play a smaller role in Chinese policy since the commodity slump in 2014. Some borrower governments have vocally spoken out against them, especially where new leadership has begun to question their predecessors’ dealings, and most of the major borrowers of the commodity boom era are now making much less use of resource collateralization. An early sign of trouble came in Ghana where in 2015 the government opted not to withdraw the second half of a planned $3 billion oil-backed loan amid concerns about low prices. Since then, much more has happened. Angola’s new president has pledged not to borrow any more with oil as collateral. The DRC is struggling as mathematical models demonstrate less resilience to copper and cobalt price drops than many might have hoped. The IMF has gotten involved in the Republic of Congo, which as part of its bailout package was required to restructure its debt to China, and in Ecuador, where China’s continuing involvement has been limited to a smaller non-oil-backed loan. In Venezuela, China has turned to “defensive lending” toward boosting local crude production just to service debt already on the books.

Conclusion

China’s resource-backed loans match a country with a strong construction sector and a shortage of commodities with partners in the inverse situation. The idea at its core is not a bad one, but problems with implementation have gotten in the way. Badly burned by events in Venezuela in particular, China is likely to be more cautious in the future, as will many borrowers. This shift should not be taken in isolation, but rather as part of a larger trend toward restraint as China’s previous deals have lost money and its foreign currency reserves no longer seem bottomless. Apart from a quantitative tightening, there may be qualitative changes in the structure of future resource-backed deals. In the next installment, I will discuss what these changes could be and which of the previous deals’ problems they most effectively address.

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Scott Wingo is a doctoral candidate in political science at the University of Pennsylvania focusing on China’s economic engagement in the developing world and why its modes of doing business are different from those used by Western governments, international organizations, and multinational corporations. He has previously worked with the Woodrow Wilson Center, the World Bank, and in the private sector, and has served as a teaching assistant for five semesters at Penn. Scott is proficient in Mandarin Chinese and Spanish and reads Portuguese. He holds both a Bachelor’s of Science in Foreign Service and a Master’s of Arts in Asian Studies from Georgetown University. You can follow him on Twitter @ScottCWingo.