China and the Lao Electrical Grid: Implications for Future Borrowers and China

Introduction

On 4 September, Reuters reported that the government of Laos, on the verge of default on its debt, planned to establish a joint venture with China Southern Power Grid (CSG), a Chinese state-owned firm, to manage a portion of its electrical grid. The deal amounts to Laos yielding control over critical infrastructure. China could hypothetically use the latent threat of interfering in a basic social service to attempt to influence Lao policy. It bears investigating how serious the situation is in Laos and whether other countries might accept similar agreements under the budgetary strain of the pandemic. In this article, I first outline what exactly happened in Laos before analyzing the deal’s implications for borrower governments and China.

Details of the Deal

Not all that much is known about the deal to date—indeed, it may not be entirely set in stone. With that in mind, I sketch out what is known first about its financing arrangements and second about what it substantively entails.

There are two basic ways China could have financed the deal. One would be to agree to write off debt in exchange for an equity stake: a “debt-equity swap.” Another would be for China to pay actual cash for the investment. (Or, of course, there could be some combination of both of the above.) Neither side has publicly stated which method was used but there are reasons for both parties to prefer the cash method. From Laos’ perspective, a cash infusion would allow them to handle not just upcoming payments due to China but also those due to other creditors. Laos’ longer-term structural problem has been debt to China: as of the end of 2019, Laos owed a stunning 50.5 percent of its public sector debt to China, as opposed to only 16.1 percent to private bond markets. However, a disproportionate amount of bond payments came due in 2020: of Laos’ payments due in 2020, 30.9 percent were due to bondholders, as opposed to 41.9 percent to China. Laos would have preferred payment in cash to deal with its immediate bond payments and not just its longer-term Chinese debt.

Chinese banks also prefer not to take a write-off. Historical precedent indicates that they prefer instead to make new business arrangements aimed at recouping at least some of the losses from the old. One notable example was a deal reached in cash-strapped Venezuela, where China set up a series of joint ventures with the host government to produce more oil in order to repay Venezuela’s substantial outstanding debt. Similarly, while the sale of Sri Lanka’s Hambantota Port was widely reported as a debt-equity swap, it actually was not. The Chinese firm paid cash, which allowed Sri Lanka to pay its bondholders but left debt due to Chinese banks on the books in hopes that Sri Lanka Port Authority profits could eventually pay it back. China’s and Laos’ lack of transparency means that we must resort to educated guesswork as to the exact nature of their financial dealings. Since there has been no public mention of a debt write-off, the safer bet would be that China stuck to the historical precedent.

This raises the question of how the joint venture will repay debts due to China. In lieu of oil (Venezuela) or port revenues (Sri Lanka), Laos has one commodity in abundance: hydroelectric resources. Laos has long held aspirations to become the “Battery of Asia,” using to its advantage its location amid larger Asian markets and along the Mekong River and tributaries. As of 2018, Laos was already exporting $1.42 billion per year in electricity. The overwhelming majority (96.8 percent) went to Thailand, a logical destination just across the Mekong (Harvard University, 2020).

Early signs indicate that the joint venture, Electricité du Laos Transmission Company (EDLT), aims to expand Laos’ electricity export capacity. The Lao state press has written that:

[…] EDLT plans to invest about US$2 billion in building Laos’ national backbone power grid and cross-border power grid interconnection for Laos and its neighbouring countries, to move forward projects such as the Laos-Cambodia power grid interconnection project and Laos-China power grid interconnection project, and in purchasing from EDL the right to use EDL’s existing power transmission assets at 230kV and above voltage levels.

So, there are both domestic and international components to EDLT’s (the new Lao-Chinese joint venture’s) plans vis-à-vis EDL (Electricité du Laos), the Lao state-owned parent company. Internationally, early statements single out not Thailand but Cambodia and China as targets for expanded trade. Apart from Laos’ obvious interest in diversifying away from overreliance on a single buyer, this also has geopolitical overtones: the Cambodian government is especially close to China. It should also be noted that while Cambodia is a potential buyer market for Lao electricity, China may actually be a seller. Northern Laos has less hydroelectric potential than the central and southern parts of the country and could potentially use excess electricity generated in China’s neighboring Yunnan Province, especially during the dry season.

The announcement also mentions “Laos’ national backbone power grid.” Laos’ power grid is historically divided into three separate regional grids, which are only imperfectly integrated. This is probably the reason for the announcement’s specification that EDLT was focusing on “power transmission assets at 230kV and above.” Laos’ local connections mostly operate at 110kV, while 230kV or 500kV lines are used for international connections or trunk lines between major hubs.

These efforts to improve Laos’ domestic electrical infrastructure and export capacity could be amplified by access to Chinese human capital. Chinese and Lao state media both report that the Lao Minister of Energy and Mines “believed that with CSG's [China Southern Power Grid’s] advantages in experience, technology and human resources, the EDLT will bring a fresh outlook to the Lao power industry.”

EDLT is meant to help repay Lao debts by increasing domestic energy efficiency and especially through electricity exports. Still, Laos is in a small minority of countries that have struck this type of deal, and the implications for sovereignty over critical infrastructure leave many unsettled.

The Borrower Perspective: Why Laos?

Laos’ reliance on Chinese engineers to maintain parts of its critical infrastructure represents an obvious point of leverage for Beijing, and there are valid questions as to why Vientiane agreed to it. The most immediate reason would be debt; Laos was having trouble repaying and needed assistance. However, this is at most a short-term spark that hit a longer-term, structural powder keg. Namely, Laos had already placed its economic bets with China, including critical infrastructure in the power generation and international transport sectors. For reasons related to domestic governance, it opted out of potential diversification opportunities with partners such as the IMF.

Large parts of Laos’ infrastructure are Chinese-built and Chinese-operated by design. The Stimson Center lists 26.43 gigawatts (GW) in operational or planned Lao hydropower capacity; of this, 6.88 GW (26.0 percent) is at least partially Chinese-funded, second only to 10.56 GW (40.0 percent) from Thailand (Stimson Center, May 25, 2020). While China is not the leader in Lao hydropower, it is not totally clear that anyone could replace it. Decreased Chinese investment could therefore lead directly to decreased Lao power exports, leaving Beijing with leverage. What’s more, in many cases, Chinese firms will remain on the ground after construction is complete. The American Enterprise Institute estimates that since 2005, Chinese firms have put forth $3.99 billion into direct equity investment in the Lao hydroelectric sector against $7.03 billion in total construction contract value. Where Chinese firms are direct investors, they may be in positions of long-term influence as owners and sometimes operators of Lao electrical generation assets. Chinese firms therefore already had a degree of power over electricity generation before the recent deal involving transmission.

Then there is the source of much of Laos’ debt to China: the railway from Kunming, China, to Vientiane, Laos. Currently under construction for an eye-popping $5.95 billion, the rail will eventually extend to the Bangkok area.

Figure 1: The China-Thailand Railway

Source: Asia Times.

From Beijing’s perspective, the rail is substantially more important than the dams. It improves landlocked and underdeveloped Yunnan Province’s access to international markets and allows traffic to bypass the contested waters of the South China Sea. Landlocked Laos, for its part, has pinned its hopes of promoting exports and industrialization on better logistical capacity through the railway.

China has put substantial sums into the project but still leaves Laos financially responsible for a part. As of 2016, both sides have agreed that the state-owned firm China Railway would take a 70 percent stake in the joint venture to the Lao government’s 30 percent. In keeping with its majority stake, China agreed to provide the majority of the nearly $6 billion in financing but left Laos to commit $250 million of its own resources and $465 million from an Export-Import Bank of China (Exim) loan at only 2.3 percent interest. On one hand, Beijing is clearly willing to lose money to make the project happen. On the other, there are valid doubts about whether Laos can pay even its minority share of the cost. It remains unclear whether the railway will ever be profitable or whether Laos will gain substantial benefits from traffic predominantly between the larger Chinese and Thai markets.

While poor planning and an excessive Lao debt burden were a recipe for disaster, they were not a recipe for Chinese control of the railway: this had already been agreed upon up front. Nor did they lead to Chinese control over parts of Laos’ electrical supply: this, again, was part of the original deals.

This left expanding electrical transmission to match increasing output as an option to alleviate Laos’ economic overreach. Indeed, this option may have already been under consideration before the handover deal. In 2018, CSG signed a memorandum of understanding to upgrade parts of Laos’ power grid. It had also been working on the power supply to the railway project since 2016. Like the new deal, the railway power supply was handled by a joint venture between CSG and EDL.

A power grid takeover was not necessarily Laos’ only option, however. The Group of 20’s (G20) Debt Service Suspension Initiative (DSSI) has already deferred many bilateral debt payments through the end of 2020. Of twelve eligible countries with projected savings of over 1 percent of GDP, Laos has so far been one of only two to opt out. Similarly, between the onset of the COVID-19 crisis and this writing, the IMF has extended either direct financial assistance or debt relief to 83 countries, but Laos has not borrowed from them since 2003. The IMF’s most recent staff report in Laos expressed concern over excessive deficit spending on investment goods as well as issues with public procurement and corruption. IMF loans tend to come with strings attached, and it is a safe bet that Laos would have had to curtail spending and increase financial transparency to get help from the Fund.

This might be a difficult ask in a regime with issues on both counts. Budget deficits are already an issue: the World Bank projects Laos government deficits to reach an unsustainable 6.3 to 8.1 percent of GDP by 2022. Requesting cuts, though, could put the Lao government in an awkward position as it tries to both provide for its population during the pandemic and borrow heavily on infrastructure projects it hopes could be transformative. Regarding transparency, the World Bank as of 2019 ranks Laos at the 13.5 global percentile for Control of Corruption and the 23.6 percentile for Regulatory Quality, an indicator meant to measure perceptions of the government’s ability to foster “private sector development.” While it is tempting to cast Laos as a hapless victim, the reality may be even less palatable: the Lao regime weighed its options and assessed a Chinese takeover of one key infrastructure item to be less demanding than broader economic and governance changes. The nature and economic strategy of the Lao regime tended to favor Chinese-style opacity over the transparency and conditionality potentially associated with other offers.

This leads to a larger question for the future. Self-isolated from other international help and closely tied to China, Laos was a most likely case for using equity to treat debt. It remains to be seen, though, whether Laos will be the only COVID-era case or the first. Countries with better access to international financing, especially from the IMF, will be in a structurally better position to avoid Laos’ fate. Greater concern accrues to a handful of countries which have leaned heavily on China.

Implications for China

The implications of the deal for China are as yet unclear but bear more downside risk than upside. While China may gain some localized strategic leverage over Laos, it could lose in the much broader sphere of international public opinion, including in the capitals of other would-be borrowers.

It is too soon to definitively say how much leverage China will acquire from the deal but initial gains should be more incremental than transformative. As mentioned, Chinese firms already had substantial positions in Lao electrical generation and especially cross-border transportation. Laos, for its part, has generally gone along with China’s international agenda regardless of debt issues. Over the past year, Laos has signed letters of support for Chinese policy in Xinjiang and Hong Kong. On the South China Sea dispute, Laos has tried to maintain better ties with Vietnam and hedged its bets to a greater degree than Cambodia, which has more enthusiastically backed China. While Beijing may be able to extract more concessions on the South China Sea, Laos had already voluntarily signed on to many other parts of China’s agenda, including the railway and common views on governance and human rights. This is the perverse logic of deals handing over control over critical infrastructure: they are most likely to happen where China already has substantial influence and additional leverage might not much matter.

On the negative side of the ledger, the decision to move in on Laos’ electrical grid shows remarkable tone-deafness on China’s part. As a practical matter, the thousands of Chinese overseas projects active at any given time are primarily handled by firms on the ground and it is understandable that CSG and Chinese lenders would see the deal favorably. Indeed, some commercial benefit may well materialize for Laos, which stands to gain from greater electricity exports.

Still, from a public relations standpoint, the move could be a disaster. The specter of Chinese firms moving in on critical infrastructure might be less likely to materialize in a typical borrower country with better access to capital, but it could have a chilling effect regardless. Unlike the small, localized issue of Lao debt, such a shift could damage the entire Belt and Road enterprise. That senior leadership let the deal go through speaks to weak coordination between firms overseas and the government at home, overreach at the expense of international public opinion, or both. In 2020, unfavorable views of China already hit high points in many developed countries. While the immediate impetus was China’s handling of the initial COVID-19 outbreak, a series of Chinese actions had already led to unease abroad. Undiplomatic “wolf warrior” diplomats and the militarization of the South China Sea have impaired the idea of a “peaceful rise,” and human rights concerns in Xinjiang and Hong Kong and trade issues have contributed to a downturn in relations as well. Many of these issues resonate more in developed countries, and developing world public opinion toward China has so far remained more positive. But, this could change with more missteps like the Laos deal which might more directly speak to developing world interests.

Conclusion

The Laos electrical grid episode carries lessons regarding both borrower countries and China.

First, the risks of a similar incident are much higher for a certain subset of countries. Many borrowers facing Laos’ situation would have immediately reached out to the IMF or another important partner, but Laos risked negotiations with China rather than give ground on fiscal deficits or transparency. Most would not make this choice, but some might, and we should understand the structural conditions of domestic governance and overreliance on China that make it more likely.

Second, it is conceivable that Chinese firms will be emboldened to pursue similar equity deals with other distressed borrowers. This could leave borrowers in a difficult place, afraid of the implications of Chinese finance but in need of development funds regardless. So far, most have not substantially changed their policies. At the moment, most borrowers are focused on riding out the COVID-19 crisis and are having to negotiate with all creditors, China included. The majority owe more money to private creditors or multilateral organizations than they do to China and might fairly assess themselves to be at lower risk than Laos. Still, there could be greater changes in the longer term. If more of these negotiations result in deals similar to the Lao arrangement, some borrowers that have bet heavily on China might begin to diversify toward whatever other funding sources are on offer; others that had been contemplating a China-heavy development path might reconsider.

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Scott Wingo focuses 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 the University of Pennsylvania. Scott is proficient in Mandarin Chinese and Spanish and reads Portuguese. He holds a doctorate in political science from the University of Pennsylvania. You can follow him on Twitter @ScottCWingo.