A great new issuer leaps forward
Nobody knows how much it will cost China to block the Yangzi and build the world’s biggest ever dam. By even the lowest estimates, it will cost more than $30 billion to fulfil Mao Zedong’s dream of taming the force of the world’s most powerful river. Yet some believe it could cost a staggering $70 billion. By comparison, Malaysia’s recently-cancelled Bakun dam would have cost less than $6 billion.
Everything about the scheme is on a vast scale, including the controversy it has generated. The Chinese government has faced an unprecedented barrage of criticism at home and abroad over the plan which will displace a million people and create a reservoir stretching over 600 kilometres.
Many observers have long doubted the government’s ability to get the dam built, and plenty still believe the project is ill conceived. One US banker in Shanghai describes it as “the last gasp of China’s Stalinists”. In 1996 the US National Security Council recommended against official support for the Three Gorges project because of uncertainty over its economic viability and doubts about China’s ability to finance the project. Later that year the US Export-Import Bank president Martin Kamarck cited environmental concerns when he refused to support letters of interest from US exporters planning to submit for the project’s first $1 billion of foreign turbines and generators.
However, disputes over whether the scheme should go ahead may soon be overtaken by controversies over the way the project is funded. Already there are rumblings of discontent among the foreign banks bidding to arrange finance for the scheme, and these may be but a prelude to bitter battles ahead. But the problems experienced by some bidders for the financing of round one are unlikely to deter competition to participate in future tranches.
The Chinese authorities signalled their intention to drive a hard bargain with foreign financiers following the submission of tenders for the first 14 of the planned 26 power units. In late August the $1 billion equipment tender was split three ways among the seven original competitors. General Electric of Canada, in a joint bid with Siemens and Brazilian turbine maker Voith, won the largest contract, to build six complete generator/turbine sets. GEC-Alsthom was contracted to build eight turbine units, and ABB of Switzerland and Kvaerner of Norway to build eight generators.
But observers cite some unusual features in the tender process. In submitting their bids – many of which were for all of the 14 generator/turbines – each bidder was required to have its financiers first negotiate funding packages acceptable to China’s State Development Bank (SDB). Each of the funding bids had to be firm for a full year despite the fact that no commitment fees were payable. Negotiations over the underwriting agreements were described by one participant as lengthy, tough and “not inexpensive in terms of legal costs and management time”.
The leaders of the three banking syndicates associated with the winning bidders were Standard Chartered and Bank of Tokyo-Mitsubishi for General Electric/Siemens/ Voith, Société Générale and UBS for ABB/Kvaerner and Banque Nationale de Paris and HongkongBank for GEC-Alsthom. The bankers probably permitted themselves a moment’s celebration following the award of the contracts. But for one group at least, the tortured process of winning the business was not yet over.
In late September Thomas Aaker, Standard Chartered Bank’s director of syndications and asset sales, was hoping that after nine months of having the bank’s China credit lines tied up with underwriting for the project, some sort of return might be in sight. But he was not yet confident that the deal was in the bag: “What I fear will happen is that the Chinese will now throw all the commercial lending open again and go to tender,” he said at the time. “With the Chinese, once you sign the contract that is when the real negotiation begins, so the negotiation process can be very time-consuming,” said Paul Kazuo Okura, senior manager at Bank of Tokyo-Mitsubishi, a couple of days earlier.
But even Aaker was shocked by what happened next. A week later he learnt through an article in the China Daily, the Beijing government’s official English language organ, that a funding package had been signed for the General Electric/Siemens/Voith group’s contract. Neither Bank of Tokyo-Mitsubishi nor Standard Chartered, the consortium’s original finance partners, was involved. Instead the entire deal had been awarded to a wholly German team of Dresdner Bank, DG Bank, Commerzbank and Kreditanstalt für Wiederaufbau.
Nobody from the SDB had bothered to contact Aaker. “I was stunned,” he says. Behind the sudden change towards the Germans was the availability of mixed credit backed by the German export credit agency, Hermes, Aaker believes. “I don’t blame the Chinese, because they were able to get very attractive funding,” he says. “In hindsight maybe there would only have been a deal for us if the [General Electric/Siemens-Voith] consortium had won the lot, although I still have some hope there will be chance for us somewhere in the deal.”
Certainly the Chinese appear to be very pleased with the outcome. The German loan package comes in two parts: a $71.41 million tranche in the form of export credits with a 21-year term and a $200 million tranche in commercial loans for a term of 17 years. Both tranches have a nine-year grace period. After what were described as “arduous negotiations”, the loans were obtained with longer terms for repayment and at lower cost than any previous loans raised by the bank, gloated an SDB spokesman to the China Daily.
But in spite of the hard terms the Chinese authorities are able to demand, the potential rewards for financing the project remain sizeable, and Standard Chartered is not the only bank still hoping to gain a share after suffering an initial setback. Money for the project is flooding in, with the German-backed financing just one of a series of landmark deals recently announced for the dam by the SDB. Total foreign loans specifically raised for the project before the end of the year are expected to amount to $1.1 billion, including $600 million in export credits and $500 million in commercial loans. The deals confirm the bank’s new status as one of the key quasi-sovereign names in the international debt market (see box on page 54) and show the increasing confidence of international investors in lending to China on extreme maturities.
Investors ignore the ratings
Indeed, investors’ perceptions of China as a sovereign risk are starting to look sharply at odds with the official credit ratings obtained by the country. Although no details have yet emerged on the pricing of recent deals, the government is believed to have ordered the SDB to pay no more than 100 basis points over Libor for financing to build the dam. Historically the SDB has been able to pay around 85bp for up to 10 years. However some observers believe a commercial rate for 15 years alone would have been 30bp to 50bp higher than this spread. According to one senior US banker in Shanghai, the going rate for SDB credit at this maturity would have been Libor plus 200bp. Unconfirmed reports suggest that the actual rate charged on the commercial portion of the German loan may be as low as 70bp to 80bp, almost certainly a new low for China.
Work continues on the loans being organized by the Banque Nationale de Paris/HongkongBank and UBS/SocGen teams, with announcements expected by the end of October. One reason for the delay is believed to be a request by the SDB for the two loans to be combined before syndication. At this stage the bankers involved seem to be taking a relatively relaxed view: “You realize that this transaction is an ever-moving target,” says Ian Adams of BNP’s project finance team. “No one is ever clear what the final outcome will be. You name it, we have changed it.”
But why are lenders so anxious to lend to the project? “When you are analyzing this kind of project you have to analyze both the borrowing entity and the policy of the national government,” says Bank of Tokyo-Mitsubishi’s Okura. “You need to assess the project’s priority in the overall political and economic context.” According to many foreign bankers, the Chinese government perceives the Three Gorges project as so essential that lenders can be sure its priority status will endure through any likely economic or budget cycles.
“The government will make the necessary exercises on the electricity side to ensure the project works,” says Stephen Taran, a Lehman Brothers managing director in Hong Kong who was involved with the SDB’s maiden yankee issue early in 1997. Of the $330 million issued, $260 million was earmarked in the prospectus for power projects, principally the Three Gorges project. The 7.375% notes, issued at 99.734% of par, have since traded in a range of 80bp to 110bp over US treasuries. “China is a hot name,” says Taran. “Good things are happening in China and everyone wants to be part of it.”
Yasutoshi Ohata, general manager of project finance at Fuji Bank, which together with Dai-Ichi Kangyo Bank planned to fund the commercial portion of a Japanese consortium’s unsuccessful bid, believes that the Three Gorges scheme is completely different from other Asian infrastructure projects, such as Malaysia’s Bakun dam. He is positive about China’s macroeconomic prospects, taking comfort from the country’s strong reserve position and its relative insulation from currency risk as a result of its strict control of foreign exchange transactions on the capital account.
Meanwhile from a revenue point of view, the returns on large mixed credits like the one assembled by the German banks are a lot more profitable than they seem at first glance. “Think of the return on equity of this kind of transaction where more than half the loan is to a government entity and has zero [capital] weighting,” says BNP’s Adams, referring to the Hermes component.
The Chinese consumer pays
Even so the intermediation of the SDB is regarded as critical. “We focused on the SDB risk and the fact that the government was to be the buyer of the electricity,” says Fuji’s Ohata. “There is no true project finance in China yet because of the lack of legal infrastructure and other mechanisms which are essential,” says Bank of Tokyo-Mitsubishi’s Okura. “One of the biggest problems is the enforceability of the laws which has still not been tested,” says Ohata.
Another barrier to project financing is the difficulty of predicting the project’s future cash flow. “There is not enough data in China to do this as reliably as you can in developed countries,” says Okura. Inevitably, bids have been based on very tentative projections. “We had a dilemma when we issued the letter of interest because we did not know the cashflows and had to make our own rough estimates,” says Fuji’s Ohata. “Our plan was to review the cashflow issues after winning the project.”
The most recent official estimate of the cost of constructing the project is believed to be Rmb250 billion ($21 billion). But this figure was calculated at 1995 prices and exchange rates, since when the renminbi yuan has been devalued and there has been significant inflation. Futhermore, this total may exclude some of the additional infrastructure associated with the project, and may even overlook the cost of debt service during the construction period. This may be significant, since the project is not scheduled for completion until 2009, although some revenues are expected to start flowing early next century.
Of the total cost of the project, the SDB was believed to be seeking just Rmb40 billion from overseas sources. Of this amount, Rmb13 billion was to come from supplier credit and Rmb27 billion in SDB commercial loans.
But the SDB plans to raise the bulk of the money for the project at home. The domestic component includes 10 annual advances of Rmb3 billion each from the SDB; an estimated Rmb67 billion earned from partial operation of the dam between 2003 and 2009; and revenue of Rmb10 billion from existing dams to be included in the complex. However the largest single contribution to the project’s budget is an estimated Rmb103 billion to be raised by 2009 from a Rmb0.004 per kilowatt-hour levy on all Chinese electricity bills.
Few observers expect this will cover the cost of the project. “We expect the structure of the finance will be changed from what was originally planned as the assumptions are modified,” says Fuji’s Ohata. “You have to consider the possibility of cost over-runs and delays to the construction timetable.” Bank of Tokyo-Mitsubishi’s Okura sees foreign investors playing a bigger role: “It is quite possible that the project may have to tap the external markets more than they expect.”
According to some observers, in the long term the project may be able to get true non-recourse project finance. Indeed, it may need to, especially given the extent of China’s other infrastructure needs, many of which will also have to be funded through the SDB. “There is a limit to the borrowing capacity of any entity, whoever they are, so a variety of fund-raising vehicles needs to be used to fund such a major project,” says Okura. However Fuji’s Ohata believes this is unlikely and expects the SDB to be involved for the entire fund-raising.
In Okura’s view, the Chinese government is fully aware that its present legal and financial system imposes limits on funding options. In five to 10 years he expects new structures to be available which will help facilitate more lending on a nonrecourse basis. One possibility may be the eventual introduction of outside equity into the state-owned company established to build the project, the China Yangzi Three Gorges Dam Project Development Corporation.
Observers have already seen some indications that this may be the ultimate government aim. Standard Chartered’s Aaker says he was struck by the fact that throughout his syndicate’s negotiations, the chief negotiators from the Chinese side appeared to be the project company. “Someone from the SDB was always at the meetings, but they were not taking the lead as far as I can tell in the early stages,” recalls Aaker.
Certainly deals are now being done in the power sector on a nonrecourse basis. However not only are these smaller, they typically involve a foreign joint-venture partner, and also have binding off-take agreements. Standard Chartered recently syndicated a 10-year $124 million non-recourse loan for the Zhardian Gas Turbine Generating Company, a joint venture between the Shanghai municipal authorities and GE, with an off-take agreement with Shanghai.
More recently even the Japanese have been persuaded to lend to private power projects in China. In mid-September the Japanese export agency Jexim signed an agreement to lend $670 million to the Guangdong Zhuhai Power Station Co. This 60:40 co-financing deal with Bank of Tokyo-Mitsubishi was for a 20-year build-operate-transfer project jointly owned by Guangdong provincial entities and interests associated with Li Ka Shing of Hong Kong.
The Japanese are expected to play a critical role in the funding of the Three Gorges project also, despite the recent rebuff to Bank of Tokyo-Mitsubishi.
Japan’s official support for the project appears to look beyond mere financial issues. Jexim’s decision to grant letters of support to the Japanese syndicate reflects both geopolitical issues and pressure from the powerful combine of Itochu, Mitsui Corporation, various members of the Mitsubishi keiretsu, Sumitomo Corporation and Hitachi.
One reason for the Japanese consortium’s knock-back over the generator/turbine deal may have been a reluctance to provide full technology transfer to the Chinese. But other reports from Beijing suggest that the consortium failed to pick up any of the contracts because of Jexim’s equivocal attitude towards the project. “The Japanese consortium heard from China that it was felt to be lacking commitment,” says Jexim spokesman Shin Oya.
Eventually, however, Jexim sank considerable resources into backing the consortium’s bid, including a lengthy process of environmental and social due diligence, he says. Jexim issued a “preliminary offer” for the package in December 1996. But unlike the financing offers attached to some other bids, this was not a firm underwriting commitment. Rather, it was a “statement that a loan application would have been positively received”, says Oya. Jexim’s contribution would have been for concessional funding for up to the maximum of 85% of the transaction, as permitted under OECD soft-lending rules.
Avoiding Latin-style problems
There must also be doubts about Japanese willingness to provide the kind of funding the SDB was eventually able to achieve. Shunichi Sakashita, general manager of export credit agency financing at Sumitomo Bank – which expected to be a syndicate participant if the Japanese consortium won – says that he was expecting loans to be for a 12- to 15-year term only. And while he was expecting the interest rate to be less than 100bp over Libor, “we would not do 15 years fixed. We have no interest”.
Most bankers expect the project to continue to draw heavily on export credit agency support. “You don’t want to be relying excessively on external commercial debt for this kind of project,” says Okura at Bank of Tokyo-Mitsubishi. “Lenders have to exercise due diligence and stick to prudent banking policy towards these projects or they may have Latin American-style problems.”
The samurai market, in which the SDB has already made its debut, is also expected to be a prime source of funds for the project. “The SDB may be able to get better pricing in Japan than in the US,” predicts IBJ director Shinichiro Kanno, head of the bank’s China department. No one can predict how much SDB paper the market could support, but he notes that the bank’s first issue was very aggressively priced. The 10-year ¥30 billion ($250 million) issue in February 1996 was launched at par with a coupon of 4% by IBJ Securities and Nomura.
And the Japanese banks’ omission from the recent round of loans to the Three Gorges project should not be taken as an indicator of their future involvement. “I expect China to be the biggest risk [on Japanese banks’ books] in 15 years time,” predicts Sumitomo’s Sakashita.
China’s awareness of the likely role of Japan as its base financing source probably accounts for the anxiety to ensure that issues in other markets don’t flow back. “Japanese banks in Europe are a source of demand [for issues in other markets], but the Chinese don’t want paper placed in Europe to go directly to the Japanese,” says Lehman’s Taran.
