For all of the various projects that are under way or planned across the Belt and Road Initiative (BRI) they all need to be funded, collateralised, insured, indexed, reinsured, hedged and sold on to say nothing of the need for a home for the various disputes which will inevitably arise. There is only one city which is well positioned to handle all of that, and it is London.
London’s true and real value to this massive sprawling global project is to be its home outside of China. In a location, language and legal construct which the world is already more than comfortable with. Especially as the road becomes less Chinese and more global in nature. I cannot think of another city which can offer the same, to anywhere near the same level. That said there are some very real gaps yet to be addressed. If I pick one in particular it would ‘the hedge’.
Currently the developers of BRI infrastructure are sitting on a considerable amount of underlying frontier market FX risk. There is a distinct lack of currency hedging tools and the cost of hedging is extremely high. Unfortunately a lot of the belt and road is currently not sufficiently protected.
Finding reliable hedging tools for the likes of Central & South East Asia, Africa, and Latam is incredibly difficult to the point that these risks are likely left unhedged.
Let’s take a typical example scenario where many African countries now enjoy new rail, road and shipping infrastructure.
The shiny new trains in east Africa are most welcome. But the smiling family on the train in Kenya is not paying for the ride in USD, they’re paying in Kenyan Shilling. Like it or not – this creates an exposure to the Shilling exchange rate when it comes to being repaid or covering the coupon. Let alone protecting the asset.
Even if the asset is hedged. The workflow for that today may go something like this. China Road, Rail and Bridge Corporation calls its house bank, (and when I say calls – I mean over something as inefficient as the telephone) which calls perhaps another bigger Chinese bank who calls a branch in London who calls a bank in South Africa to give a price for forward Kenyan Shilling in a large amount. Who may have to call into Kenya itself and spread it around a few banks to price it. Each adding a sizable margin to the chain. None of it necessarily benefiting the underlying Kenyan forward market nor the risk holder.
African financial markets are poorly represented in London and yet there are 10 African related Banks active in the London Market. The same is true of the wider BRI countries. London is the only place in the world where they are all represented in a meaningful way and yet they do not have a unifying structure to bring them all together. Until now.
NDFs in London
Whilst this only forms a small part of the wider BRI financial agenda it does give an easy method to follow for the larger infrastructure funding discussion, where some of the downside risks are addressed. It also acts as a catalyst to a bigger agenda - BRI FX hedging. The underlying political, market and settlement risks approach basic mitigation with the use of USD based Non Deliverable Forwards (NDF) in London.
Bank of England figures show the NDF market is up 24% in London and turnover has increased to $139 billion per day, its highest absolute turnover to date, and has seen steady growth of over 200% over the last 4 years.
A very small portion of that figure currently represents Frontier BRI currencies.
Electronification of that market will certainly increase its size, number of participants, regulatory oversight and most importantly London’s role as the BRI FX Hedging centre.
And now for the shameless plug. R5 will be launching an electronic BRI FX Hedging service shortly which links the original Chinese house bank with the African pricing bank directly. No need for all the middle men and all via London using cutting-edge technology.
RMB versus USD
One question that does get raised - is - will more and more of the Belt and Road be denominated in RMB rather than USD? This is a relevant but misleading question. Like it or not the global capital market is built, measured and sustained in US dollars.
That isn’t to say it will always be that way as one could argue the world was based on GBP during the nineteenth century, USD for the twentieth and could well be RMB in the twenty first. Or dare I say some sort of global crypto currency which incorporates them all.
But the local market risk remains. Whether it is an airport in Sri Lanka, a port in Malaysia, a train in Kenya or a dam in Pakistan. These projects are all in country, at risk to local market factors, and their ability to be repaid is dependent in part of the FX rate of that nation. Leaving that unhedged will create far more than a mere pot hole in the road and subsequent belt tightening on the pay back. Steps need to mitigate this risk, and there is really only one place in which to do it.