Pakistan and China’s “all-weather friendship” has come under increasing stress in recent months. The two countries have been strong diplomatic partners for 70 years, at first as a geostrategic counterweight to the ties between India and the Soviet Union, but increasingly because of China’s enormous investments in Pakistan. Today, Pakistan is one of China’s few close allies, with officials on both sides frequently invoking their “iron brotherhood” and “sweet as honey” relationship.
That relationship grew even stronger with the launch of the Belt and Road Initiative (BRI) in 2013, and in particular the China-Pakistan Economic Corridor (CPEC) in 2015. CPEC aims to connect western China, which borders Pakistan, to the southern Pakistani port of Gwadar on the Arabian Sea. To that end, Chinese actors have funneled billions of dollars into transportation and energy infrastructure in Pakistan, including road networks, power plants, and transmission lines.
But the relationship between both countries has faced increasing stress as China’s economic footprint in Pakistan continues to grow. There have been periodic questions regarding the economic benefits of CPEC projects. This resentment has boiled over into periodic acts of violence against Chinese interests by different groups, including the Pakistani Taliban.
In 2018, four people were killed when armed gunmen assaulted the Chinese consulate in Karachi. Another attack in 2020 at the Pakistan Stock Exchange, which is majority owned by the Shanghai Stock Exchange, also claimed four casualties. Violence has become especially pronounced in Balochistan, Pakistan’s largest and poorest province, which shares a long border with Afghanistan. Most recently, in April of this year, extremists bombed the Serena Hotel in Quetta, Balochistan during a visit by the Chinese ambassador.
But the Dasu terror attack on a bus on July 14 stands out as the first time a large-scale Chinese-financed infrastructure project has been targeted. The nine Chinese nationals killed in the bombing were among about 30 engineers employed by China’s Gezhouba Group to build the large-scale Dasu hydropower project. The project, though not a part of CPEC, is one of at least 33 Chinese-financed electricity-generation projects currently underway in Pakistan. The attack also led China to cancel the planned meeting of the Joint Coordination Committee (JCC), the highest decision-making body of CPEC.
In the broader context of CPEC, the targeting of a Chinese-backed energy project may give Chinese actors cause for alarm. The energy sector is the primary recipient of Chinese foreign direct investment (FDI) through CPEC and is slated to receive over $30 billion, or 72 percent of total Chinese investment, over the next decade.
Chinese and Pakistani policymakers initially envisioned CPEC as a three-stage development process. In the first, between 2016 and 2020, investment focused on eliminating supply bottlenecks in the energy and transport sectors. In the second, up to 2025, investments will target industrial cooperation. In the third stage, set to end in 2030, investments will shift toward developing bilateral and regional connectivity.
Pakistan has good reasons to encourage Chinese foreign investment. Like many developing countries, Pakistan has a large public debt, at about 100 percent of GDP, and currently relies on a large IMF program – about $6 billion – for fiscal relief. The country has faced periodic boom-bust cycles and has been to the IMF 15 times since 1980. As the country continues to struggle to attract investment, policymakers in Pakistan have come increasingly to rely on Chinese capital. According to the United Nations 2020 World Investment Report, China was by far the largest contributor of FDI to Pakistan, most of it through CPEC.
Pakistan is in dire need of private sector investment – a focus of CPEC’s second stage – to stimulate sustainable economic growth and to relieve pressure of the current account deficit. While advanced economies like the United States typically maintain current account deficits, developing economies like Pakistan often run surpluses. When coupled with structural problems in Pakistan’s economy and infrastructure bottlenecks, a severe and persistent current account deficit may compound the country’s external debt situation and worsen the fiscal challenges facing the country.
Currently most of the Chinese FDI to Pakistan has come from centrally administered state-owned enterprises (SOEs) and smaller local SOEs. Investment under CPEC has flowed primarily to the power sector. This investment is backed by sovereign guarantees provided by the government of Pakistan and provides Chinese investors with dollar-based guaranteed returns. Furthermore, it has limited local linkages. Pakistani policymakers across the political divide believe that this situation will change and private Chinese firms will eventually invest in the manufacturing sector in the priority Special Economic Zones (SEZs) that are being developed in different parts of the country.
They hope that Chinese firms will relocate some of their labor-intensive manufacturing to Pakistan to take advantage of the country’s low-cost labor. Private Chinese investment in the manufacturing sector will increase Pakistan’s exports and support the upgrading of local firms, helping them become part of dynamic global value chains. Despite the wish to attract such efficiency-seeking investment, to date there is limited evidence that private Chinese firms want to invest in Pakistan and CPEC’s second stage is effectively at a standstill.
The situation is made worse because, contrary to popular rhetoric, China’s international investment regime is highly decentralized among government agencies like the Ministry of Commerce and the Ministry of Foreign Affairs (MFA), the goliath centrally-administered SOEs, and collections of smaller public and private corporations. Research has shown that these firms are independent of the central government but can be incentivized to invest in particular regions or countries.
Political scientist Shaun Breslin’s work on Chinese development aid has emphasized this point. He argues that because of the institutional deficiencies of the MFA and central bureaucracy, many Chinese actors – including large and small SOEs and private firms – pursue profit-driven agendas separate from those of the central government. As a result, Chinese commercial interests often dominate relations with developing countries like Pakistan.
Those commercial actors will likely be more cautious about investing in Pakistan as long as the risk of terrorism remains high. Reversing this trend will require changing the perceptions of the hundreds of Chinese actors that will collectively provide the private sector and export-oriented investment that Pakistan desperately needs. Pakistan’s rising current account deficit and external debt situation, coupled with security challenges, are likely to increase the short to medium-term economic challenges. Already, the impact of instability in Afghanistan and a delay of the most recent IMF tranche have contributed to an 8 percent decrease in Pakistani bond prices this year.
For Pakistan, this means that it might not be able to attract Chinese FDI in the manufacturing sector despite the generous incentives being offered to foreign investors in the SEZs and the deep strategic linkages between the two countries. Pakistan could lose out to other countries in the region that are more stable – like Bangladesh – in the quest to attract Chinese manufacturing capital.
The external economic and geopolitical challenges require both Pakistani and Chinese actors to work toward rebuilding confidence that has been lost in recent months. In the absence of such measures, the sustainability of CPEC and the broader BRI are likely to remain in question