A quest for Middle East business brought China Railway Construction to Mecca, but unexpected costs followed

The first, Chinese-built railway in the Middle East has landed on slippery financial tracks that could affect China’s wider plans for business expansion in the region.

State-owned China Railway Construction Corp. announced October 25 that it expects to lose about 4.15 billion yuan on a contract for a light-rail line in Mecca, Saudi Arabia – a huge loss for a project that was supposed to lay a foundation for CRCC’s future growth in the Middle East.

CRCC cites the client – the Saudi Ministry of Municipality and Rural Affairs – for unexpected project adjustments that substantially increased construction and future operations costs tied to the US$ 1.77 billion contract.

“There was only a conceptual design” for the 18-kilometer railway when the contract was signed in 2009 “which led to constant changes in requirements and the raising of standards by the customer, resulting in a larger amount of work,” a CRCC executive who asked not to be named told Caixin.

Some analysts add that CRCC may have underestimated the potential risks that go hand-in-hand with any overseas business contracts with non-Chinese clients.

Meanwhile, CRCC is under pressure at home. Dissatisfaction with the Mecca railway’s progress prompted the Chinese Ministry of Railways to suspend all grants to the railway builder, said a CRCC employee who participated in the Saudi project.

The rail contractor hasn’t given up. And its executives have not forgotten that Mecca, as Islam’s holiest city and a magnet for millions of pilgrims every year, may be worth the extra effort as a springboard for breaking into the Middle East market.

Nevertheless, CRCC is in business to make money and is banking on long-range success in Mecca. To that end, the company recently dispatched a negotiating team to discuss possible contract adjustments with the Saudis.

The Saudis agreed to set up a special committee to negotiate claims. But prospects for an agreement before next May appear dim. And the Saudi committee apparently plans to wait to review CRCC’s alleged overruns only after the railway is built.

All Aboard Mecca

When CRCC and the Saudi ministry signed the contract in February 2009, the Chinese company agreed to handle all design, procurement, construction, system installation and commissioning for the nine-station railway. The builder also agreed to operate and maintain the line, with a capacity of 70,000 passengers per hour, for the first three years.

That three-year period was supposed to start in November. But the contract glitch has now delayed the scheduled start-up until at least May 2011.

“A light rail project in China of this size would take two to three years from design to operation, and the construction period should be even longer under the high-temperature conditions in Saudi Arabia,” said Professor Jia Limin of the Research Center for Railway Intelligent Systems and Safety Technology at Beijing Jiaotong University.

CRCC’s latest loss forecast is based on its estimated costs for the extra workload demanded by the customer, as well as projected higher costs during the operational period. The 4.15 billion yuan loss estimate was based on September 30 currency exchange rates.

CRCC’s red ink in Mecca has been spreading since the company reported a 294 million yuan loss for the project in 2009. The losses accelerated to 254 million yuan in the first half 2010, said the executive, although the bad news never made it to the public because the company expected a turnaround.

Some analysts say CRCC should accept some blame for the losses based on problems with the company’s pre-bid risk evaluation process. In an interview with Caixin, an industry source with experience in overseas contracting said many contractors are often willing to sign similar design-build-operate contracts because they leave room for procurement controls and can yield strong profits.

The CRCC executive, however, said its Saudi client put restrictions on the selection of the design contractor, which slowed the design phase of the project and increased costs.

Under the contract, the client was to provide only a conceptual design for the railway project. “The contractor had the obligation to design the project development and draft construction drawings,” said the industry source.

CRCC could have sought permission to suspend construction after the client asked to modify the contract without changing the payment plan, according to a lawyer.

Indeed, the CRCC executive admitted the company could have stopped construction at any time. But the client then would have had the right to seize the contractor’s performance bond and push the company’s losses to 1.2 billion yuan.

So rather suspend the project, CRCC dispatched a contract negotiating team led by a vice president to Mecca on October 30. Documents for modifying payments have been submitted to the Saudis as well.

CRCC hopes to buck a trend: Few Chinese companies have ever won payment disputes linked to projects outside China, the lawyer said, noting that international project claims can be extremely complicated. But in this case, much more than a Mecca railway is at stake.

“If the project were terminated or not completed on time, the whole Middle East and Arabian market might feel that CRCC, or even all Chinese companies, lack the strength and expertise to complete such projects,” the executive said. “That would affect market development efforts of CRCC and Chinese companies overall in the Middle East.

“Despite our losses in the Saudi Arabian light-rail project, we will not abandon future cooperation with the Saudi Arabian government. All the more, we will not slow down our globalization strategy, ” said the CRCC executive.

“We are quite confident about prospects for the claim.”

By staff reporter Zhang Boling