Domestic Bonds

China is not Sri Lanka’s largest creditor

Can Sri Lanka emerge from its deep economic and political crisis? A decade of fiscal mismanagement has resulted in dwindling foreign exchange reserves and public debt that has fallen from 91% to 119% of gross domestic product in just three years. The coronavirus pandemic has reduced tourism income and remittances from the Sri Lankan diaspora – while rising global fuel and food prices have only made matters worse. Inflation hit a record high of 60.8% in July, making it difficult for Sri Lanka to pay for its imports.

The result was widespread protests and a decision by the government in April to suspend payment of sovereign bonds – an important way in which governments borrow money. Sri Lanka owed $6 billion in external debt service (interest) payments for the rest of 2022, but had only $1.9 billion in foreign exchange reserves. It was the first default in the country’s history.

In the past, Sri Lanka looked to the Chinese government for help in reducing its debt burden. Can he do it again?

When the going got tough, Sri Lanka turned to China

Past Chinese aid has enabled Sri Lanka to repay its debts and strengthen its foreign exchange reserves. In 2017, the Sri Lankan government granted China Merchants Port Holdings a 99-year lease for the international port of Hambantota in President Gotabaya Rajapaksa’s home district, in return for money being used to pay down short-term government debt and bolster reserves. In 2020, Sri Lanka received a $3 billion loan from China to help pay off existing debts. In January, the president again appealed to China to help him restructure its debts to Chinese entities.

Sri Lanka’s multiple crises have just reached their climax

Now Sri Lanka has a new president, Ranil Wickremesinghe, chosen by parliament in July to take over after his predecessor, the increasingly unpopular Rajapaksa, fled the country. Wickremesinghe continued to rely on China, but also asked for help from the International Monetary Fund (IMF).

On September 1, Sri Lanka reached an agreement in principle with the IMF staff mission. Once approved by IMF management, the deal is expected to provide a $3 billion loan, subject to changes in economic policies.

Unlike the IMF, China does not demand changes in economic policy

China is now playing an increasing role as a global creditor. Beijing has found itself embroiled in current and latent debt crises in countries like Ethiopia, Ghana and Zambia. China’s Belt and Road Initiative, launched in 2013, has offered large loans to governments in developing countries to finance infrastructure projects. The China Development Bank and the China Export-Import Bank – China’s “strategic banks”, funded by Chinese government resources and whose staff are accountable to Chinese government officials – have granted many of these loans.

Many debtor countries preferred China’s approach, which did not demand policy changes or austerity measures like the World Bank and IMF do, even though Chinese lending often involved higher financing costs. high and sometimes allowed China greater control over strategic assets (some have called it “debt-trap diplomacy”). And countries have found it convenient that China can issue emergency loans much faster than institutions like the IMF, because Beijing has not insisted on negotiating public spending cuts or other types of economic restrictions with recipient governments.

G-7 wants to mobilize new global funding as an alternative to China’s multilateral push

When countries had difficulty repaying these loans, China was sometimes willing to restructure debtors’ obligations. Last month, for example, China announced it would forgo 23 interest-free loans to 17 African countries. Chinese authorities previously restructured around $15 billion of debt in Africa between 2000 and 2019.

So why worry about Chinese loans?

China is not Sri Lanka’s biggest creditor. The largest share (36%) of Sri Lanka’s external debt accrues to private sector bondholders, many of whom are institutional investors based in the United States and Europe. China is only the fourth creditor, after the Asian Development Bank and Japan.

But many commentators worry more about China because of geopolitics. They fear that China is turning debt into influence and power. Other countries have expressed concern that China will use its debt, along with the possibility of debt relief and currency swaps, to claim a strategic position in the region. China has stayed away from the most important international multilateral agreements on debt rescheduling, although it has begun to work, through the Group of 20, of which China is a member, on rescheduling efforts for Zambia. Of course, other countries also use loans as well as aid for strategic reasons.

It is unclear how Sri Lanka will resolve its debt crisis. Sri Lanka owes money to many types of creditors, which complicates efforts to reach an agreement between them. Although Japan recently offered to host talks among all of Sri Lanka’s creditors, it’s unclear whether those talks will move forward – and whether China will participate.

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Unless its various creditors commit to acting quickly, Sri Lanka is heading into a long economic crisis. The IMF deal demands politically unpopular austerity measures in return for a loan. But without implementation of the IMF-agreed changes, most creditors will be reluctant to move forward. This could prompt Sri Lanka to seek help from China again, in the hope that Beijing’s demands will be less onerous.

Yet China’s domestic politics may limit its freedom to maneuver. Chinese economic policymakers disagree on whether to participate in multilateral financial institutions and debt restructuring, and whether to bear losses on outstanding loans. China’s central bank and finance ministries have mostly supported debt relief efforts, but political banks want to avoid writing debt and incurring losses.

And, after years of expansion of the Belt and Road Initiative – and in light of recent downturns in the national economic outlook – the Chinese public may be fed up with its leaders unilaterally granting debt relief.

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Layna Mosley (@LaynaMosley) is a professor of politics and international affairs in the School of Public and International Affairs and the Department of Politics at Princeton University. His current book project with B. Peter Rosendorff, “Game of Loans”, explores the domestic political economy of sovereign borrowing and restructuring.

B. Peter Rosendorff (@PeterRosendorff) is a professor of politics at New York University.