Understanding China’s Role in Sri Lanka’s Debt Restructuring Efforts

China has never been Sri Lanka’s biggest lender. However, as Sri Lanka has fallen into economic trouble, particularly in the wake of COVID-19, blame has fallen on china. However, Sri Lankan officials have repeatedly expressed the opinion that China is not the source of the country’s economic problems. So what is the real story?

China has undoubtedly figured more in the Sri Lankan economy in recent years. In the early 1970s, Sri Lanka borrowed around 4 per cent of its loans from China and borrowed more from the UK, Japan and Germany, around 17 per cent, 8 per cent and 6 per cent respectively. At the time, Sri Lanka also borrowed more from the IMF and the World Bank: they represented around 25% and 9%, respectively, of the island country’s external debt.

Fast forward to 2020 and that profile had changed a bit. Japan and the World Bank remained major lenders at 7 per cent each, but the IMF’s share had shrunk to just 4 per cent, as had the UK and Germany, which then accounted for about 1 per cent of Sri Lankan debt. They had been replaced by commercial lenders (“bondholders”) at 29 percent and China at 14 percent.

How did this change come about and what does it suggest about China’s role in Sri Lanka’s current debt problems?

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Sri Lanka, which defaulted on its sovereign debt in May, the first Asia-Pacific country to do so in more than two decades, has not faced an easy economic ride since the 1970s, despite at times it is considered an exciting and growing market. .

Between 1983 and 2009 Sri Lanka went through a civil war, whose roots go back to the colonial era when the country was known as Ceylon. During the civil war period, Sri Lanka’s debt levels in absolute terms increased steadily, especially from the World Bank and Japan, and the country’s debt-to-GDP ratio swung up and down depending on growth shocks from the war. However, economic growth was quite positive and poverty rates fell from 26.1 percent in 1990-91 to 15.2 percent in 2006-07. The country was on track to meet the Millennium Development Goal target of halving poverty nationally by 2015.

Given steady growth, although Sri Lanka was deemed a “serious concern” in 2005 under the World Bank and IMF’s new debt sustainability framework and ruled in 2006 that it was technically eligible for debt relief through the Heavily Indebted Poor Countries (HPIC) Initiative, along with Bhutan, Laos, Kyrgyzstan and Nepal, Colombo opted out of the relief. Sri Lanka also did not seek debt relief from China. Furthermore, as internal tensions eased, the government began to take steps to try to further improve Sri Lanka’s economic situation by increasing debt and stimulating growth. This is where a new shift began that explains some of the current dynamics.

From 2007 onwards, with the growth of the agricultural, industrial and tourism sectors, Sri Lanka presented itself as a new and exciting destination for global investment and began to borrow more than ever, in a rational attempt to turn growth into a increased productivity through investment. in infrastructure projects that previously seemed impossible. For example, in 2007, prior to the Belt and Road Initiative (BRI), the Sri Lankan government announced the idea of ​​building a port in hambantota near the Indian Ocean shipping lane that accounts for more than 75 percent of world seaborne trade. Anticipating a growing middle class in Africa and India and a growing demand for Chinese goods, Sri Lanka wanted to hook up some of the cargo that would otherwise pass through Singapore, the world’s busiest transshipment port. China Harbor Group finally built the port in 2010; it was financed through a 15-year loan of $307 million with a four-year grace period and a fixed interest rate of 6.3 percent from China Eximbank. There are other similar examples of loans from China.

Along with this vision, global conditions for private sector borrowing improved. Following the 2008 global financial crisis, interest rates were lowered and, with a “moderate” debt label from multilaterals, Sri Lanka sought international sovereign bonds to continue financing spending. Local consumption increased, although international trade was not necessarily increasing. Thus, despite growth and poverty reduction, Sri Lanka began to become what is known as a twin deficit economy – an economy that imported more than it exported and spent more than it generated.

This could have been a good strategy were it not for external shocks. In 2016 and 2017, Sri Lanka experienced a sharp decline in growth, which fell to the lowest level since 2001 due to repeated floods and droughts. Then a series of bombings on Easter Sunday 2019 cut off tourism. In an attempt to stimulate economic activity, and as promised in the presidential campaign, the government implemented some drastic tax cuts in all sectors of the economy at the end of 2019. This cost the government close to 800 billion rupees ($2.2 billion). However, before the tax cuts could begin to stimulate the economy, COVID-19 hit, devastating the tourism sector, a major source of revenue. COVID-19 also required increased spending and imports of health and other products, exacerbating the trade deficit.

Foreign exchange reserves fell by 70 percent, which means fewer dollars to buy essential but increasingly expensive imports, including fuel and basic goods. To resolve this, the government encouraged local spending, for example on locally sourced fertilizers rather than importing non-organic fertilizers, which were also having adverse effects. environmental and health effects – and printed money, as many richer countries did. However, all these movements had the effect of increasing inflation, which reached 60 percent by June 2022, while farmers ran out of fertilizer, seeds and pesticides to grow their produce.

Given all this, a key question is whether fewer loans from China, or any other lender, would have made much of a difference to Sri Lanka. The answer is unclear, but seems unlikely, given China’s rather limited role in Sri Lanka’s overall debt levels. Furthermore, the fact is that countries like Sri Lanka need more financing, not less, to build infrastructure to develop diversified, efficient and growing economies, and to escape the kind of traps the country has found itself in.

Looking ahead, what role, if any, can China or other lenders now play?

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Classified as a middle-income country, Sri Lanka is not eligible for the G20 Debt Service Suspension Initiative or its Common Framework, of which China is a part. The Sri Lankan government has explored an IMF bailout, but the IMF has said it cannot help until there are “adequate financial guarantees from Sri Lanka’s creditors that debt sustainability will be restored”. This is language similar to what the IMF has used with respect to Zambia (which is eligible for the Common Framework). As a veiled reference to China, IMF language suggests that if China shows a willingness to restructure Sri Lanka’s existing debt to other creditors, the IMF could provide a bailout.

That said, an IMF bailout will come with its own challenges. The IMF has already indicated that it will promote austerity in Sri Lanka, cutting spending and raising taxes. Sri Lanka did not seek debt relief in the 1990s or early 2000s for a reason. Furthermore, an IMF bailout will not reduce the debt service of Sri Lanka’s largest lenders, the bondholders.

But Sri Lanka can still use its relationship with China in a way that helps more directly address the crisis.

The first step is for Sri Lanka to formally request meetings with China to discuss payment reductions, beyond DSSI. All dollars or renminbi saved will count. The second step is to meet with other similarly situated borrowers, such as Zambia and Ghana, to strategize on how to manage both China and other lenders, including multilaterals and the private sector. Ultimately, a reform of the international financial architecture is needed to ensure that borrowers, such as Sri Lanka, can weather external shocks while spending needed development finance.

Ultimately, it is key for Sri Lanka to work with China and other major economies to explore how to revive growth, while learning from past mistakes and avoiding a two-way economy. China, as a large global exporter and importer, can be a partner in that, but it will take work and a new emphasis on the relationship.

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