Is China responsible for Sri Lanka’s debt problems? – The Diplomat

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China has never been Sri Lanka’s biggest lender. Nonetheless, as Sri Lanka has fallen into economic difficulties, particularly as a result of COVID-19, the blame shifted to China. However, Sri Lankan officials have repeatedly expressed the view that China is not the source of the country’s economic difficulties. So what’s the real story?

China has certainly played a bigger role in the Sri Lankan economy in recent years. In the early 1970s, Sri Lanka borrowed around 4% of its loans from China and borrowed more from the UK, Japan and Germany, at around 17%, 8% and 6% respectively. At that time, Sri Lanka also borrowed more from the IMF and the World Bank – they accounted for around 25% and 9% of the island country’s external debt, respectively.

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 They had been replaced by commercial lenders (“bondholders”) at 29% and China at 14%.

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 journey since the 1970s, although it is at times seen as an exciting and growing market.

Between 1983 and 2009, Sri Lanka went through a civil war, whose roots date back to colonial times when the country was known as Ceylon. During the civil war period, Sri Lanka’s debt levels in absolute terms rose steadily, particularly from the World Bank and Japan, and the country’s debt-to-GDP ratio rose. and decreased according to the impacts of the war on growth. Nevertheless, economic growth has been quite positive and poverty rates have fallen from 26.1% in 1990-91 to 15.2% in 2006-07. The country is on track to achieve the Millennium Development Goal of halving national poverty by 2015.

Given the steady growth, although Sri Lanka was rated as a “serious concern” in 2005 under the World Bank and IMF’s new debt sustainability framework and in 2006 it was deemed technically eligible for debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative, along with Bhutan, Laos, Kyrgyzstan and Nepal, Colombo decided not to avail itself of the assistance. Similarly, Sri Lanka has not requested debt relief from China.. Furthermore, as domestic tensions subsided, 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 started that explains some of the current momentum.

From 2007, seeing growth in the agriculture, industry and tourism sectors, Sri Lanka presented itself as an exciting new destination for global investment and began to borrow more than ever, in a rational attempt to convert growth into increased productivity through investment. in infrastructure projects that previously seemed impossible. For example, in 2007, before the Belt and Road Initiative (BRI), the Sri Lankan government announced the idea of ​​building a Port of Hambantota close to the Indian Ocean Seaway which accounts for more than 75% of world maritime trade. Anticipating a growing middle class in Africa and India and growing demand for Chinese goods, Sri Lanka wanted to grab some of the cargo that would otherwise pass through Singapore, the world’s busiest transshipment port. China Harbor Group eventually built the port in 2010; it was financed by a loan of 307 million dollars over 15 years with a grace period of four years and a fixed interest rate of 6.3%, granted by China Eximbank. There are other examples of loans from China.

Along with this vision, global private sector borrowing conditions have improved. After the global financial crisis of 2008, interest rates fell and, with “moderate” debt from multilateral institutions, Sri Lanka sought to international sovereign bonds to fund further expenses. Local consumption has increased, although international trade has not necessarily increased. Therefore, despite growth and poverty reduction, Sri Lanka began to become what is known as a double deficit economy – an economy that imported more than it exported, and spent more than it produced.

It might have been a good strategy had there been no external shocks. In 2016 and 2017, Sri Lanka experienced a sharp decline in growth, which fell to its lowest level since 2001 due to repeated floods and droughts. Then a series of bombings on Easter Sunday in 2019 cut off tourism. In order to revive economic activity, and as promised during the presidential campaign, the government implemented drastic tax cuts in all sectors of the economy end of 2019. These cost the government almost 800 billion rupees ($2.2 billion). However, before tax cuts could begin to stimulate the economy, COVID-19 hit, ravaging the tourism sector, a major source of income. COVID-19 has also necessitated increased spending and increased imports of health and other products, worsening 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 commodities. To address this, the government encouraged local spending – for example, on locally sourced fertilizers rather than imports of inorganic fertilizers, which also had adverse effects. environmental and health effects – and printed money, as many wealthier countries have done. However, these movements all had the effect of increasing inflation – which reached 60 percent by June 2022 – when farmers ran out of fertilizers, seeds and pesticides to grow their produce.

Given all of this, a key question is whether fewer loans from China – or any other lender – would have made a big difference for Sri Lanka. The answer is unclear, but it seems unlikely, given China’s fairly limited role in Sri Lanka’s overall debt level. Furthermore, the fact is that countries like Sri Lanka need more – not less – finance to build infrastructure in order to develop diversified, efficient and growing economies, and to escape the kinds of pitfalls in which the country found itself.

Going forward, what role can China or other lenders play now, if any?

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Classified as a middle-income country, Sri Lanka is not eligible for the G-20 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 said it couldn’t help until there are “adequate financing assurances from Sri Lanka’s creditors that debt sustainability will be restored”. This is similar language to that which the IMF used regarding Zambia (which is eligible for the Common Framework). As a veiled reference to China, IMF language suggests that if China indicates its 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 set of challenges. The IMF has already indicated that it will encourage austerity in Sri Lanka – by 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 debt service to Sri Lanka’s biggest lenders, the bondholders.

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

The first step is for Sri Lanka to formally request meetings with China to discuss payment cuts, beyond the DSSI. Any dollars or renminbi saved will count. The second step is to meet with other borrowers in similar situations – such as Zambia and Ghana – to strategize on how to handle both China and other lenders, including multilaterals and industry. private. Ultimately, a reform of the international financial architecture is needed to ensure that borrowers such as Sri Lanka can withstand external shocks while continuing to spend the funds needed for development.

Finally, it is critical that Sri Lanka works with China and other major economies to explore how to revive growth, while learning from past mistakes and avoiding a two-track economy. China – as a major global exporter and importer – can be a partner in this, but it will take work and a new focus in the relationship.

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