Belt and Road

Rajapaksa raj ends

Chinese loans crucial as Sri Lanka melts down


Protests in Colombo

Sri Lanka is home to one of the world’s highest concentrations of leopards. However, the country’s people seemed to overlook the old maxim about the big cats not being able to change their spots when they voted the Rajapaksa family back into power in 2019.

At least that’s how critics of the deposed family see the situation. The administrations of Mahinda Rajapaksa, who governed from 2005 to 2015, followed by his brother Gotabaya between 2019 and 2022 (alongside assorted family members) have each ended in a crisis, one more devastating than the other.

Some trace the roots of Sri Lanka’s economic problems back to Mahinda Rajapaksa’s Chinese-funded infrastructure projects, which triggered a balance of payments crisis in 2015. Firstly, there were allegations of corruption (investigators for the coalition government that followed traced $2 billion in funds to one Dubai bank account and claimed to have information on a further $8 billion that had been secreted offshore).

Then there were issues relating to the repayment terms for financing of projects in the Rajapaksas’ hometown, which weren’t economically viable. These carried interest rates around the 5% to 6% mark, compared to the 1% to 2% levels that Sri Lanka was paying on concessional loans to lenders such as the Asian Development Bank (ADB).

This time round, the government’s economic mismanagement has precipitated the world’s second sovereign debt default of the 21st century after Zambia in 2020. It also appears to have finally brought the Rajapaksa era to a close. Last weekend, protesters stormed the presidential palace, prompting the president and prime minister to finally stand down, paving the way for a national unity government.

Sri Lanka is now embarking on a debt restructuring of its roughly $51 billion in foreign borrowings. China is one of its biggest creditors, behind the ADB on $13 billion and on a par with Japan’s $10 billion in loans.

However, any suggestion that Beijing sucked Sri Lanka into a debt trap through its Belt and Road Initiative (BRI) is provoking fury in the Chinese press. China isn’t Sri Lanka’s largest creditor, but its largest foreign direct investor, says the Global Times, noting in a recent editorial that China had signed more than 200 BRI contracts with 150 countries to develop “productive aspects of the economy such as modernising the infrastructure”.

Instead the newspaper attributes Sri Lanka’s woes to commercial creditors and multilateral lenders from Western countries, accusing them of selling Sri Lanka’s debt to vulture funds, which have no interest in the country’s wellbeing, only the returns they will make.

It’s certainly true that almost half of Sri Lanka’s external debt was raised in the international bond markets on commercial rates. S&P Global Financial Markets Intelligence data shows that $15.8 billion in principal repayments on these debts also falls due from 2022 to 2025. Interest on these borrowings is eating up the government’s revenues too. Asia Securities economist Lakshini Fernando calculates that the government raised $1.48 billion in taxes during the first four months of this year but had to spend $1.18 billion simply to cover interest payments.

The crunch point came when the central bank ran out of foreign exchange reserves to service the debt. In recent years, it hasn’t been able to build up reserves equating to more than six months of imports. And by April, the central bank was down to its last $50 million. Since then, the economy has ground to an almost complete halt and the government has lacked the foreign currency to pay for fuel, food and medicine imports.

One of Sri Lanka’s most respected former central bank governors, Dr Indrajit Coomaraswamy, penned an article encapsulating its predicament. He said that as Sri Lanka moved from low income to middle- income status, it transitioned from multilateral lending to international bond market funding. However, he also noted that when that happens, countries become subject to the strictures of rating agencies and bond investors. “If you act outside of their disciplinary framework, for them it signals non-prudence and they penalise you,” he warned.

And non-prudence has been a particular feature, as far as the financial markets are concerned, since Gotababaya and Mahinda Rajapaksa entered office respectively as President and Prime Minister in 2019. They abandoned an IMF programme that had been in place since the balance of payments crisis in 2015. They also sought to cement their populist credentials by slashing VAT from 15% to 8%. However, this shrank government revenues from an already low 14.4% of GDP in 2018 to just 9.8% as of 2022.

The pair were further criticised for risking agricultural yields in a dramatic policy push for organic farming rather than phasing in the new techniques more gradually. These self-inflicted wounds, combined with a collapse in tourism revenues because of Covid-19, as well as soaring energy prices thanks to the ongoing war in Ukraine, left the government with no room for maneouvre.

The normal response would be to call the IMF in. Sri Lanka has already done that 16 times since independence. However, the Rajapaksas weren’t keen on the governance conditions that always come with IMF involvement. Instead, they tried to tough it out by relying on bilateral aid from the two countries that have been vying for greater influence in their country: China and India.

So far, India has stepped up with $4.5 billion in financial support, according to Dr Coomaraswamy’s calculations (including $500 million for fuel imports and $1 billion for other essentials). He thinks another $1.5 billion in assistance will be forthcoming and the Indian press has been trumpeting its government’s help. “India’s massive and material assistance to Sri Lanka stands in stark contrast to the perception that Chinese debt contributed to the crippling mess in the island nation,” crowed The Times of India.

Social media contributors wonder if the celebrations are premature, however. “The concept of owing and being thankful doesn’t work in international politics,” the most- liked comment to the Times of India article warned. “You have to remember that all our neighbours are envious of our size and strength.”

Further financial support from the Chinese during the worst of the crisis has not been as forthcoming as many expected, not least by the Rajapaksas themselves. The main assistance to date has been Rmb500 million ($73 million) for humanitarian aid. Gotabaya Rajapaksa told Bloomberg that Beijing appeared to have shifted its strategic focus towards Southeast Asia and Africa after it refused to amend the terms of a $1.5 billion credit line, which required Sri Lanka to hold three months of import cover.

However, Dr Coomaraswamy believes that the Chinese held back because they don’t want the credit line reclassified as a loan, which would then see it included in the country’s imminent debt restructuring.

Beijing’s current BRI debt policy appears to be guided by a preference for loan extensions rather than forgiveness and for entering into bilateral negotiations rather than participating in the Common Framework – a 2020 G20-led debt relief plan for 70 struggling developing countries in danger of default. It is well aware that there are many largely African nations struggling to repay the roughly $150 billion it has lent to the continent since 2000 and which are now watching to see how much Sri Lankan and Zambian debt gets written off. China is already facing criticism from French officials co-chairing the creditors committee in Zambia, where China is owed about one third of the country’s $17 billion external debt. They told Reuters there was slow coordination among China’s public lenders and cited a lack of experience in debt restructurings.

As we reported in WiC475, most of China’s original BRI lending came from the country’s policy banks and commercial lenders with almost no multilateral experience. Back in 2018, Zou Jiayi, Vice Minister of Finance, hinted that this was one of the main reasons why some ‘white elephant’ projects had been funded and then failed. She added that, in future, policymakers in Beijing would do more to assess debt sustainability before loans were endorsed at government level.

The Sri Lankans have tried to play on the rivalry between Beijing and New Delhi to source capital on more preferential terms. The Chinese can’t have been happy when a renewable energy project that had been awarded to a company from China was cancelled earlier this year after India cited security concerns, for instance. It was then awarded to an Indian firm instead.

In a birthday letter to Gotabaya Rajapaksa this June, Chinese President Xi Jinping had offered no new financial aid. Instead he referenced the seventieth anniversary of the Sino-Ceylon Rubber-Rice Pact. This saw Sri Lanka receive rice from China during a period of strained domestic supply in return for exports of rubber to China, which needed to get round American sanctions stemming from the Korean War.

In the letter Xi also flagged how the pact had reflected a “spirit of independence, self-reliance, unity and mutual support”. But Sri Lanka’s new government will be hoping for a bit more of that support from the Chinese in the months ahead as it looks for ways of rescuing its ravaged economy.

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