Can Sri Lanka pivot away from its deep economic and political crisis? A decade of fiscal mismanagement has led to diminishing foreign exchange reserves and government debt that jumped from 91 percent to 119 percent of gross domestic product in just three years. The coronavirus pandemic cut tourism revenue and remittances from Sri Lanka’s diaspora — while rising global fuel and food prices only made things worse. Inflation reached a record high of 60.8 percent in July, making it hard for Sri Lanka to pay for imports.
The result has been widespread protests and a government decision in April to suspend payment on sovereign bonds — an important way in which governments borrow money. Sri Lanka owed $6 billion in external debt service (interest) payments for the remainder of 2022, but it had only $1.9 billion in foreign currency reserves. This was the first default in the country’s history.
In the past, Sri Lanka looked to the Chinese government to help address its debt burden. Can it do this again?
When things got tough, Sri Lanka turned to China
Past Chinese assistance has allowed Sri Lanka to service its debts and bolster its reserves of foreign currency. In 2017, the Sri Lankan government granted China Merchants Port Holdings a 99-year lease for the Hambantota International Port in then-President Gotabaya Rajapaksa’s home district, in exchange for money used to repay short-term government debt and shore up reserves. In 2020, Sri Lanka received a $3 billion loan from China to help pay off existing debts. In January, the president once again appealed to China for help restructuring its debts to Chinese entities.
Now, Sri Lanka has a new president, Ranil Wickremesinghe, tapped by Parliament in July to take over after his predecessor, the increasingly unpopular Rajapaksa, fled the country. Wickremesinghe has continued to rely on China — but has also enlisted the help of the International Monetary Fund (IMF).
On Sept. 1, Sri Lanka reached a tentative deal with the IMF staff mission. Once approved by IMF leadership, the deal should provide a $3 billion loan, conditional on changes in economic policies.
Unlike the IMF, China doesn’t demand economic policy changes
China now plays an increasing role as a global creditor. Beijing has become embroiled in current and brewing debt crises in countries such as Ethiopia, Ghana and Zambia. China’s Belt and Road Initiative, launched in 2013, offered significant loans to developing countries’ governments to finance infrastructure projects. The China Development Bank and the Export-Import Bank of China — China’s “policy banks,” funded by Chinese government resources and with staff accountable to Chinese government officials — issued many of these loans.
Many debtor countries preferred China’s approach, which didn’t demand policy changes or austerity measures as the World Bank and IMF do, although Chinese loans often involved higher financing costs, and sometimes allowed China greater control of strategic assets (what some people have called “debt-trap diplomacy”). And countries found it convenient that China could issue emergency loans far more quickly than institutions like the IMF, because Beijing didn’t insist on negotiating cuts to government spending or other types of economic belt-tightening with recipient governments.
When countries found it difficult to repay these loans, China sometimes was willing to restructure debtors’ obligations. Last month, for instance, China announced that it would forgive 23 interest-free loans to 17 African nations. Chinese officials had previously restructured approximately $15 billion of debt in Africa between 2000 and 2019.
So why worry about Chinese loans?
China isn’t Sri Lanka’s biggest creditor. The largest share (36 percent) of Sri Lanka’s external debt is to private-sector bondholders, many of them U.S.- and Europe-based institutional investors. China is only the fourth-largest creditor, after the Asian Development Bank and Japan.
But many commentators worry more about China because of geopolitics. They fear that China may turn debt into influence and power. Other countries have expressed concerns that China will use its debt, as well as the possibility for debt relief and currency swaps, to claim a strategic foothold in the region. China has kept its distance from the most important international multilateral arrangements for rescheduling debt, although it has begun working, 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 isn’t clear how Sri Lanka will resolve its debt crisis. Sri Lanka owes money to many kinds of creditors, complicating efforts to reach agreement among them. Although Japan offered recently to host talks among all Sri Lanka creditors, it’s unclear whether those talks will move forward — and whether China will participate.
Unless its various creditors agree to act quickly, Sri Lanka is in for a long economic crisis. The agreement with the IMF requires politically unpopular austerity measures in exchange for a loan. But without implementation of IMF-agreed changes, most creditors will be reluctant to move forward. That may tempt Sri Lanka to apply to China for assistance once more, in the hope that Beijing’s demands will be less onerous.
Still, China’s domestic politics may limit its freedom of maneuver. Chinese economic decision-makers disagree over whether they should participate in multilateral financial institutions and debt restructuring, and whether they should take losses on outstanding loans. China’s central bank and finance ministries have mostly supported debt relief efforts, but the policy banks want to avoid writing down debts and taking losses.
And, after years of Belt and Road Initiative expansion — and in light of the recent downturns in the domestic economic outlook — the Chinese public may be getting tired of its leaders granting debt relief unilaterally.
Layna Mosley (@LaynaMosley) is professor of politics and international affairs in the School of Public and International Affairs, and the Department of Politics, at Princeton University. Her current book project with B. Peter Rosendorff, “Game of Loans,” explores the domestic political economy of sovereign borrowing and restructuring.