DEBT-TRAP DILEMMA OF THE THIRD WORLD

Updated: Sep 18


China's debt trap diplomacy

Image Graphics by Team Geostrata


“There are two ways to conquer and enslave a nation, one is by the sword and the other is by debt” - John Adams


We often see some reports published by different governments across the globe covering their foreign debt - its nature, its composition, its ratio to their GDP, etc but what exactly is foreign debt or foreign lending? Foreign lending is money borrowed by a government or private corporation from another country’s government or private lenders.


Why exactly do governments need foreign loans?


Well, there can be a variety of reasons but the most common ones include local debt markets may not be deep enough to meet their borrowing needs, particularly in developing countries. Or foreign creditors may offer more lucrative terms. For low-income countries especially, borrowing from international organisations like the World Bank is an essential option, as it can provide the funding it might not otherwise be able to get, lucrative rates, and easier repayment schedules.


Institutions like the IMF, the World Bank, and the Asian Development Bank are among the most prominent creditors to governments across the globe. Interestingly, China is the single largest creditor in the world and it has contributed a humongous sum of $180B to low and middle-income economies.


Why do the Bretton-Woods institutions prove ineffective in the face of Chinese loans?


The IMF conditions its loans towards a calculated economic reform which would ultimately serve the economy of the borrower and help them lift to a significant position to pay back the loans without damaging the lives of their people.


On the contrary, China lends money for specific infrastructure projects to be completed by Chinese companies. Observers who believe that IMF’s prescriptions for economic reforms provide the surest way toward prosperity and stability raise alarms over China’s unchecked involvement in these economies might doom their financials and push them into a vicious cycle of debt and default. Critics of the IMF cheer on China’s lending as a source of “policy space” for governments to choose their development strategies. Whatever may be the poles, everyone agrees with the original logic at play that Chinese loans act as an effective alternative for countries not willing to reform the IMF way.


In a working paper, James Sundquist makes two points that clarify the scope of Chinese competition with the IMF.


First, he emphasises that the simple depiction of China as always willing to provide a bailout exaggerates China’s willingness to lend. Financially, underbidding the IMF in dealings with governments that are not able to raise money on private capital markets is a self-harming proposition. China has always opposed the IMF’s practice of prescribing reforms to its clients, but providing the low-income countries with a financial exit option would require large sums of money.


Second, Sundquist argues that China will offer bailouts to contest with the IMF when the loanee country can provide some other form of repayment. The IMF has limitations in accepting repayment in any form other than hard currency, whereas the Chinese government has other interests. Broadly speaking, they can take the form of repayment in-kind with natural resource exports, or geopolitical favours. Thus, some countries, but not all, are presented with the opportunity to attract a Chinese bailout.

He finds that one percent of GDP loans from China decrease the absolute probability of a borrower turning to the IMF by six percentage points, which is both statistically and substantively significant.


Several case studies ground-truth the statistical analysis, finding that natural resources and diplomatic considerations explain much of China’s bailout behaviour. China’s repayment concerns generally dominate but can be waived in pursuit of geopolitical gain.


Are there any ‘debt traps’ paved down by the Chinese?


One example often cited by the critics of Chinese loans is that of Sri Lanka which years ago embarked on a new massive port project in Hambantota with Chinese investment. But the billion-dollar project supported by Chinese money and contractors soon found itself amidst controversy and struggled to prove viable, leaving Sri Lanka saddled in high debt which it was in no position to repay.


As Colombo’s debt swelled, it had to sell an 85% share of the Hambantota Port to state-owned China Merchants Port Holdings Company for $1.12B. By December 2017, the port was officially handed over on a 99-year lease.


UK-based think tank Chatham House has questioned if the narrative of “debt trap” strictly applies in the case of Hambantota ship port, given that the project was driven by local political motivation and that China never formally took over the port. The study also points out that a major share of Sri Lanka's debt was owed to non-Chinese creditors, and that there is not much evidence that China used its vantage point to secure tactical military advantage from the port.


In spite of that, there's not much doubt that China's economic involvement in Sri Lanka has been rising in the last decade, and there are concerns that this could be used to boost its political ambitions in the region. There are some parts of the world where Chinese lending has also been called controversial, with arrangements whose terms could favour China in getting a hold over important assets.


But there are no cases as analysed by AidData and some other researchers of state-owned Chinese lenders acquiring any form of major asset given a loan default. Now, this stirs the next big question, if Beijing is patiently waiting to gain the trust of its borrowers and overcome the narratives established by the West, or does it believe in soft power diplomacy driven by its upper hand leverage in the local and global geopolitical game of influence?


What leverage and immunity does China enjoy as a lender?


As a tool to gain considerable power worldwide, China uses financial debt. It is often noticed that for infrastructure projects in developing countries, China offers cheap loans which attract them. Almost every time these countries are unable to repay these loans providing Beijing with a chance to gain control over them.


Also, there is no cap on Chinese lending. China is not a member of the Paris Club and is not bound by the sustainable debt relief clauses which the other lenders follow. Joint research conducted by Peterson Institute for International Economics, Kiel Institute for World Economy, and the Centre for Development and AidData reported by International Forum for Rights And Security(IFFRAS) reported that China used legal contracts to gain a hidden advantage over borrowers with most of the clauses being strict and do not provide any rights to the borrower.


In this analysis, it's been found that almost all of the contracts contained classified clauses, meaning no details can be revealed by the countries to other creditors. This makes it highly unlikely for other lenders to calculate the position of the borrowers. Nor can they divulge the conditions of the agreement to their citizens, who have a justifiable right to know about these agreements. These hidden agreements are hidden from the common masses and they’re not able to hold their governments liable for their crisis.


Besides, almost all the contracts analysed have clauses saying that in case of a law or policy change, the lenders can terminate the contract and can ask for an immediate repayment thus providing no right to borrowers and providing the Chinese lenders an upper hand. Countries entering into these credit agreements are required to keep a special bank account as wished by the lender, implying that the revenues of the government will remain out of the borrower’s hands. This makes a collateral arrangement for getting control over the revenue accounts for debt repayments. This also includes termination of diplomatic relations in an event of default. Furthermore, these agreements contain a clause of stabilisation that shields the lenders from any political risks or any legislative or regulatory change in the borrower’s country.


With the introduction of such clauses, the Chinese limit the borrowers’ crisis management options. Overcoming repayment hurdles becomes almost impossible and the borrower gets engulfed in a vicious cycle of debt and default.


What can low and middle-income countries do to avert such an event of default?


First, Boost alternatives to borrowing.


Low-income countries face a public deficit problem even for the fulfilment of their basic expenditure needs. A recent ODI study reveals how significant tax increase and financial aid is needed by countries to meet their basic expenditure needs without falling short of funds by 2030.


Second, Manage borrowing and lending better.


Creditors could offer State Contingent Debt Instruments (SCDIs), where payments are paused when the borrower faces difficulty in loan repayment. They can use better clauses for easy and healthy loan restructuring for the borrower.


Third, Increase accountability to improve the behaviour of borrowers and lenders.


Transparency is an idea that is only followed up to a limited extent by international programs. The public divulgence of lending contracts could allow parliaments, media reporters, and civil society organisations to openly analyse them, and could also allow other creditors to have all the knowledge before making any further loans.


Fourth, Introduce better ways of managing shocks and crises.


Low-income countries are at risk of crises caused externally for various reasons. A high proportion of their debt is in foreign currency and their economies are small and vulnerable to changes in the prices of commodities or global financial markets, including the availability and cost of borrowing.


However, there is a limit to which countries can insulate themselves from a shock, which is why the role of international creditors remains important. The evidence shows that restructuring is a common feature of sovereign debt markets keeping that in mind, the focus should be on how unsustainable debt can be restructured better.



THE BELT AND ROAD INITIATIVE -


The Belt and Road Initiative (BRI), formerly known as One Belt One Road is a global infrastructure development strategy adopted by the Chinese government in 2013 to invest in nearly 150 countries.


But why was BRI introduced and why is it considered the centrepiece of China's foreign policy?


Around 2010, China started to experience a problem. After so much infrastructure growth and development that started under the rule of Deng Xiaoping in the 1980s, China was running out of infrastructures to build. The growth and development weren't giving many returns. By 2012, the profit rate of new domestic infrastructure fell below zero.


The entire economy of China and the CCP's political agenda depends on construction jobs, excess foreign exchange, and the manufacturing industry. To feed its massive infrastructure industry, new fields of opportunity were needed.


Thus came BRI, a gigantic plan for a global network of ports, roads, railways, and other infrastructures to connect China to the world. This would achieve 4 broad objectives:

  1. Feed the infrastructure industry of China

  2. Make the Chinese banks more relevant in the foreign markets

  3. Ease in exports as China would be connected to the world

  4. To confirm to the world China's role as a global power.

The BRI weaves together lots of projects. It could be China building things from scratch, upgrading existing infrastructure, handing out loans, or making investments. There are existing land routes that connect China to Central Asia, the Middle East, and Europe. That's the belt.


One of the first countries to join was India's neighbour Pakistan through the China-Pakistan Economic Corridor which includes $60 billion worth of infrastructure projects. It then includes the Maritime Silk Road or the "string of ports" that connect China to Africa, South East Asia, and Europe.


This includes major investments in ports in Sri Lanka, Djibouti, Dubai, Greece, Spain, and even as far as Peru.


What's interesting is the classified nature of BRI. There is currently no confirmed list of everything and everyone involved. It is estimated to include more than 2600 projects in more than 100 countries. It is believed that China's expenses could reach $ 1.3 trillion by 2027.


How is China getting approval from so many countries for BRI?


The answer is not very complicated.

  • For almost every country in the world, China's money is the right kind at the right time. Chinese investments are designed to be as scrupulous and economically viable as the recipient governments. Even Italy, a member of the G7, has agreed to enter the BRI.

  • One other major reason is corruption. When local politicians are careful and institutions are strong, Chinese investment is uniquely valuable. For example, Chinese shipping company Cosco turned Greece's Piraeus port into the Mediterranean's second largest port. Also, low-interest Chinese loans helped Angola boost its credit rating. But there is an ugly side too. The state-owned Chinese construction company was debarred by the World Bank for bribery and Chinese officials were involved in Malaysia's Development Berhad Scandal.


Interestingly in the case of Hambantota Port of Sri Lanka, the town nearby is the hometown of President Rajpakshe who signed off on the project despite a large rock blocking the harbour making it entirely unusable. Corruption or Coincidence?

There have been allegations that $7.6 million of project funds were diverted to his failed reelection campaign. And as we know, China took the majority ownership of the port.


Observers have seen the same early warning signs play out across the globe in places like Tajikistan, Djibouti, Ethiopia, Kyrgyzstan, Nigeria, and Angola. The consequence of not being able to pay off the loan can depend on whether the country has a strategic location or valuable natural resources or simply put the ability to back China on an international stage.


This is observed by critics as debt-trap diplomacy resulting in neocolonialism and economic imperialism. For example - Djibouti is facing "debt distress". Its debt to China amounts to 70% of its GDP. It allowed China to establish a military base there in 2015 overseeing an 18-mile choke point between the Red Sea and the Indian Ocean.


Ways ahead:

  • Most countries are not currently falling into the debt trap. But, given the huge investment, China gains something valuable though intangible and that is diplomatic recognition and silence in places like the South China Sea, Xinjiang, and Tibet. This is a major problem. One way around it for countries like India and the US is to increase cooperation with these countries. For example - China is building huge infrastructure in Senegal, Croatia, the Serbia-Montenegro expressway, etc. Although the EU has pledged $300 billion to counter China by having a giant investment plan of its own, it is still not enough. The US-led G7's plan B3W(Build Back Better World) which wants to bring the private sector to invest funds is thin on details like budget and timetable. India's options could be to cooperate with the EU and G7 in their plans and increase diplomatic channels with countries in Africa and Central Asia.

  • As Chinese companies start projects, they introduce a significant number of Chinese workers in countries like Pakistan and Tajikistan. This leads to an increase in the Chinese diaspora and the mixing of cultures which enables China to start soft power diplomacy. Not much can be done about this by the countries opposing China. But giving these countries lucrative incentives like free trade agreements, sharing of technologies, and increasing cooperation in various fields could be some of the ways to counter China.

  • Loans from institutions like the World Bank need severe reforms in the financial and political structure of the countries which feel hostile to these countries. It's imperative now that the US and Europe reform the structure of these institutions and involve a touch of diplomacy in the negotiations with low-income countries so that these countries see these funds as long-term investments that would give returns, instead of loans, which could be seen as liabilities.

  • There is also the problem of a lack of consensus against Chinese investment. Unfortunately for many of the BRI members, it becomes a political situation where influential people are putting projects where it best suits them politically, hence the low return on the investments, which leads to massive debt accumulation. The USA, India, the UK, France, and Germany have opposed China's investments. But many influential countries in the EU( like Italy), Asia (like Russia), South America (like Argentina), and Southeast Asia have signed up for the BRI. This has led to the problem of developing consensus among the nations that could feel the impact of the Chinese upper hand directly or indirectly. This issue needs to be addressed.


Nevertheless, on one end we can speculate on all that is in the future but on the other end we cannot falsify the infrastructure opportunities that the Chinese are providing to poor nations who cannot afford it themselves. However, it surely is the collective responsibility of the financial institutions and the borrowing governments to keep a check on the depth of Chinese involvement in their ecosystem.




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BY DIGVIJAY AND SHUBHAM

TEAM GEOSTRATA

thegeostrata@gmail.com


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