For months, Sri Lanka has been engulfed in an economic crisis resulting from the decline of its foreign exchange reserves. Ballooning inflation and a shortage of oil, gas, food and medical essentials brought people out to the streets in protest demanding the resignation of the Rajapaksa family.
In response, the cabinet resigned en masse and Prime Minister Mahinda Rajapaksa, the brother of President Gotabaya Rajapaksa, resigned. On 12 May, Ranil Wickremesinghe was sworn in as the new prime minister, forming a new all-party government.
Sri Lanka’s current economic plight has its origins in long-term macroeconomic instability and economic mismanagement by successive governments, which led to a balance of payments problem and a foreign exchange deficit problem.
Even though it opened up its economy in the early 1970s, Sri Lanka failed to make it an export-led economy. Successive government tax reduction and tax exemption policies since the early 1990s have led to a steady decline in government revenue collection. In 2021, Sri Lanka’s tax revenue was only 9.6% of the GDP, against its expenditure which was close to 20% of the GDP.
The situation was exacerbated by President Gotabaya Rajapaksa’s government’s misplaced policies, such as the overnight ban on fertilisers, as well as exogenous factors such as the global pandemic and the Russia-Ukraine war.
Among the various factors contributing to the economic crisis is unsustainable external debt. Sri Lanka’s public debt to GDP ratio rose from 91% to 119% between 2018 and 2021. As of the end of March 2022, its external debt service payments per year were at US$6 billion, whilst its foreign reserve was only US$1.9 billion.
Whilst negotiating an IMF bailout, on 12 April, Sri Lanka temporarily suspended its foreign debt payment as a preemptive measure. On 18 May, Sri Lanka missed the 30-day grace period of repayment, making a ‘preemptive default’ for the first time in history. In response, Fitch downgraded Sri Lanka to “restrictive default”.
As Sri Lanka’s economic crisis worsens, the debate on Chinese lending and its impact on small states has reignited, challenging Beijing’s global image.
Are loans from China a significant cause?
For years, international media and certain groups of analysts and observers have asserted that China has lured Sri Lanka into a debt trap by offering lucrative unconditional loans. As a result, China is often highlighted as the primary cause of Sri Lanka’s dwindling economy and rising debt.
Since the early 2000s, China’s engagement with Sri Lanka and its footprint in the Indian Ocean island state has significantly increased. From being a relatively low-profile partner who provided occasional humanitarian assistance and development support in 2004, China emerged among Sri Lanka’s largest bilateral donors and development partners within a couple of years. Its role as a main creditor in Sri Lanka’s post-war development through providing loans for road infrastructure, ports and airport building, and investments in the port industry and real estate have garnered widespread attention.
While Sri Lanka has borrowed significantly from China in the last few years via concessional loans, its debt problem has not been made in China.
Indian and Western strategic analysts and observers have been apprehensive about China’s increasing engagement in Sri Lanka, referring to it as being part of its “string of pearls” strategy in the Indian Ocean and its strategy of encircling India. China is suspected of wanting to build a military base in Sri Lanka by entrapping Colombo via massive unpayable loans and its ambitious Belt and Road Initiative (BRI) project. Such assumptions were further reiterated when Sri Lanka leased its strategically important Hambantota port to China on a debt-equity swap in 2017.
In recent years, there has been scholarly research produced discrediting the discourse on China’s debt trap diplomacy in Sri Lanka. While Sri Lanka has borrowed significantly from China in the last few years via concessional loans, its debt problem has not been made in China. A study conducted by London-based Chatham House emphasises that Sri Lanka’s loans from China in the BRI period only saw a modest rise from its pre-BRI period.
Beijing’s lukewarm response to Sri Lanka’s crisis has seemingly alerted small developing countries that have been borrowing from China...
Challenges for China
However, China’s relatively slow response to Sri Lanka’s economic crisis has kindled a debate on whether Beijing is truly a dependable friend to developing countries. In January, during the visit of Chinese Foreign Minister Wang Yi, President Gotabaya Rajapaksa extended a request for debt restructuring and concessional credit facility for imports of essentials, to which he received no immediate response.
Later China stated its interest in offering a new loan to settle the debt as opposed to the proposed debt restructuring proposed by Sri Lanka’s central government in responding to the existing crisis. While India has been active in offering credit lines and financial support for Sri Lanka as its economic crisis deepened, China was mulling over the credit line requests. Beijing’s lukewarm response to Sri Lanka’s crisis has seemingly alerted small developing countries that have been borrowing from China for their development activities.
For China, it must carefully strategise its response to Sri Lanka’s crisis. On the one hand, China would not want to set new precedents in its lending practice. Beijing is a significant creditor of a number of small and developing countries. Unilaterally granting a debt moratorium for Sri Lanka would set a precedent for having to do similar negotiations with other debtors. This has put China in a strategic dilemma.
In a context where both India and Japan agree on debt restructuring, which is the most likely scenario, China will be put in an awkward situation.
At the moment, Sri Lanka has identified its main way out of the crisis to be a financial bailout package from the IMF. For this, the international institution has already preconditioned Sri Lanka to seek debt moratorium from its creditors. China is among the main bilateral creditors, along with Japan and India. In a context where both India and Japan agree on debt restructuring, which is the most likely scenario, China will be put in an awkward situation.
In the meantime, it will pave the way for Beijing’s strategic rival, India, to further its influence and presence in Sri Lanka, displacing China. If this happens, China’s decades of efforts in building strategic positioning in the middle of the Indian Ocean region will dissipate in a short time.
...the impact that it will have on China’s global image will supersede the impact on bilateral relations.
On the other hand, China has to maintain its carefully built image as an unwavering friend to small developing nations. Beijing’s diplomatic and economic support for Colombo post-war established its image as a dependable partner who comes to the help of small countries at times of dire need. However, Beijing’s failure to accommodate Sri Lanka’s plea for debt restructuring and related mechanisms will paint a different picture.
As a global power, China would not want to be seen as a power that does not come forward and assist one of its biggest partners and fails to provide public goods in a crisis.
Additionally, Sri Lanka’s economic crisis settlement will also impact China’s investments. In recent years, China has invested in Sri Lanka in massive projects, including the Colombo Port City project. Only a stable economy and political stability would allow Beijing to reap the benefits of those investments in Colombo.
There is no argument on the impact of this economic crisis on the bilateral relations between Sri Lanka and China. However, the impact that it will have on China’s global image will supersede the impact on bilateral relations.
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