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Patrick Mendis and Joey Wang say Sri Lanka’s debt trap should serve as a warning on Chinese largesse, amid doubts over efficient resource allocation by China’s banks and concerns that borrowing nations may be committing to a Faustian deal

Belt and road, or a Chinese dream for the return of tributary states? Sri Lanka offers a cautionary tale

Patrick Mendis and Joey Wang say Sri Lanka’s debt trap should serve as a warning on Chinese largesse, amid doubts over efficient resource allocation by China’s banks and concerns that borrowing nations may be committing to a Faustian deal

On the face of it, China does ­appear to be the lender of choice over multilateral institutions, for not interfering in the domestic ­affairs of recipient countries. But there are, in fact, many unwritten but ­implied strings attached. And the consequences can be costly. Illustration: Craig Stephens
With the 19th Communist Party Congress concluded, President Xi Jinping’s “Thought on Socialism with Chinese Characteristics for a New Era” is now ­ enshrined as the North Star for government action. His thought, ­incorporated into the constitution, is the continued development of the “Belt and Road Initiative” as part of the “ Chinese dream”.
The initiative, first unveiled by Xi in 2013 as a “One Belt, One Road” strategy, is expected to relieve China of the “Malacca dilemma”, what then president Hu Jintao in 2003 called China’s overreliance on the Malacca Strait for trade.

Touted as a modern-day Silk Road, the belt and road network would link China with Central Asia, South and Southeast Asia, Africa and Western Europe, through ports, roads, airports, pipelines and other infrastructure involving “65 countries, 29 per cent of global GDP, and 60 per cent of the world’s population”, as the Paulson Institute put in.

The goal, China says, is to promote efficiency in resource allocation and the “deep integration of markets”, raise standards of regional cooperation, and achieve “open, inclusive and balanced regional economic cooperation”.

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The enormity of the undertaking, of course, gives rise to questions. While many countries along the belt and road are in desperate need of large-scale infrastructure investment, it is also true that there are a myriad other reasons for China to find these investments worth the attendant risks.

One reason is to diversify, and get better returns on China’s foreign ­exchange reserves, with infrastructure investments generating higher profit. Another is to provide relief for domestic overcapacity and zombie state-owned enterprises, particularly in the metals sector, as well as construction and materials.

But it is as much a matter of self-interest – part of China’s overall strategy of peripheral diplomacy – as it is about regional stability and development. As such, some argue that since these projects are motivated more by political factors than real economic rationale, there is a significant risk that they will fail to ­deliver the expected returns. Those concerns are not without merit.

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Ratings agency Fitch, for one, is sceptical: “Chinese banks do not have a track record of allocating ­resources efficiently at home, especially in relation to infrastructure projects.” As such, they are unlikely to have more success overseas. Meanwhile, local politicians, their families, and corrupt officials have an incentive to push white elephant projects, subordinating business logic to political and family agendas, and increasing the risks of ­unprofitable projects.

Fitch also estimates that the countries to which about US$900 billion in credit has been extended all run a high risk of default.

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Adding to the risks in these projects is the issue of soft budget constraints, a feature especially of socialist systems. The China Development Bank and the Export-Import Bank of China, for example, lend largely on political considerations and lack clear-cut debt sustainability limits. As Xu Chenggang at the Cheung Kong Graduate School of Business in Beijing argues: “Instead of solving the overcapacity problems, they are expanding the problem to projects overseas.”
These projects are fraught with financial risks, and Sri Lanka is the prime example. During the nine years of president Mahinda Rajapaksa’s rule, the country began slipping away from traditional funding institutions – such as the Asian ­Development Bank (ADB), International Monetary Fund and World Bank – and edging towards China, which became its leading investor and lender, and second-largest trading partner.

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President Maithripala Sirisena, who unexpectedly defeated Rajapaksa in 2015, had campaigned on the promise to extricate Sri Lanka from China’s onerous debt terms. But, by then, the die had been cast. Exacerbating the issue was the fact that, having risen to middle-income status, Sri Lanka no longer qualified for concessionary loans and had to obtain commercial credit – where terms are guided by the markets.

After suspending projects like the Colombo Port City, the Sirisena-Wickremesinghe coalition government tried to renegotiate the terms of servicing its debt, but was told ­unequivocally that the debt would not be written off. “But if you can’t pay,” the Chinese told Prime Minister Ranil Wickremesinghe, “we are ready to swap debt for equity.”

The Sri Lankan minister for ports and shipping, Mahinda Samarasinghe (left), and Hu Jianhua, executive vice-president of China Merchants Group, exchange gifts as Chinese ambassador Yi Xianliang (far right) looks on, during the signing ceremony of the Hambantota Port concession agreement, in Colombo last July 29. Photo: EPA
Unable to repay mounting debts (more than 95 per cent of government revenue goes towards servicing debt), and already near default, Sri Lanka was forced to enter into a debt-equity swap, in which China would pay US$1.12 billion for a 99-year lease agreement giving it a 70 per cent stake in the Hambantota Port and the control of a strategic land parcel in Colombo Port City.

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The far-reaching strategic implications are now clear, and certainly have not been lost on protesters and critics who claim that Sri Lanka’s sovereignty has essentially been handed over to China. It’s no surprise that some ­observers call the belt and road “one road, one trap”, as if to subtly transform Xi’s “Chinese dream” into a kind of Middle Kingdom tributary system.
It’s no surprise that some ­observers call the belt and road ‘one road, one trap’

Many nations in the region are somewhere on the slope of a similar debt trap. The China-Pakistan Economic Corridor (CPEC), Malaysia’s Forest City, Cambodia’s Sambor Dam and other projects, as well as countries like Bangladesh, Nepal, Indonesia and the Maldives, along with Ethiopia, Kenya and Venezuela, are all vulnerable to significant economic, political and environmental risks when they too readily accept Chinese money.

Recently, Pakistan pulled the plug on the Diamer-Bhasha dam, a major CPEC project under the belt and road, with Pakistan’s Water and Power Development Authority chairman labelling Chinese conditions for financing the dam “not [feasible] and against our interests”.
In a similar blow, Nepal recently scrapped its US$2.5 billion Budhi Gandaki ­hydropower plant with the China Gezhouba Group, citing ­“irregularities” in the bidding process. The plant had also been identified as a belt and road component.

These moves suggest some of these countries are waking up to the fact that what appears to be Chinese largesse must be subjected to much greater scrutiny, lest they commit themselves to a Faustian deal.

President Xi Jinping leads the way, as belt and road leaders including Russian President Vladimir Putin (centre right) arrive for a group photo during the Belt and Road Forum, in Beijing last May 15. The summit positioned Beijing as a champion of globalisation, as some countries raised concerns over China’s trade ambitions. Photo: AFP

Is an all-powerful Xi Jinping and an emboldened China good for Southeast Asia?

On the face of it, China does ­appear to be the lender of choice over multilateral institutions such as the IMF, World Bank or ADB – for not interfering in the domestic ­affairs of recipient countries, and a no-strings-attached approach. But there are, in fact, many unwritten but ­implied strings attached. And, as Sri Lanka has learnt, the consequences can be costly.

A Chinese flag flies over Sri Lanka as China extends its reach into India’s backyard

However, China views the situation quite differently. Liu Xiaoxu of the China Academy of Social Sciences writes, “China has no strategic illusion about Sri Lanka, which is too close to India geographically to resist any influence from its powerful northern neighbour, neither is there any deliberate or insidious plan to trick Sri Lanka into a debt trap. Nor is it economically naive to squander money building the largest swimming pool in a tiny island which is thousands of miles away.”

This clearly reveals the working of invisible hands by a very visible statecraft with a mission to create a “pacific” new world order mirroring the old tributary system.

Patrick Mendis, an associate-in-research at the Fairbank Centre for Chinese Studies, Harvard University, is the author of Peaceful War: How the Chinese Dream and the American Destiny Create a Pacific New World Order. Joey Wang is a defence analyst. Both are alumni of the Kennedy School of Government at Harvard

This article appeared in the South China Morning Post print edition as: Borrower beware