The Dark Side of the Chinese Investments and Loans to Sri Lanka

Chinese investments were financed by Chinese state-owned banks at high interest rates and without transparency, leaving Sri Lanka heavily indebted to Beijing.

Commentary

China’s investments and loans to Sri Lanka have turned the island nation into a modern-day semi-colony, placing the future of its economy in the hands of Beijing’s state-owned contractors and bankers and the International Monetary Fund.

Sri Lanka’s close relations with China, which brought the country into this dire situation, began in 2007 when Beijing provided President Mahinda Rajapaksa with military and diplomatic assistance to fight the Tamil Tigers. Over time, the two countries has become closer thanks to high-profile Chinese investments in Sri Lanka’s construction projects, including the deep-sea Hambantota port project, the Colombo Port City complex, and the Mattala Rajapaksa International Airport (MRIA).

In theory, building infrastructure is something developing countries such as Sri Lanka need to do to develop a market economy, stimulate economic growth, and turn into a regional trade hub.

However, that isn’t how China’s infrastructure investments in the small island nation worked in practice.

Building these projects initially stimulated economic growth through the “multiplier effect.” Sri Lanka’s GDP growth jumped from low single digits in 2009 to 16.12 percent in 2012, but it has been mostly heading south for the rest of the decade.

There is a good explanation for this pattern. All three major infrastructure projects were pursued with political rather than economic criteria, serving Beijing’s interests in expanding its presence in the Indian Ocean and encircling India, rather than the interests of the local economy.

As a result, Chinese investments failed to have an accelerator effect that stimulated economic growth by building sustainable infrastructure projects.

Some projects aren’t economically viable, as they don’t serve a large enough market to justify the resources allocated to them, such as MRIA airport. As a result, they end up wasting the country’s precious resources.

Other projects are economically viable but built at excessively high costs by Chinese state construction firms instead of private contractors through transparent, competitive bidding.

In addition, Chinese investments turned into debt traps, as they were financed by loans from Chinese state-owned banks at high interest rates and without transparency, leaving Sri Lanka heavily indebted to Beijing.

Sri Lanka’s government debt stood at 103 percent of GDP in 2023, with a growing portion owed to China. In addition, Sri Lanka’s government budget deficits are running at 10.51 percent of its GDP, adding to its indebtedness.

The country’s growing debt came when Sri Lanka was already living beyond its means, as evidenced by persistent fiscal and current account deficits.

To cope with rising debt to China, Sri Lanka has signed agreements with China that swap loans for equity, transforming China into an owner of significant infrastructure projects like Sri Lanka’s principal port and a key outpost in the Indian Ocean for Beijing.

“In 2016, a Chinese state-owned company purchased the asset of the Hambantota port, generating concerns about sovereignty in Sri Lanka and Chinese naval ambitions in Delhi and Washington, DC,” write Meg Rithmire and Yihao Li in a Harvard Business School research paper. “This case explores the dynamics of China’s ambitious Belt and Road Initiative, a large-scale infrastructure and connectivity project launched under its powerful leader, Xi Jinping, as well as the politics and economics of sovereign borrowing in the age of Chinese lending.”

Still, these agreements weren’t enough to save the country from seeking debt relief from the International Monetary Fund (IMF).

In March 2023, the Washington-based institution—notorious for its stringent loan terms and conditions—cleared a $2.9 billion loan to ease its balance-of-payments crisis. This crisis made importing essential products like food, fuel, and medicine difficult, causing social unrest.

But the loan came with strings attached, like dictating the future course of the country’s economic policy.

“Maintaining macroeconomic stability and restoring debt sustainability are key to securing Sri Lanka’s prosperity and require persevering with responsible fiscal policy,” said the IMF in a transcript defining the terms and conditions of the loan. “Continued revenue mobilization efforts and spending restraint are needed to prepare the 2025 budget in line with program parameters.”

China’s investments are supposed to help Sri Lanka grow and develop. Instead, they have pushed the Sri Lankan economy into a perfect storm, putting it in a position no country wants to be in: counting on the IMF and China for its survival.

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