Is Sri Lanka a victim of Chinese debt trap?

It is undeniable that China has been Sri Lanka’s largest bilateral creditor stemming from the economic relationship, which goes back 70 years to the Rice-Rubber Pact signed between the two countries in 1952 as one of the first trade agreements between China and a non-Communist country after the 1949 Chinese revolution. 

Since 1952, China has offered bilateral assistance to Sri Lanka, including bilateral loans, particularly during the country's left-leaning governments. Between 2000 and 2020, close to $12 billion of Chinese loans flowed into Sri Lanka for major infrastructure projects, power plants, a port, and an international airport that turned into white elephants. 

In this context, Sri Lanka is frequently described as a nation that fell into a debt trap as a result of Chinese-financed public investment projects. One of these investments was the leasing of the Hambantota port to China Merchant Port Holdings Limited (CM Port) in 2017 for 99 years and $1.12 billion. This project is primarily to blame for Sri Lanka's reputation as a country that became entangled in Chinese debt and was compelled to give up assets that were crucial to its national and strategic interests to China.

According to reports, Sri Lanka was forced to hand over the port to China because it was unable to repay the debts it had originally taken out from that country to build Hambantota port.
In addition, serious doubts, in fact, existed whether the necessity of building a second international port in Sri Lanka, particularly one financed by borrowing at market rates, as well as whether or not such a port would be able to turn a profit. As it turned out, the Hambantota port was unable to pay back China when the loan payments were due. 

The actual motivation for Sri Lanka's decision to lease the port to China, however, goes much beyond the challenges of making loan payments on debt incurred to build the port. Unsettlingly, the Hambantota transfer suggests that Sri Lanka is currently experiencing a much worse economic crisis.

The economic reality is that Sri Lanka leased out Hambantota port to China primarily as a result of a lingering balance of payment (BOP) problem brought on by the decline in trade over the years, even as the expenses of servicing external debt rose sharply. Owing to the maturities of international sovereign debts and the impending debt servicing requirements, Sri Lanka was severely short on foreign reserves. As a result, the nation had to explore a number of options to bring in foreign currency. One strategy to boost the nation's foreign exchange reserves was to lease the Hambantota port.

Although the government leased the Hambantota port to CM Port, the loans taken out to build the port were not written off, and the government is still obligated to make the loan repayments in accordance with the original arrangements. In 2017 and 2018, the funds generated from leasing the Hambantota port were utilized to increase Sri Lanka's dollar reserves, especially in view of the enormous foreign debt servicing resulting from the maturity of global sovereign loans in early 2019.

On the other hand, according to media sources, the government intends to lease India access to Hambantota's Mattala Rajapaksa International Airport (MRIA), one of the world's most deserted airports. Both of these infrastructure projects were funded by Chinese financing and received harsh criticism for being unwise financial decisions.

It is true that over the past ten or so years, China has acquired a significantly larger share of Sri Lanka's foreign debt as a result of funding numerous infrastructure projects. Between 2008 and 2012, China accounted for over 60% of all foreign borrowing.

Having said that, Sri Lanka would have faced worries about the sustainability of its external debt and ongoing balance of payment (BOP) problems even in the absence of Chinese loans. Of course, there were substantial doubts raised about the viability and necessity of the Chinese-financed projects at the time they were launched. The decision to borrow from international capital markets at commercial rates at a time when Sri Lanka's exports were declining, even as the government repeatedly failed to address structural issues like the reduction of trade, rising protectionism, and decreased government revenue, was the bigger factor behind the country's debt crisis. With those fundamental problems, significant worries about debt management are unavoidable. Resolving the problem will require a consistent effort for reforms, which involves serious political challenges.

In this scenario, China will have to play a crucial role in Sri Lanka’s debt restructuring process, with US$ 7.4 billion or 19.6 percent of outstanding public debt owed to China at the end of 2021 (out of a total of US$ 37.6 billion in total public external debt excluding central bank debt), and it will be the first time a major Asian Belt and Road Initiative borrower is going through the process. Thus, Sri Lanka expects a lot from China as a long-lasting friend; however, it is highly unlikely that China would extend its helping hand to Sri Lanka.