Sri Lanka’s Debt Troubles Go Beyond China: Uncovering the Real Causes.

Sri Lanka’s 2022 sovereign debt crisis not only exposed the widespread development impacts and the heavy human costs that debt crises lead to, but also sheds light on the vulnerabilities that developing economies face in an evolving global lending landscape. Yet, more politically sensational topics such as China’s role in Sri Lanka’s debt dynamics, have come to the forefront in global discussions - pushing real issues to the backburner.  

Sri Lanka has often been linked to the narrative around China as a predatory bilateral lender that lends heavily towards infrastructure projects in strategically important locations through the Belt and Road Initiative (BRI). Critics argue that such projects, linked to China’s ‘’debt-trap diplomacy narrative’’ are in essence aimed at advancing geopolitical and strategic interests of China. Sri Lanka’s Hambantota port in particular (a Chinese funded port situated in Southern Sri Lanka), which was ultimately leased on a 99-year lease through a joint venture to its main Chinese investors to cover losses (albeit with the condition that it cannot be used for military purposes), is a prime example of Sri Lanka being portrayed as a victim of China’s debt-trap narrative. Sri Lanka’s 2022 economic crisis has once again renewed these debates around China’s debt-trap narrative, with some linking Sri Lanka’s debt troubles to China.

However, Sri Lanka’s debt troubles go beyond China and stem from a confluence of economic and political drivers of unsustainable debt within Sri Lanka, and shed light on the need for developing economies to handle the transition to commercial debt with care.

Analysing Sri Lanka’s borrowing structure: who should take the blame.

Sri Lanka’s 2022 economic crisis was not the first occasion on which the country’s debt-to-GDP (Gross Domestic Product) ratio exceeded 100%. In fact, one of the unique features that stand out in Sri Lanka’s 2022 debt crisis is the upshoot of commercial debt which started ticking-off steadily since the country’s graduation to low middle-income status. As a country graduates to a middle-income economy, concessionary (soft) loans provided by multilaterals to finance development needs begin to unwind.

Sri Lanka has a long history of using concessionary credit to bridge economic/development needs. Sri Lanka benefited from various concessionary credit lines since independence, and became to be known as a ‘’donor darling’’. Following Sri Lanka’s graduation to low-middle income status and consequent drying up of concessionary credit from multilateral agencies, Sri Lanka issued its first International Sovereign Bons (ISB) in 2007 and began actively accessing international capital markets as an alternative source of development financing. Additionally, the government at the time also started looking towards long-term bilateral loans (particularly form China) to finance politically appealing development projects - such as a seaport and an airport in the hometown and key political constituency of then President Mahinda Rajapaksa.  

A first look at Sri Lanka’s borrowing structure shows that bilateral loans from China, Sri Lanka’s largest bilateral creditor, accounted for only about 13% of Sri Lanka’s central Government external debt stock in 2022 (at default); compared to commercial debt which accounted for about 42% of central Government external debt during the same period. Meanwhile, majority of this commercial debt, i.e. as high as around 85%, consisted of debt tied to International Sovereign Bonds (ISBs) - typically obtained from international capital markets in the West.

Further, research shows that debt repayments to China accounted for only around 20% of Sri Lanka’s total debt servicing costs around the time of its default, while ISB repayments accounted for as high as around 50% of foreign debt repayments in 2021. Moreover. majority of Sri Lanka’s bilateral loans from China (i.e. 60%) are concessionary loans which have been granted at lower interest rates and longer repayment periods. These loans are less costly compared to commercial debt tied to ISBs which typically have higher interest rates and tighter repayment periods.

This sharp rise in commercial debt owes to a number of factors. Firstly, the lower interest rates in advanced economies following the 2007/8 Global Financial Crisis (GFC) led to increased availability of credit in advanced economies for emerging markets to capitalise on. Political appetites of successive governments in power in Sri Lanka (and elsewhere), made the turn to such readily available credit more and more appealing. The lack of conditionality and more financial freedom associated with commercial credit made it an attractive source of funds. These factors made commercial debt a preferred form of credit following the drying up of concessionary credit lines. These dynamics led to Sri Lanka’s debt profile transitioning from concessionary-led borrowing to heavily commercially-driven borrowing. Consequently, the share of commercial debt rose to 50% of total outstanding external debt by 2012 from 7% before the first issue of ISBs in 2006.  ISB borrowings typically obtained from international capital markets in the West continued to be the primary source of this commercial debt, compared to term-financing from China which accounted for only about 15% of commercial debt.  Thus, it is evident that commercial debt tied to ISBs mattered more in Sri Lanka’s debt crisis than bilateral debt from China.

However, the availability of commercial credit was not the only factor that mattered in Sri Lanka’s debt episode, but it was rather the inability to improve/manage repayment capacities of commercial debt when they fell due, that mattered more.  

The availability of credit made it easier for successive governments of Sri Lanka to bankroll debt, manage growing twin fiscal and current account deficits and continue to fund largely political projects and objectives - without bringing in difficult (and less politically appealing) reforms to address the country’s growing vulnerability to debt. Thus, the underlying critical need to improve the country’s debt repayment capacity (through increased export earnings/addressing the underlying anti-tradable bias in the economy and strengthening tax revenues) began to be pushed to the backburner, consequently weakening the repayment capacity of these costly commercial borrowings when they fell due; and thus, gradually increasing the country’s vulnerability to debt crisis. Further, unforeseen external shocks, such as pandemic induced economic difficulties, became far more difficult to manage given underlying debt repayment weaknesses and increased vulnerability to debt crisis.  Short-sighted and politically motivated policies such as large tax cuts following elections (particularly in 2019), further dampened tax revenue and debt repayment capacities.  Hence, Sri Lanka’s debt issues should not be mistaken for being created outside the of the country.

Key lessons learnt

These dynamics expose the complexities that developing economies face in an evolving lending architecture - characterised by loss of access to concessionary borrowing and the need to therein tap more risky commercial borrowing in the process of graduating along the income scale. In fact, these concerns have often been overshadowed by global politics and the quest to blame China.

The right mix of policy priorities that provide due attention to both economic and governance reforms that address a country’s debt repayment capacity are vital in reducing a country’s vulnerability to debt distress amidst (often unforeseen) external factors and increased access to risky commercial borrowing.

DISCLAIMER: All views expressed are those of the writer and do not necessarily represent that of IIPA and this platform.

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Author

Nipuni Perera is a PhD Candidate from the Department of Political Science and International Relations at the University of Canterbury in Christchurch, New Zealand

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