Currently, Sri Lanka is in the process of restructuring its foreign debt after announcing the country’s first sovereign default on April 12. As the largest bilateral creditor, China is playing a key role in Sri Lanka’s debt restructuring process.

The topic is not merely a domestic and bilateral matter. Sri Lanka’s debt restructuring, and China’s engagement within it, is receiving global attention given the debt distress across emerging markets and the significant lending China has done to such countries over the past decade or so. During her recent visit to China, International Monetary Fund (IMF) Managing Director Kristalina Georgieva discussed China’s role in addressing the emerging market debt crisis, with special reference to Sri Lanka and Zambia. According to the IMF, discussions with Chinese authorities were fruitful and the IMF sees space for a platform for more systematic engagement on debt issues, where China can play an active role.

On Sri Lanka specifically, the island-nation is expecting China’s assurance regarding debt restructuring in the coming months, which will pave the way to obtain IMF board approval for the $2.9 billion, four-year Extended Fund Facility (EFF) program. The initial expectation was that Sri Lanka would reach an agreement on financing assurances with its major bilateral creditors (China, India, and the Paris Club, led by Japan) by November or early December and get the IMF Executive Board’s approval in December. China’s approach and assurances are vital in this process, because the other creditors are waiting on China to confirm its own offers. However, no firm financing assurances have been reached with the bilateral creditors so far. The IMF Executive Board’s meeting schedule indicates that it will not discuss Sri Lanka’s EFF in December. Thus, the IMF program can only commence in early 2023.

China’s response to Sri Lanka’s debt crisis has not been proactive, but neither has it been negative. During a Chinese Foreign Ministry Press briefing on December 5, the spokesperson noted that “China attaches high importance to Sri Lanka’s difficulties and challenges,” and said that it supports relevant financial institutions in discussing with Sri Lanka and properly resolving them.

How Much Does Sri Lanka Actually Owe to Chinese Creditors? 

Understanding China’s role in Sri Lanka’s debt restructuring process requires a complete picture of 1) how much Sri Lanka actually owes to Chinese creditors and 2) the composition of those loans. While the often-cited number is that Sri Lanka’s debt to China is approximately 10 to 15 percent of its total public external debt, its debt to Chinese creditors amounted to approximately $7.3 billion, or 19.6 percent, of the country’s total outstanding foreign debt as of the end of 2021, as detailed in our briefing paper published by China Africa Research Initiative (SAIS-CARI) at Johns Hopkins University’s School of Advanced International Studies. The largest share of Sri Lanka’s foreign debt consists of Eurobonds (international sovereign bonds), which accounted for 36 percent of the country’s public and publicly guaranteed foreign debt  by the end of May 2022.

While the often-quoted numbers are lower than our calculations, it is important to emphasize that there was no “hidden debt.” Our numbers are in line with both the World Bank’s International Debt Statistics and the Sri Lankan Ministry of Finance’s figures provided in creditor presentations in November.

Then where does the often-quoted figure that China accounts for a 10-15 percent share of Sri Lanka’s external debt originate from? There are two reasons for this underestimation of Sri Lanka’s Chinese debt stock: First, the exclusion of debt recorded under state-owned enterprises (SOEs) from the easily referred to central government debt in Sri Lanka, and, second, Foreign Currency Term Financing Facility or term loans obtained from China Development Bank (CDB) being classified as market borrowings instead of bilateral debt within the central government debt figures. The Sri Lankan Ministry of Finance’s External Resources Department, while reporting bilateral debt from China as 10 percent of the total as per their classification, had made it very clear that these calculations exclude SOE loans, while term loans from CDB were categorized as market borrowings (as they were first obtained through a commercial bidding process in 2018) obtained at commercial interest rates – albeit below the cost of international sovereign bonds (ISBs).

The exclusion of a significant part of SOE debt from the topline figure is an interesting story. During 2005-2010, most of the Chinese lending provided to Sri Lanka went to project financing. Of the debt outstanding at the end of 2010, 90 percent was from China Exim Bank. Three of the largest projects financed by China Exim Bank in Sri Lanka were the Norochcholai Puttalam Coal Power Plant, Hambantota Port, and Mattala Airport. Each of these assets are owned by the respective SOEs, which are the largest service providers in each sector. For example, Norochcholai Puttalam Coal Power Plant is an asset of the Ceylon Electricity Board, which provides around 40 percent of the country’s electricity generation. Sri Lanka Port Authority (SLPA) owns Hambantota Port, while the Airport and Aviation Services Limited owns the Mattala Airport.

However, loans to construct these infrastructure project were obtained by the Sri Lankan government as a borrower, not by these SOEs. Since it was the government that obtained these loans, there was no need of a public guarantee. These loans therefore were recorded as central government debt until 2013.

In 2013-14, the loans obtained to construct these infrastructure projects were transferred to the respective SOEs under a directive from the cabinet of ministers. At the end of 2015, these loans amounted to approximately to $2.4 billion, or 3.1 percent of GDP. Therefore, recording these loans under SOEs allowed the government to show a lower central government debt-to-GDP ratio of 78.5 percent for 2015, instead of 81.6 percent.

However, public debt as recorded by the Central Bank of Sri Lanka continued to report these SOE loans as a separate category alongside publicly guaranteed SOE debt, leading to public debt ratio of 85.3 percent at the end of 2015. So, Sri Lanka’s public institutions did not “hide” these loans; they were just more complicated to pinpoint through casual observation due to the complicated classification system.

Sri Lanka’s Previous Debt Restructuring Efforts With China 

Although Sri Lanka has not defaulted on its debt before, the country has grappled with severe external debt and balance of payment (BOP) issues for decades. These issues became more severe after 2010 as a result of the significant increase in the country’s foreign debt burden with its rising reliance on commercial borrowings, including ISBs or Eurobonds, raised largely from institutional investors based in the West) and export credit to finance projects (with China’s policy banks being the largest source). The repayments on these loans increased significantly from 2014 onward. To tackle these debt repayment and BOP challenges, Sri Lanka used various methods, including obtaining a EFF program from the IMF in 2016.

Sri Lanka also sought to increase FDI and restructure loans obtained from China. In 2014, then-Treasury Secretary P.B. Jayasundara requested that China Exim Bank restructure loans obtained to construct the Hambantota Port. There was no request for principal haircuts. Instead, Sri Lanka’s request was to reduce interest rates and extend payback periods, making it viable to operate as a joint venture with two Chinese SOEs.

It is important to note that this request came in September 2014, just before Chinese President Xi Jinping visited Sri Lanka. This visit in turn took place just four months before Sri Lanka’s presidential election, in which Mahinda Rajapaksa, who had been in power since 2005, was defeated.

During Xi’s visit, Sri Lanka signed a Supply Operate Transfer agreement to further develop Hambantota Port terminals as a joint venture with China Harbor Engineering and China Merchant Port (CM Port). Therefore, the major aim of this debt restructuring request was to help further develop the port and reduce losses incurred by the SLPA. Further development of Hambantota, while retaining overall state ownership, was politically important for Rajapaksa.

Regardless of the motive, this proposed loan restructuring did not happen. Rajapaksa lost the 2015 presidential election and the plans for the port changed, with the new government agreeing to lease Hambantota to CM Port in late 2016.

Sri Lanka’s second effort to seek debt relief from China was in 2017, when then Prime Minister (and current President) Ranil Wickremasinghe visited China and met with Chinese leaders. At the time, Sri Lanka had requested debt relief from China, but the request was dismissed the Chinese. This was according to former Minister for Special Projects Sarath Amunugama, who told the Sri Lankan Parliament on August 10, 2017 that China turned down Sri Lanka’s request for debt relief. Amunugama summarized China’s attitude as follows: “We had lent to many countries in the world. If we give debt relief to Sri Lanka, 30-40 will ask for same treatment.”

His statement clearly echoes China’s sentiment regarding debt restructuring. Chinese financial institutions do not like principal haircuts and are afraid to set a precedent by extending such an offer to one country. According to Kanyi Lui, head of China practice at the law firm Pinsent Masons, principal haircuts on loans might require approval from China’s State Council – the highest political authority – and due to bank officers taking personal accountability for loans they handle there is a reluctance to restructure loans at the bank level.

Historically, China has a history of principal haircuts with regards to the interest-free loans provided as official development assistance via the Ministry of Commerce since the 1960s, as highlighted by Professor Deborah Brautigam in her book “The Dragon’s Gift.” But this is not the case with regards to lending by China’s financial institutions, especially the two major policy banks relevant to Sri Lanka, China Exim Bank and CDB, which have only existed since the mid-1990s. In the most recent example, both banks provided an interest rate moratorium and maturity extensions, without principal haircuts, to Ecuador in September of this year.

Sri Lanka’s Future Debt Restructuring With China

Given that China is Sri Lanka’s largest bilateral creditor, finalization or even basic agreements pertaining to debt restructuring require its involvement and support. But we are not talking about dealing with one entity. There are a few Chinese financial institutions that have provided loans to Sri Lanka. Based on relevant studies and scholars who follow Chinese financial institutions, it is clear that these banks make their own decisions. Sri Lanka has borrowed heavily from both China Exim and CDB, which operate in separate ways, so they cannot be expected to act in concert in the debt restructuring negotiations.

Even within China Exim Bank, there are different departments that provide different kinds of lending. Our briefing paper showed that Sri Lanka had both commercial and concessional loans from the bank, with the concessional ones having their lower interest rates being subsidized by the Chinese government. Therefore, a great deal of consensus within and between policy banks is required for China to formulate its approach to debt restructuring.

The complexities of debt restructuring don’t end there. Both China Exim and CDB lending are attached to activities of Chinese SOEs. While the loans were provided by CDB and Exim, the benefits were received by the SOEs that implemented the projects. That is the basis of export credit lending: A significant portion of the inputs for the projects are exported from China and the projects involve Chinese construction firms. This means, in the debt restructuring process, banks become the risk bearers while the SOEs have already gained the rewards. While banks can’t retroactively share the current risk with SOEs, the state-owned firms face the risk of reduced export credit financed projects to handle if the banks become more risk averse as a result of losses sustained by debt restructuring.

Jin Zhongxia, the director general of the People’s Bank of China’s department of international affairs, recently provided some insights into the complexities of debt restructuring. Addressing the China Finance 40 Forum held in Beijing, Jin noted that it is essential for China to coordinate all its involved creditor organizations (such as CDB and Exim Bank), which independently select most of their lending projects and follow a more or less commercial logic.

“If now the government is to tell them what to do, it is a complicated process as the government did not participate in most of the project-level decisions in the first place,” Jin said. He added that Chinese creditor organizations have relatively little experience dealing with large-scale debt restructures and need to learn by doing.

Chinese banks’ inexperience with overseas lending is a matter constantly highlighted by Michael Pettis, who has pointed out that most of China’s development finance in the Global South was driven by inexperience and very poor assessments both of the risks involved and of their own capabilities. Jin’s statement reflects a realization among Chinese banks regarding the consequences of inexperienced lending and the complexities of handling those consequences.

This means that, amid Sri Lanka’s debt restructuring process, there might be a need to gain consensus among a wide array of Chinese state-linked entities, not simply the policy banks and the political leadership. The political leadership also faces a constraint with regards to offering debt relief to foreign countries: a potential perception among Chinese citizens that their government is subsidizing other countries in crisis at a time they themselves have been struggling through the COVID-19 pandemic and an overall economic slowdown.

Therefore, Sri Lanka’s debt restructuring cannot be looked at in isolation as a domestic crisis, which Sri Lanka has to handle on its own. It is deeply embedded both within a global emerging market debt crisis and a moment of rethinking within China about its global role as a creditor. What happens in countries like Suriname, Zambia, Ghana, Ecuador, and Pakistan has a bearing on what happens in Sri Lanka, and vice versa. These are all co-evolving crises, to which the global and domestic responses need to happen in coordination. But in doing so, neither can one forget the domestic complexities that must be overcome. The nuances of Sri Lanka’s situation carry lessons for both the ongoing processes on debt restructuring and for other countries facing debt distress.