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Debunking the Myth of ‘Debt-trap Diplomacy’
How Recipient Countries Shape China’s Belt and Road Initiative
Critics of the BRI accuse China of pursuing a policy of ‘debt-trap diplomacy’: luring poor, developing countries into agreeing unsustainable loans to pursue infrastructure projects so that, when they experience financial difficulty, Beijing can seize the asset, thereby extending its strategic or military reach. This paper demonstrates that the evidence for such views is limited.

RESEARCH PAPER
19 AUGUST 2020
ISBN: 978 1 78413 411 2
Officials visit the tunnel of the East Coast Rail Link project in Dungun, Malaysia
on 25 July 2019. Photo credit: Rushdi Samsudin/Contributor/Getty
— Officials visit the tunnel of the East Coast Rail Link project in Dungun, Malaysia on 25 July 2019. Photo credit: Rushdi Samsudin/Contributor/Getty
Lee Jones
Reader in International Politics, Queen Mary University of London

Shahar Hameiri
Associate Professor of International Politics, University of Queensland

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4. Sri Lanka and the BRIHide contents
Debunking the Myth of ‘Debt-trap Diplomacy’
Summary
1. Introduction
2. The Economic Drivers of the BRI
3. Governing the Belt and Road
4. Sri Lanka and the BRI
5. Malaysia and the BRI
6. Conclusion and Policy Recommendations
About the Authors
Acknowledgments
References
4. Sri Lanka and the BRIShow contents
Topics
BRICS ECONOMIES CHINA’S BELT AND ROAD INITIATIVE (BRI) CHINA’S FOREIGN RELATIONS
Regions
CHINA SOUTH ASIA SOUTHEAST ASIA
Departments
ASIA-PACIFIC PROGRAMME
Projects
TRADE, INVESTMENT AND ECONOMICS
4. Sri Lanka and the BRI
The debt-trap diplomacy thesis arose directly from Sri Lanka’s experience, making it a crucial test case.2 The conventional account is that China lent money to Sri Lanka to build a major port at Hambantota on Sri Lanka’s southern coast, knowing that Colombo would experience debt distress, and that this allowed Beijing to seize the port in exchange for debt relief, permitting its use by the Chinese navy (Chellaney, 2017). Indian commentators frequently argue that China is using the BRI to pursue ‘strategic ambitions’ in South Asia, in this case ‘creating a Chinese naval outpost’ as part of a ‘salami-slicing approach’, and arguing that ‘there is little doubt that China’s leadership would seek to leverage its possession for strategic gains’ (Singh, 2018). Hambantota is thus presented as ‘part of a larger modus operandi’, as US analyst Constantino Xavier has put it, ‘Beijing typically finds a local partner, makes [them] accept investment plans that are detrimental to their country in the long term, and then uses the debts to either acquire the project altogether or to acquire political leverage in that country’ (Stacey, 2017). Similar accounts abound throughout the media, and across a wide range of think-tank and academic literature.

As this section shows, there are many misconceptions in this conventional narrative. First, the Hambantota Port project was not proposed by China, but by the government of former Sri Lankan President (and current Prime Minister) Mahinda Rajapaksa, in cooperation with a profit-seeking Chinese SOE. Second, it was a commercial, not a geostrategic, venture, but one which created vast surplus capacity due to governance problems in Sri Lanka. The port was one of several ‘white elephant’ projects promoted by Mahinda Rajapaksa as part of a corrupt and unsustainable developmental programme. Third, Sri Lanka’s debt distress was unconnected to Chinese lending, arising instead from excessive borrowing on Western-dominated capital markets and from structural problems within the Sri Lankan economy. Fourth, there was no debt-for-asset swap. Rather, after bargaining hard for commercial reasons, a Chinese SOE leased the port in exchange for $1.1 billion, which Sri Lanka used to pay down other debts and boost foreign reserves. Fifth, Chinese navy vessels cannot use the port, which will instead become the new base of Sri Lanka’s own southern naval command. All these problems arose not from a carefully crafted top-down strategy, but rather as a result of the dynamics described in chapters 2 and 3 of this paper.

The origins of Hambantota Port
The Hambantota Port project originated not in the minds of Chinese strategists, but rather in those of Sri Lankan developmentalists. The idea of building a deepwater harbour there originated in the 1970s, conceived by local parliamentarian D. A. Rajapaksa (SLPA, 2010). In 2001, one of his sons, Mahinda, then minister with responsibility for ports, gazetted the port and commissioned a feasibility study, but this judged the location to be unsuitable (SLPA, 2010; Wijenayake, 2017). Nonetheless, it was included in the government’s 2002 ‘Regaining Sri Lanka’ development strategy (Government of Sri Lanka, 2002). After becoming prime minister in April 2004, Mahinda Rajapaksa commissioned another feasibility study, but was deterred by projected costs. However, in 2006, another feasibility study, by Danish firm Rambøll, found that a first phase would be commercially viable (Rithmire and Li, 2019: p. 8). This persuaded the Sri Lankan Ports Authority (SLPA) to champion the project, which was finally green-lighted in 2007 (SLPA, 2010). The government then began seeking international backers.

The Hambantota Port project, together with other infrastructure projects, reflected both need and greed. Sri Lanka has a serious infrastructure gap – estimated at $36 billion in 2014 – and post-2006 pledged Chinese investment eventually covered one-third of this (Wignaraja et al., 2020: p. 8). However, these plans also reflected Mahinda Rajapaksa’s wish to direct resources to his home district, and the wider region, where his Sri Lanka Freedom Party faced a mounting opposition challenge (US Embassy, 2007a). Alongside the port development came ambitious plans for road and railway links, a new airport (the largest in South Asia), and a new airline. As early as 2006, US diplomats observed that political motives were overriding rational development planning:

Rajapaksa […] has chosen large projects that will attract a lot of attention and praise for him and his party. Unfortunately, little thought has been put into what Hambantota District actually needs, what types of projects would provide jobs that locals can fill, and what would raise standards of living. There is no strategic approach to developing the region and no coordination between the agencies responsible for the different projects. There also seems to be a lack of understanding, even within the business community, that a certain level of demand and investor interest is necessary for some of these projects to be successful. An empty port, an empty airport, and an empty vast convention center would not generate the benefits that Hambantota needs […] (US Embassy, 2006).

These projects also serviced a corrupt and increasingly authoritarian network centred on the president’s family. The government assigned infrastructure projects to regime-linked cronies, while cramming key agencies with loyalists to mute bureaucratic objections and facilitate off-balance-sheet borrowing by state-owned companies and private banks (Kelegama, 2017: pp. 441, 446–7). The company responsible for building Hambantota Port also allegedly funnelled at least $7.6 million to affiliates of Mahinda Rajapaksa, to assist his 2015 bid for re-election to the presidency (Abi-Habib, 2018).

Reflecting the recipient-driven nature of Chinese development financing, Chinese involvement in Hambantota was initiated by Colombo, not Beijing. In 2007, Sri Lanka made an ‘open request for funding’, apparently also directly approaching India, but only China responded favourably (SLPA, 2010). As Rajapaksa stated in 2009, ‘I asked for it. […] It was not a Chinese proposal. The proposal was from us; they gave money. If India said, “Yes, we’ll give you a port”, I will gladly accept. If America says, “We will give a fully equipped airport” – yes, why not? Unfortunately, they are not offering to us’ (Thotham, 2009). Similarly, Sri Lanka’s ambassador to China subsequently insisted:

[…] Sri Lanka asked for this project loan on our own. We were not forced to get this loan. […] It is very unfair to blame China or [EXIM Bank] or the firms that constructed the Hambantota port. […] It is a decision taken by the government of Sri Lanka […] if something was wrong in the decision, we are responsible (Global Times, 2018).

However, reflecting the dynamics described in Chapter 2 of this paper, China’s engagement was also shaped by profit-seeking SOEs. Colombo’s application for Chinese funding was strongly encouraged by China Harbour Engineering Group (CHEG), which had been implementing Chinese-funded reconstruction projects in Sri Lanka in the aftermath of the December 2004 Indian Ocean earthquake and tsunami. Seeking more lucrative opportunities, CHEG lobbied the Rajapaksa government to transform an initially modest plan to expand Hambantota’s fishing harbour into a megaproject, offering free feasibility studies and exaggerating the likely economic benefits (Zhu, 2015: pp. 7–8). The contract was also shaped by SOE competition, which manifested within the Sri Lankan regime itself. Although CHEG was well placed, given its early involvement, the Chinese hydropower construction company Sinohydro also pursued the contract. In 2007, the country’s former minister of ports and aviation reportedly stated that both companies recruited brothers of the president to separately press their different cases, resulting in the contract being shared between them (US Embassy, 2007b). Such rivalry between SOEs again suggests little strategic coordination on the Chinese side, but rather implies profit-seeking behaviour.

As with many other Chinese-backed projects,3 Hambantota Port turned out not to be commercially viable, generating massive surplus capacity and losses for the SLPA. The first phase was built between 2008 and 2010, followed by a second stage designed to make the port South Asia’s largest by 2014. In reality, the port was barely operational, with usage actually declining year-on-year (see Table 2). In 2016, it took just $11.8 million in revenue, versus operating expenses of $10 million (Grey, 2018). Sri Lanka’s finance ministry reportedly estimated the port’s total losses at $230 million for 2011–16 (Aneez, 2017). Local experts place the blame squarely on the government’s ‘incompetence and disregard of any commercial sense’ (Kulamannage, 2018). They cite its premature opening of the port to celebrate Rajapaksa’s birthday in 2010, despite the fact that a large rock still blocked entry to the harbour, and the government’s failure to secure investors able to provide ‘the services needed to operate a non-containerised port’; in short, ‘everything was bungled’ (ibid.). Moreover, Colombo’s response was to seek even more Chinese investment. In September 2014, CHEC and China Merchants Port Holdings (CMPort) agreed to jointly develop and run a new container terminal under a supply-operate-transfer model. The SOEs would take a 65 per cent equity stake, supply the necessary equipment, and operate the terminal for 35 years, during which 35 per cent of the revenue would be used to repay EXIM Bank, before Hambantota was returned to the SLPA (Rithmire and Li, 2019: p. 9).4

Table 2: Usage of Hambantota Port 2014–18

2014

2015

2016

2017

2018

Number of ships

335

295

281

230

270

Cargo (’000 tonnes)

474

293

355

213

494

Source: Department of Census and Statistics (2017: p. 65; 2019: p. 65).

Sri Lanka’s debt crisis
By 2014, Rajapaksa’s debt-fuelled programme of economic stimulus was collapsing amid unsustainable debts. The regime’s mismanagement, authoritarianism and corruption were major electoral issues in 2015, resulting in Rajapaksa losing the presidential election to Maithripala Sirisena. The new president turned to the IMF for assistance, agreeing a $1.5 billion stabilization package in June 2016.

Sri Lanka’s debt crisis was made, not in China, but in Colombo, and in the international (i.e. Western-dominated) financial markets. By 2016, 61 per cent of the government’s sustained budget deficit was financed by foreign borrowing (Central Bank of Sri Lanka, 2016: p. 69), with total government debt increasing by 52 per cent between 2009 and 2016, to Rs. 9.4 trillion ($64.5 billion). Of this, 34.2 per cent ($22 billion) comprised external borrowing, while debt servicing absorbed 44 per cent of government revenues (Central Bank of Sri Lanka, 2016: p. iv). Rajapaksa’s borrowing-and-spending spree was facilitated by low global interest rates caused by the policy of quantitative easing favoured by many Western central banks. Three-quarters of external government debt was owed to private financial institutions, not to foreign governments (IMF, 2017: p. 35). But this borrowing was unsustainable given Sri Lanka’s persistent current account deficit, reflecting a widening trade deficit, low competitiveness and weak inward investment. However, despite ample warnings, foreign creditors kept lending, while the government refused to change course for political reasons (Kelegama, 2017: pp. 437–9).

The debt crisis was precipitated by the winding-down of quantitative easing in the US from 2013, which sharply increased Sri Lanka’s borrowing costs. From 2011–16, interest rates on Sri Lanka’s short-term borrowing doubled, to around 10 per cent, while long-term rates increased from 7–8 per cent to 11–13 per cent; meanwhile, the rupee fell 36 per cent against the dollar, further increasing repayment costs (Central Bank of Sri Lanka, 2016: p. 32; IMF, 2017: p. 19). Failed efforts to defend the currency shrank Sri Lanka’s foreign reserves to just $6 billion by 2016, below the demands on foreign currency in 2017 (IMF, 2017: p. 5). With over 58 per cent of Sri Lanka’s government debt being denominated in dollars, Colombo faced being unable to repay or ‘roll over’ (extend) its loans, with $17 billion being required from 2019–23 (Central Bank of Sri Lanka, 2016: p. 14; IMF, 2017: p. 6; Wheeler, 2020).

Table 3: Ownership of Sri Lankan government external debt 2007–16 ($ billion, at current exchange rates)

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

% share of total (2016)

Multilateral

5,531

5,706

5,786

5,969

6,529

6,617

7,000

6,801

7,320

7,395

Asian Development Bank

2,782

2,933

2,998

3,174

3,468

3,514

3,710

3,613

3,929

3,913

International Development Association (World Bank)

2,464

2,469

2,471

2,487

2,734

2,743

2,891

2,781

2,879

2,869

Bilateral

5,376

6,153

5,957

6,538

7,623

8,118

6,378

6,075

6,543

6,496

Japan

3,121

3,941

3,713

4,236

4,785

4,291

3,629

3,189

3,367

3,340

India

141

156

153

379

614

797

919

1,011

977

China*

216

274

406

499

538

528

520

672

863

904

Financial markets

1,726

1,514

3,573

5,399

6,915

6,952

9,558

10,967

12,223

13,899

China EXIM

–

1,120

684

1,665

Other

1,445

1,366

3,535

5,366

6,884

6,925

9,534

9,825

10,782

12,218

International sovereign bonds

518

522

995

1,963

3,091

3,488

3,546

5,018

7,052

8,386

Total

12,633

13,373

15,316

17,906

21,067

21,687

22,937

23,843

26,086

27,791

100

Source: Calculated from Central Bank of Sri Lanka (2016: p. 63).

Note: *Excludes loans to SOEs.

Although data irregularities make it hard to establish China’s share of Sri Lankan debt, it was relatively small. Excluding borrowing by Sri Lankan SOEs, Chinese loans comprised just 9 per cent of Sri Lankan government debt by 2016 (see Table 3). Moreover, with maturities of 15–20 years and interest rates averaging 2.5 per cent, these were far less pressing than other foreign loans (Weerakoon and Jayasuriya, 2019). Wheeler (2020) estimates that instalments due to EXIM Bank comprised just 5 per cent of the government’s annual debt-servicing payments. The Chinese loans for Hambantota Port specifically totalled $1.3 billion (see Table 4), i.e. just 4.8 per cent of the government’s total external debt (excluding SOEs). According to one source, in 2016 repayment costs for Hambantota Port were $67.5 million (see Table 5), i.e. just 3.3 per cent of the total cost ($2.03 billion) of foreign debt servicing in that year (Central Bank of Sri Lanka, 2016: pp. 16–8). According to slightly higher figures announced in January 2017 by Ravi Karunanayake, Sri Lanka’s Minister of Finance, from 2011 to 2016 the government ‘lost’ a total of Rs. 31.4 billion ($215.6 million) through ‘loan instalments and interests’ for the port project, with Rs. 10.6 billion ($73.2 million) being ‘needed to service this debt in 2018’ (Mudalige, 2017). Even using these higher values, it is clearly absurd to claim that Hambantota Port, or even Chinese lending in general, caused Sri Lanka’s debt crisis. The government’s desire to offload the port – and other loss-making ventures, like the Hambantota airport – seems instead to reflect the terms of Sri Lanka’s IMF ‘bailout’, which demanded reducing the losses of five SOEs, including the SLPA (see IMF, 2017: p. 12).

Table 4: Loans from China EXIM Bank for Hambantota Port, 2005–13
Year

Amount ($ million)

Type

Interest rate (%)

Maturity (years)

Grace period (years)

Grant element (%)*

2005

307

Loan

6.3

21.6

2009

Loan

n/a

2012

600

Export credits

54.6

2012

158.35

Loan

2 + 1% fees

54.6

2012

Buyer’s credit loan

4.69 (LIBOR 06 + 4%) + 1.6% fees

2013

147

Loan

6.3

Total

1,340.35

Source: Based on data from Dreher et al. (2017).

Note: n/a = not available. * The grant element percentage measures the concessionality level of a flow, using OECD methodology or, where data are insufficient, taking into account the discount rate, annual repayments and type of repayment.

Table 5: Hambantota Port loan repayments 2010–17 ($ million)
Year

Interest

Principal

2010

7.5

2011

18.3

2012

21.7

2013

25.4

2014

31.3

30.8

2015

34.7

33.8

2016

33.7

33.8

2017 (Jan.–Jun.)

16.2

16.9

Source: Sautman and Yan (2019a: p. 3).

The Chinese ‘bailout’
The usual account of subsequent events has been that, given Sri Lanka’s inability to repay China’s EXIM Bank, Colombo was forced into a ‘debt-equity swap’, ceding ownership of Hambantota Port to China in exchange for debt relief. Both parts of this story are simply untrue. Ownership was not transferred, and no debt was forgiven. A Chinese SOE paid Sri Lanka to lease the port, providing Colombo with liquidity so that it could repay Western creditors; the debt to China remained in place. Claims that China ‘seized’ the port to extend its naval reach are likewise false.

In 2016, to raise urgently needed US dollars, the Sri Lankan government asked Japanese and Indian firms (unsuccessfully) to lease Hambantota Port, and also ‘lobbied hard’ in China (Sautman and Yan, 2019b). Sri Lanka’s ambassador to Beijing said that the ‘Chinese government never asked [us] to hand over the port […] this proposal came from Sri Lanka, asking [for] partnership from China’ (CGTN, 2018). According to Minister of Ports and Shipping Mahinda Samarasinghe, Sri Lankan Prime Minister Ranil Wickremesinghe asked President Xi to provide financial aid or to take a majority equity stake in the port; Xi refused, but promised to help find an investor (Rithmire and Li, 2019: p. 10). This led to a lease agreement between the Sri Lankan government and CMPort in July 2017. Samarasinghe stated, ‘We thank China for arranging this investor to save us from the debt trap’ (Sirilal and Aneez, 2017).

The agreement’s terms are partially revealed through CMPort’s statutory disclosures to the Hong Kong Stock Exchange (CMPort, 2017b; 2017c). The SLPA agreed to create two subsidiaries: Hambantota International Port Group (HIPG), which would develop and operate the port under a 99-year lease from SLPA (which remained the port’s legal owner), and Hambantota International Port Services (HIPS), which would run common user facilities. The SLPA agreed to sell 85 per cent of HIPG’s shares to CMPort for $973.7 million; HIPG would in turn purchase 58 per cent of HIPS’s shares. CMPort also agreed to invest an additional $146.3 million, the exact use of which would be decided jointly with the government of Sri Lanka within one year.

Although Xi may have helped to ‘arrange’ this investment to support bilateral ties, CMPort clearly prioritized its commercial interests. As Wickremesinghe stated in a speech in June 2018, CMPort would not ‘[take] over the Port as charity. It had to be made a viable business model’ (Imtiaz, 2018). Sri Lankan government officials are reported to have claimed that CMPort disputed the port’s valuation and demanded an additional 15,000-acre site for an adjacent industrial zone in exchange for its investment (Abi-Habib, 2018). This was necessary for CMPort’s longstanding ‘port-park-city’ business model, whereby industrial parks and real estate are developed alongside ports to generate cargo throughput. After pursuing this model to the point of oversaturation in China, CMPort had externalized this approach, as part of a commercially driven international expansion seeking new resources, expertise, markets and distribution networks (Huo, Zhang and Chen, 2018: p. 72). CMPort had acquired a 49 per cent stake in a French port operator in 2013, followed by investments in Brazil, Djibouti and Australia, including a 99-year lease on the Australian port of Newcastle (Bloomberg, 2018; CMPort, 2019b; Bräutigam, 2020: p. 9).5 Thus, far from being a one-off transaction as part of a plot to ‘grab’ a particular port, CMPort’s investment was part of a wider corporate strategy of overseas expansion, exploiting the ‘development opportunities arising from the “Belt and Road” initiative’ for its own purposes – as expressed in company documents published well in advance of the Hambantota deal (CMPort, 2017a: pp. 22–3). By 2018, overseas ports already accounted for 18.9 per cent of the group’s total container throughput (CMPort, 2019b). CMPort faces formidable challenges in making Hambantota profitable, but is courting investors and managed to increase bulk cargo throughput from 81,000 to 455,000 tonnes in the first half of 2019, while wheeled volume increased 57.6 per cent year-on-year (CMPort, 2019a).

CMPort thus only leased the port, not taking formal ownership, and Sri Lanka did not receive debt relief as part of the agreement. CMPort’s investment was used to stabilize foreign reserves and service non-Chinese debt. The central bank’s deputy governor reportedly stated, ‘from 2019 onwards, several international and domestic sovereign bonds are set to mature and this is a problem’. The deputy governor noted that ‘[t]he additional Chinese money […] will help us manage our short-term liabilities [and] help the Central Bank manage its foreign reserves’ (Imtiaz, 2017). Based on interviews with Sri Lankan policymakers, including the Central Bank governor and his predecessor, Sautman and Yan (2019b) conclude that the CMPort investment was ‘not used to repay port-related debt, but to pay off more expensive loans, generally to Western entities’. Moreover, the ‘loans obtained [from China] to construct [Hambantota] port were not written off and the government is still committed to loan repayments as per the original agreements’ (Moramudali, 2019).6 In July 2018, Minister of Ports and Shipping Samarasinghe confirmed that the debt obligation still existed, but had been shifted from the SLPA to the Treasury, enabling the SLPA to report higher profits (Nafeel and Ables, 2018) – as required by the IMF bailout.

Finally, the claim that China could use Hambantota as a naval base is clearly erroneous. Sri Lankan politicians and diplomats have repeatedly insisted that this never featured in their discussions with Beijing. As Sri Lanka’s ambassador to China has stated flatly, ‘China never asks us. We never offered it’ (CGTN, 2018). The SLPA–CMPort agreement assigned responsibility for port security to an oversight committee comprising the Sri Lankan navy and police, the SLPA, and the secretary to the minister of development strategies and international trade, with HIPG only being responsible for internal port security (Carrai, 2019: p. 1097). Several hundred Sri Lankan naval personnel are stationed at Hambantota and in 2018 it was decided to relocate the navy’s southern command to the port. There is no evidence of any Chinese military activity at or near Hambantota since CMPort’s lease began; conversely, there have been port visits by US and Indian naval vessels, and Hambantota port is subject to US Coastguard inspections under the International Port Security scheme (Wignaraja et al., 2020: pp. 25–6).

Conclusion
This chapter has disproven the debt-trap diplomacy claims surrounding Hambantota Port. China did not propose the port; the project was overwhelmingly driven by Sri Lankan actors for their own domestic purposes, with some input from a Chinese SOE acting for commercial reasons. Sri Lanka’s debt trap was thus primarily created as a result of domestic policy decisions and was facilitated by Western lending and monetary policy, and not by the policies of the Chinese government. China’s aid to Sri Lanka involved facilitating investment, not a debt-for-asset swap. The story of Hambantota Port is, in reality, a narrative of political and economic incompetence, facilitated by lax governance and inadequate risk management on both sides.

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