Interest Rates & 'White Elephants': Why is Sri Lanka Buried in Chinese Debt?

With a ruined economy, Sri Lanka is borrowing from China to eventually pay back the previous loans it took from it.

With the economy in ruins, Sri Lanka is taking loans from China to pay back previous loans it took from China.

(Image: Deeksha Malhotra/The Quint)

(This story was originally published on 6 April and is being republished from The Quint's archives in light of Mahinda Rajapaksa's resignation as the prime minister of Sri Lanka.)

As Sri Lanka continues to face one of its worst-ever economic crises, refugees have already started flowing into India.

A total of 16 Sri Lankan nationals from the Jaffna and Mannar regions reached Tamil Nadu earlier this week.

The main cause of the country's crumbling economy is its shortage of foreign currency, which has led to a massive reduction in imports of essential items.

The drop in tourism and FDI, along with the Sri Lankan government's initial refusal to be bailed out by the International Monetary Fund (IMF), are some of the crucial factors that have brought about the economic ruin. You can read about them in more detail here.

Amidst all of this, the role of China is a hotly debated issue. It is no secret that Sri Lanka owes a massive amount of money to China. On top of all that, on 21 March, the former made a loan request worth $2.5 billion in order to fix its economy.

So, what are the key features of this economic relationship? Does China provide better offers to Sri Lanka than countries like India or those in the West?

Big Loans at Low Interest Rates? 

According to the 2021 numbers, China accounts for more than 10 percent of Sri Lanka's $35 billion foreign debt, and is owed around $4 billion.

It is Sri Lanka's largest bilateral lender and its fourth-biggest overall lender, behind international financial markets, the Asian Development Bank (ADB), and Japan.

One of the main reasons why Sri Lanka has been taking loans from China over the past 15 years is that it seems to have calculated that Beijing is offering better deals than other countries like India or the United States.

For instance, in the case of the Hambantota International Port (a frequently used example by those analysts who accuse China of debt-trap diplomacy), it was reported by The Atlantic that Sri Lanka had first approached the US and India in 2007 for investments and loans, but its request had been refused.

China stepped in and offered Sri Lanka a 15-year loan of $307 million at a 6.3 percent interest rate to construct the port.

The Sri Lankan Civil War ended by 2009 and naturally, the economy was suffering, which forced the government to take loans from international lenders.

Hambantota was not generating expected returns, forcing Sri Lanka to borrow another $757 million from China at an interest rate of 2 percent.

But these loans, along with loans for the construction of the Colombo-Katunayake Expressway and Mattala Airport, were project loans, which meant that the Sri Lankan government did not have the authority to use this money to resolve its already existing balance of payments (BOP) problem (especially because of heavy reliance on imports).

To resolve the BOP crisis, the Sri Lankan government in 2018 took a $1 billion loan from the China Development Bank. This loan was taken at the global benchmark USD LIBOR (London Inter-Bank Offered Rate) 6-month interest rate and a margin of 2.56 percent per annum. It had to be repaid in eight years.

Another $500 million was borrowed in March 2020 from the China Development Bank, with a better interest rate considering that the USD LIBOR 6-month rate in 2020 was less than that of 2018.

Jumping forward to 2022, Chinese Ambassador to Sri Lanka Qi Zhenhong told reporters earlier this week that the $1.5 billion loan that Beijing is providing in response to the current meltdown was "in addition to the $2.8–billion assistance that China has extended to Sri Lanka since the outbreak of the pandemic."

Therefore, it seems as if Sri Lanka has been turning to China because of the attractive deals that the latter offers. But are these deals as good as they look?

'White Elephant' Projects?

The term 'white elephant' is used to refer to something that is an expensive investment with unsatisfactory returns, making it a financial burden.

Critics of their economic relationship argue that China shrewdly funds white elephant projects in Sri Lanka.

The most often cited case is that of the Hambantota International Port, for which the Sri Lankan government, as already mentioned above, took loans at commercial rates from the Export-Import Bank of China (EXIM Bank) between 2007 and 2016.

The port, however, hardly attracted any ships and had been long predicted to fail. It could not generate revenue from transit fees, servicing fees, cargo fees, and leasing land for commercial and industrial activities.

By January 2015, a big chunk of Sri Lanka's external debt was owed just to China. To repay the money, Sri Lanka decided in 2017 to privatise a majority stake of the port to a Chinese company called the China Merchants Port Holdings Company.

That company, owned and controlled by the Chinese Communist Party, completed a deal in July 2017 with the Sri Lanka Ports Authority after which the former controlled a 70 percent stake, essentially handing over control of the port to China and the 15,000 acres of land around it.

In conclusion, because it was unable to repay the loan for the construction of the port, Sri Lank was forced to lease the facility to China for 99 years.

The United States and India have warned that the location of the Hambantota International Port, along important east-west international shipping routes, could give China a military advantage in the Indian Ocean.

Beijing has denied having any ulterior, military motives with respect to the port, and claims that the port is part of its Belt and Road Initiative (BRI) aimed at helping Sri Lanka.

Another 'white elephant' seems to be the Mattala Rajapaksa International Airport, which is referred to by Nicholas Assef, founder of LCC Asia Pacific, as the "world's emptiest international airport."

Not only has the airport failed to do anything to boost trade and tourism, it hardly functions as a local airport for intra-Sri Lanka travel, due its remote jungle location.

The Dependence Continues

Despite all the controversy surrounding Hambantota International Port, Sri Lanka continues to rely heavily on China, given the latest $2.5 billion loan request.

When the economic crisis caused food and fuel shortages in January earlier this year, Governor Ajith Nivard Cabraal of Sri Lanka's central bank refused to take an IMF loan, saying that it is "not a magic wand".

"At this point, the other alternatives are better than going to the IMF," he had asserted. This was a reference to China.

"They would assist us in making the repayments... the new loan coming from China is in order to cushion our debt repayments to China itself," Cabraal had concluded, as quoted by Reuters.

The idea of taking a loan from someone to repay a previous loan provided by the same someone is quite literally the definition of a debt trap.

Whether China is engaging in "debt-trap diplomacy" to exploit the Sri Lankan economy's structural weaknesses for its own profit is a separate question.

But what we can conclude for sure, based on an analysis of the past few years and of the past few days, is that Sri Lanka is more than happy to fall into China's "debt trap". Until it finds alternatives to snap out of the economic crisis, Colombo could be stuck in Beijing's trap for a very long time.