Debt trap diplomacy myth busted, but China not out of water yet

Evidence analysed by an Australian policy think tank suggests China has not been engaging in debt-trap diplomacy, despite the allegation being made internationally that it has.

The Lowy Institute said while the accusations of intention debt traps may not be true, China’s scale of lending and a lack of debt-protection mechanisms “poses clear risks.”

Simulating the future debt-to-G.D.P. ratios of Pacific Island countries China currently lends to according to its current activity reveals “significant risks of future debt sustainability problems under a business-as-usual scenario for bilateral Chinese lending.”

The report, titled Ocean Of Debt? Belt and Road and Debt Diplomacy in the Pacific, was written by Roland Rajah, Alexandre Dayant and Jonathan Pryke.

Their research shows that if nothing changes, China will push the six countries it lends to well over the 50 per cent debt-to-G.D.P. ratio threshold, which the International Monetary Fund believes leads to serious debt distress.

According to projections to 2024, Vanuatu, Tonga, Samoa and Papua New Guinea would well breach the threshold, while Fiji would just go over it. 

Pacific countries not yet lending from China may also find themselves in unsustainable levels of debt. Nauru and Kiribati are projected to hit near 75 per cent debt-to-G.D.P. Nauru’s debt levels are already over the threshold while the I.M.F. predicts Kiribati’s debt levels will climb due to climate change adaptation requirements. 

“Our findings show that a continuation of business as usual for bilateral Chinese lending in the Pacific would quickly give rise to potential debt sustainability problems,” the report states.

“China will therefore need to reconfigure its approach significantly if it wants to disprove the debt trap accusations made by its critics.” 

And while China is responding to debt-sustainability criticisms and committed to taking steps to safeguard against it, the Lowy Institute says it is time for China to make good on their promises.

“China should adopt formal lending rules similar to those of the M.D.Bs. (multilateral development banks),” they suggest.

“These could mandate the use of the Belt and Road Initiative debt sustainability framework by China’s policy banks, notably EXIM Bank, when undertaking sovereign lending to less-developed countries, and require the provision of more concessional financing to countries at greater risk of debt distress.”

The report comes at a time when the international community has its eyes on the Pacific, and in particular China’s advances in the region. 

China’s Belt and Road Initiative, President Xi Jinping’s effort to rebuilt the Silk Road and connect China to the world, has come under scrutiny for lending at unsustainable rates in an effort to gain assets in strategic areas.

An oft-cited example is Sri Lanka’s strategically located Hambantota Port, where a state-owned Chinese firm took on majority of the equity state after the country struggled with the debt it incurred to build it.

The Lowy Institute found Tonga, Samoa and Vanuatu are among the most heavily indebted countries to China in the world, let alone the region.

But, the Pacific Islands deal with several challenges that make debt less simple than for most countries.

Being geographically distant and unconnected by transport to major international economic centres, have a widely dispersed population, generally being small in population, land area and gross domestic product (G.D.P.) all contribute to this challenging environment.

The effects of climate change and natural disasters are extreme and harshly felt, and income is unsteady, coming largely from scarce resources, unpredictable tourism and remittances. 

Four Pacific Islands, including Samoa, recently assessed by the International Monetary Fund (I.M.F.) on debt sustainability found themselves with worse ratings than their previous one. 

Average debt-to-G.D.P. has risen in Papua New Guinea, Vanuatu, Samoa and Tonga by 17 percentage points while in other countries the ratio declines. 

And while China is an “important creditor” in these countries, other drivers of debt risk like economic shocks from natural disasters, countries prioritising economic growth over being cautious and poor economic management in some countries have exacerbated debt unsustainability.

The I.M.F also changed its methodology, explicitly incorporating natural disasters into debt sustainability analysis into the Pacific, causing ratings for the region to have greater risk assessment, the report states.

“Overall, it is clear that rising debt risks in the region, as assessed by the IMF, have been driven by a multitude of factors, rather than by Chinese lending alone.” 

In recent years, both China and its Pacific Island debtors have become more cautious about debt sustainability. 

Out of the six debtor countries, (Cook Islands, Fiji, Papua New Guinea, Samoa, Tonga and Vanuatu), only Papua New Guinea and Vanuatu have taken new loans from China since 2016, the report states.

And as recently as April 2019, Chinese President Xi Jinping said debt sustainability would be an important part of future B.R.I. projects. 

The six Pacific Island’s in debt to China officially signed onto the B.R.I in 2018, and there are “several very large loan-financed projects are officially in the pipeline in Papua New Guinea and Vanuatu,” the report states.

Though a moratorium on lending is unofficially in place for countries like Samoa which have stopped taking on loans from all development aid partners, joining the B.R.I. and its loan driven infrastructure projects suggests this could change.

“Chinese lending may also expand to more countries in the region as Pacific governments look to maximise the amount of external financing available to them,” the report states. 

In the Pacific, China has never been the biggest contributor of aid in the region. Last year, the Lowy Institute released its Pacific Aid Map to show not only where aid comes from, but where it is going in order to improve accountability and efficiency.

It shows that Australia, New Zealand and Japan are the frontrunners for most cash spent in the Pacific, with Australia more than tripling New Zealand’s spend with US$855.67 million (T$2,377 billion) compared with $222.24 million (T$596.69 million). 

But the B.R.I’s commitments tell a different picture. When comparing total committed aid, not spent, China comes first at a whopping US$4.78 billion (T$12.8 billion), with Australia in second with $1 billion (T$2.6 billion). 

Under the Pacific Step Up, Australia established a $2 billion Infrastructure Financing Facility for the Pacific, three quarters of which is for loans.

The Australian credit export agency Export Finance Australia has been given another billion in callable capital and has been given the remit to finance overseas infrastructure projects.

“These initiatives are in the early stages of operation,” the report states.

“Still, there are concerns that in seeking to compete directly with loans from China, Australia might simply exacerbate existing debt sustainability problems in the Pacific.

China became a major lender in the region as traditional bilateral donors reduced their grant financing to the region within the last decade. 

From 2011 to 2017, “official financing flows fell by 1.7 percentage points relative to regional G.D.P.

“Importantly, the decline was entirely driven by a sharp reduction in grant financing from traditional bilateral donors — notably from Australia, reflecting a combination of stagnant grant assistance in Australian dollars and unfavourable exchange rate movements,” the report states.

Against this backdrop, China committed to US$6 billion worth of loans, though $4.1 billion is earmarked for the roads of Papua New Guinea.

When compared against traditional lenders, the Asian Development Bank and the World Bank which accounted for 53 per cent of all loans to the Pacific, Japan which contributed seven per cent and other smaller lenders (I.M.F, Canada, for example), more than 60 per cent of lending between 2011 and 2017 did not come from China.

“Looking at China’s role as a creditor to individual Pacific countries presents a similar picture,” the report states.

“China is the single largest creditor in Tonga, Samoa, and Vanuatu. However, it is only in Tonga that China accounts for more than half of total outstanding debt. 

“Elsewhere, either traditional official lenders or domestic creditors dominate. Meanwhile, China is not an active lender to the rest of the region, which remains dominated by traditional creditors, notably the M.D.Bs. (multilateral development banks).

“With the important exception of Tonga, China is currently not a dominant creditor in the Pacific.”

In Samoa, Chinese debt accounts for $410 million, or around 40 per cent of total debt. 

Between 2013 and 2017, Chinese loans paid for the Faleolo International Airport build, the Ministry of Justice and Courts Administration building, the national hospital and the T.A.T.T.E. building, among other projects.

The report suggests China should set out clear policy frameworks on debt and work with other official creditors on their way forward.

More lending rules would, among other benefits, encourage better coordination between China and other official creditors, “with greater information sharing also potentially helping to reduce some of the geopolitical tensions surrounding the B.R.I.,” they suggest.

Rules would also help ensure sustainable debt management by the borrowing countries, including greater involvement of their finance officials, which are often bypassed by more senior political leadership.

 “The most important conclusion from our scenario projections is that China cannot remain a major lender in the Pacific at the same scale as in the past without fuelling significant debt sustainability risks in most of the countries in which it is currently active,” the report states.

“Even the provision of more concessional loans would likely prove problematic if at the same scale as the past. While China has begun to provide more grant financing to the Pacific, it is starting from a low base. 

“If China wants to remain a major financier in the region without fulfilling the debt trap accusations of its critics, it will need to shift dramatically to provide far more grant funding than loans.

But for the Pacific countries themselves, the report suggest they should take care while taking advantage of the current political climate in the region to push for more grants and favourable loans.

“External players have a responsibility to avoid overly geopolitically-driven financial assistance that risks prioritising short-term wins at the expense of undermining the incentives for reform and better governance that are critical to sustainable development.

“Amid rising competition for influence, the risk of inadvertently creating long-term ‘governance traps’ instead is an equally if not more concerning risk than the potential for debt traps.”

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