China can turn the debt trap of its own making into a historic opportunity

Minxin Pei is Professor of Government at Claremont McKenna College and Nonresident Senior Fellow of the German Marshall Fund of the United States.

When it comes to China’s economic engagement with the developing world, the most controversial aspect has been the massive lending programs that have injected hundreds of billions of dollars in loans into poor countries over the past 15 years. years.

Critics have denounced Beijing’s foreign lending practices as a form of sinister debt trap that ends up turning loan recipients into economic vassal states. Today, however, the other side of this narrative is that China itself has fallen into the debt trap it dug for others.

Following Russia’s invasion of Ukraine, high inflation, rising interest rates and an impending recession in the United States and Europe, many poor countries are facing the worst economic crisis. since the near collapse of the global financial system in 2008.

As they struggle with capital flight, food shortages and falling commodity prices, with the exception of oil and gas, governments in low-income countries will find it increasingly difficult to ensure the service or repay their Chinese loans.

Although there is no official data on the loans Beijing has given to developing countries, China is now the largest official creditor to developing countries. In all likelihood, actual Chinese lending could be significantly larger than most estimates suggest.

An in-depth review of overseas Chinese lending by economist Carmen Reinhart, now the World Bank’s chief economist, and her colleagues in 2018 found that unreported Chinese lending to overseas borrowers, mostly developing countries development, accounted for 15% of the gross domestic product of these countries. produced on average.

As the clouds continue to darken over the global economy, Beijing should brace for a debt crisis of its own.

Sri Lanka’s recent economic collapse is the proverbial canary in the coal mine. The South Asian country’s external debt reached $38.6 billion, or around 47% of its GDP. About 10% of this amount is due to China.

By early 2022, Sri Lanka could not repay nearly $7 billion in debt that was coming due. After Beijing failed to offer debt relief, Sri Lanka opted in April to suspend repayment of part of its external debt pending restructuring. Soon after, massive protests overthrew the government of Sri Lanka.

Demonstrators shout slogans during a protest rally against the economic crisis in Colombo on April 19: Sri Lanka is the proverbial canary in the coal mine. © PA

As global economic conditions are set to deteriorate further, many other developing countries are expected, like Sri Lanka, to default on their foreign loans. Many of them are countries that have received hundreds of billions of dollars in loans from China and will present an almost impossible challenge to President Xi Jinping.

Under Xi’s rule, China has vigorously promoted itself as an alternative to the West and generously funded risky projects in developing countries. But now hundreds of billions of dollars in loans that China has extended to poor countries are at risk because the conditions attached to them make them particularly vulnerable to economic downturns.

First, while 55% of loans and grants from Western governments and international financial institutions fund social programs such as health, education and humanitarian programs, nearly two-thirds of Chinese loans have gone to infrastructure.

During an economic downturn, completed infrastructure projects such as toll roads, ports and power plants will generate less revenue due to lower traffic and lower energy consumption, making it more difficult for the projects themselves to generate the revenue needed to service the loan.

Second, because Chinese loans are often backed by resource-generated revenues, the risks of default increase dramatically during a recession, as lower demand typically drives down commodity prices, with the exception of oil this times, because of the sanctions imposed on Russia because of the war in Ukraine. This adds another drag on the revenue needed to cover debt repayments.

China has few good options to get out of this hole it has dug itself. Pressuring insolvent governments like Sri Lanka to service loans in the midst of an economic crisis will be futile and counterproductive. China will not only lose its money, but its reputation will be destroyed in the process. Yet completely canceling the debts will devastate the balance sheets of China’s state banks, which provided these loans, and Beijing will end up having to cover their losses.

The best option for China is to adopt a multi-pronged approach that can save its image and reduce its losses.

The first component should be the cancellation of the debt of the poorest countries. As low-income sub-Saharan African countries account for about half of China’s overseas lending, they should be given priority if Beijing plans to write off a substantial portion of their debt.

The case for canceling the debt of these countries is particularly strong as they are likely to be hardest hit by the global food crisis. China will suffer irreparable damage to its reputation if it continues to pressure these countries to pay their debts when there are bread riots in the streets.

The second component should be debt restructuring. China is expected to cut interest rates, temporarily suspend debt servicing and extend loan terms to stave off the near-term threat of further defaults.

The third prong should be to work with other international donors and lenders. As the world’s largest official lender, China has real leverage. If it can use a debt relief program to encourage other lenders to do the same, China can potentially lead an international effort to help developing countries weather the impending global economic storm.

The upshot is that this may be a historic opportunity for China to demonstrate its international leadership. Ironically, it was China’s financial recklessness, not its strategic foresight, that created this opportunity in the first place.