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Home»Finance»Beyond Debt: China-Sri Lanka Economic Relations in a New Era
Finance

Beyond Debt: China-Sri Lanka Economic Relations in a New Era

January 15, 2025No Comments11 Mins Read
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Beyond Debt: China-Sri Lanka Economic Relations in a New Era
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Sri Lankan President Anura Kumara Dissanayake’s visit to Beijing from January 14 to 17 is his second foreign trip following a mission to India last year. While his trip to India reflected its status as Sri Lanka’s major economic partner, his trip to China also signifies the country’s importance in Sri Lanka’s economic recovery and growth. Dealing with debt will be high on the agenda – but it is investment rather than loans from China that Sri Lanka will need to prioritize. 

Dissanayake’s election in September 2024 was an important political landmark that demonstrated the huge public backlash against establishment politics following the forced resignation of then-President Gotabaya Rajapaksa amid island-wide protests. Dissanayake and his National People’s Party (NPP) represent a new alternative to the political parties that had governed Sri Lanka over the last seven decades. Through the election victory, and its subsequent win in the parliamentary polls, the NPP was given a mandate to address bribery and corruption, punish those involved in the devastating 2022 Easter attack, reduce tax burdens, and provide more relief to the poor.

Although his campaign had implied it would renegotiate Sri Lanka’s debt restructuring, upon becoming president, Dissanayake proceeded with the previous agreement in principle that was reached with private creditors under the former president’s tenure. While this ends Sri Lanka’s sovereign default and reopens market access, accessing development finance will be critical in supporting the country’s path to transformative growth.

Wiping the Slate Clean

Alongside its role as a prominent trading partner and a major source of imports, China has been Sri Lanka’s major lender and source of foreign direct investment for the last 15 years. Dissanayake’s visit to China is also notable given the role of Chinese creditors within Sri Lanka’s sovereign borrowing, which has raised controversy, most notably over (debunked) claims of debt-traps related to Chinese-built port infrastructure in Hambantota.

Sri Lanka’s sovereign default meant that the country has not received any new loans from bilateral or commercial sources. The only loans Sri Lanka received from foreign creditors since its default were from the World Bank and Asian Development Bank. Since 2021, Sri Lanka has not received any new project loans from China, with only budget support loans received from the China Development Bank (CDB) in April and August 2021. Since then, Sri Lanka has not received any loans from China.

Unlike in Zambia or Ghana, where China (via China EXIM Bank) was part of the Official Creditors Committee (OCC), and contributed to a prolonged renegotiation processes, for Sri Lanka, the process has been comparatively smooth. While China EXIM Bank sat outside of the OCC, it was notably the first bilateral creditor to finalize the debt restructuring agreement in October 2023. Sri Lanka completed restructurings with its major bilateral creditors on the OCC along with China EXIM Bank in June 2024, and finalized a deal with the CDB in September 2024.

Under the new administration, restarting flows of development finance from China will be a high priority. Sri Lanka concluded restructuring its International Sovereign Bonds last month. With the exchange concluded, other partners such as Japan stepped up to confirm that they will restart the projects with Sri Lanka that had been halted as a result of sovereign default. Neither China nor any of its policy banks has yet commented on resuming their projects or new lending commitments. Recent experience suggests that China will be more cautious in lending to Sri Lanka given the concerns pertaining to debt sustainability. However, there is a significant amount of undisbursed balance for already committed Chinese loans, most of which were from China EXIM Bank.

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One such major loan involves the Central Expressway, which is one of several mega infrastructure projects initiated by the Sri Lankan government in 2015-16. Sri Lanka had signed a loan agreement with China EXIM Bank to obtain $989 million to construct section one of the expressway, which aims to connect Colombo and Kandy. Audit reports show that only $51 million of the loan was handed over, meaning $937 million remains to be disbursed by China EXIM Bank to continue the project. Construction on the Central Expressway was halted alongside other infrastructure projects due to the budget constraints Sri Lanka encountered during its economic crisis.

With Sri Lanka coming out of default, Dissanayake’s visit to Beijing will be a good platform to announce the resumption of the Central Expressway project, and a potential reset of Sri Lanka’s relations with Chinese financiers and other Chinese state-owned enterprises (SOEs). That said, Chinese institutions are gradually shifting their approach in engaging with Sri Lanka, particularly after the country’s sovereign default.  

For instance, China’s major fuel SOE, Sinopec, has shifted to engage in Sri Lanka as an investment partner as opposed to using debt finance supported by China’s policy banks. Sinopec had already become a fuel distributor in Sri Lanka. Sinopec had also submitted a proposal to construct a petroleum refinery in Hambantota, which was accepted by the Sri Lankan government. The latter is considered to be an investment, which does not involve the Sri Lankan government taking any loan from Chinese policy banks. 

In addition, Sinopec was awarded the refinery project after a competitive bidding process as opposed to unsolicited bidding, which was the frequent practice with previous Chinese SOE contracts. After Sri Lanka declared a sovereign default, the country was compelled not to entertain unsolicited proposals. Sri Lanka had received a few unsolicited proposals to construct a petroleum refinery, but instead of facilitating those the government went ahead with an open bidding process. The practice of Sinopec indicates that Chinese SOEs are adopting to this practice. 

The refinery is supposed to be established in Hambantota with close proximity to the Chinese-built Hambantota port, which had been embroiled in debt trap controversies. The repayment of port loans was not stopped in 2017, as claimed by proponents of the “debt trap” narrative; neither there was an asset seizure. However, repayments on the Hambantota port loans – alongside all other loans – were halted for two years as a result of Sri Lanka’s sovereign default. 

The port is currently managed by China Merchants Port Holdings, and it provides the necessary logistics and support for Sinopec to make the refinery project a success. Recently, Hambantota port expanded its services in the energy sector by offering LPG vessel gas-ups and direct bunker supplies, and the port is focused on promoting the energy sector as a key growth market. The plans for Hambantota port therefore align with the interests of Sinopec. 

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A Shift From Lending to Equity

The recent behavior of Chinese SOEs suggest that they are moving toward equity-based interactions with Sri Lanka as opposed to debt finance, which dominated Chinese SOE projects in Sri Lanka during 2005-2017. During this period, SOE projects were facilitated through Chinese policy bank lending to Sri Lanka. While Chinese policy banks, largely China EXIM Bank, bore the risk of lending, a number of Chinese SOEs benefited through these loans, which won them contracts for large-scale infrastructure projects in Sri Lanka. 

After 2014, this practice was further expanded as the China Development Bank also got involved in expanding the Chinese SOE presence in Sri Lanka. The CDB provided loans to water supply projects carried out under a Sri Lankan SOE, the National Water Supply and Drainage Board, and some of the road development projects carried under Road Development Authority. Contracts were carried out by China National Aero-Technology Import & Export Corporation for the water project, and Hunan Construction Engineering Group Corporation as well as Xi’an Dagang Machinery Corporation in road development.  

The initial sign of a shift from loan to equity finance, and the first case of a Chinese SOE getting involved in a large-scale infrastructure project in Sri Lanka based on equity (without the Sri Lankan government obtaining loans) was the Colombo Port City project. While some have portrayed it as a project funded by loans to Sri Lanka, that has not been the case. While the CDB indeed provided loans to fund the development of the port, the recipient borrower was not the Sri Lankan government but the project developer, China Harbor Engineering Company (CHEC), a Chinese SOE that is a subsidiary of the China Communications Construction Corporation (CCCC). This project was carried out as a public-private partnership in which CHEC carried out construction. The CDB financed CHEC Port City Colombo Ltd, a special purpose vehicle owned by CHEC and CCCC for a 10-year loan of $805 million in 2017, which covered a part of the costs for the first phase of land reclamation. 

While Colombo Port City has not added to the debt burden of the Sri Lankan government, the country’s economic and political challenges have still impacted its progress. A second loan agreement from the CDB was planned to be signed with CHEC Port City Colombo in 2019, this time with the Sri Lankan Ministry of Megapolis and Western Development, for a $100 million interest free loan for an underground tunnel and access road. Although Sri Lanka’s Cabinet approved the loan, it was not obtained. It is not clear whether Sri Lanka would pursue this loan at this point given the restrictions on lending. 

The progress with Colombo Port City, however, has been slow and it had also attracted some criticism, one of which was the major issue of sovereignty, as the port city (as a special economic zone) will be governed by a different law. The fact that port city was viewed as a “Chinese project” also discouraged investment from China’s rivals such as India and from Western firms amid deepening geopolitical rivalries.

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Currently, Sri Lanka is in the recovery phase following its sovereign default and the country is required to bring down the public debt to GDP ratio to 95 percent by 2032 as per the IMF targets. This means Sri Lanka is restricted from borrowing heavily for development projects. For the time being, Chinese SOEs have slim chances to obtain contracts for new infrastructure projects funded by the Sri Lankan government. The “wait and see approach” of Chinese policy banks has led some SOEs like Sinopec to shift track, from debt finance to direct FDI.

Future Directions

As Chinese banks are likely to remain risk averse for the time being, direct investment from SOEs and private companies is likely to be a more prominent source of infrastructure finance going forward. Trends in FDI from other parts of the Global South such as Africa indicate that lending from policy banks has been slow to recover, though FDI has grown. Recent policy discourse also indicate a shift in China’s overseas engagement from direct lending toward investment promotion.   

What does this all mean to Sri Lanka and its Chinese counterparts? 

Sri Lanka is currently faces a challenge in stimulating growth given the constraints on increasing government expenditure and the need to increase tax revenue. Thus far, Sri Lanka has been relying on loans from multilateral banks to manage finances. As the country comes out of default, it will need foreign investment and budget support from other sources, bilateral partners in particular. Being a country with a trade surplus and major FDI provider, China remains a key bilateral partner for bringing investment to Sri Lanka. 

Such investments should be complemented with increasing trade. Sri Lanka’s exports to China have been less than 5 percent country’s total exports and have not grown considerably over last decade. Low export revenue was one of the major long-term causes for Sri Lanka’s default. To address that and avoid future defaults, Sri Lanka must expand its exports to China as well as India, two of the biggest markets in Asia.

In terms of attracting Chinese investments, Colombo Port City and Hambantota port both have significant potential. Under a new phase of the Belt and Road Initiative, Chinese companies and investments should fulfill the promises of these projects and support greater investment and trade. Dissanayake’s visit to China would be a good stepping stone to restore Chinese investor confidence in Sri Lanka, and to accelerate the development of both the Colombo Port City and Hambantota projects, where Chinese SOEs are involved as major stakeholders and operators in both. 

The Sri Lankan president’s visit and negotiations with his Chinese counterparts will be crucial to navigate the evolving bilateral relations, amid an increasingly complicated geopolitical landscape, and to reassert Sri Lanka’s balanced approach in working with its regional partners. 

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