**2. Chinese "debt trap": the cases of Sri Lanka, Pakistan, Ecuador, and parts of its mechanism**

A China expert Tom Miller, in his book *The Chinese Asian Dream*, explains the distribution of Chinese growth model in Asia and also mentions some examples of the countries that have fallen into so called Chinese "debt trap" including some from Central and Southeast Asia [9]. His story can be expanded beyond 'Belt and Road' initiative as it reminds of the history of China's work in Africa from 2006 to 2010, when, in 2007, Beijing was forced to write off foreign debt to 33 African countries, due to their insolvency - totaling \$1.5bn [10]. Among rich international experience of debt cooperation with China three cases can become the description of its political economic interconnections: Sri Lanka, Pakistan, and Ecuador.

#### **2.1 Demonstration cases of Chinese "debt trap"**

#### *2.1.1 Sri Lanka*

This case was among the hottest example of Chinese "debt trap" in international media in 2010s. Between 2010 and 2015, 70% of infrastructure projects in this country were built and funded by China. China built an airport, expressways, power plants, a cricket stadium, conference centers, office buildings, residential areas and more. There were cases reported in international media when, during the construction process, Chinese contractors increased the cost of the project by

#### *Belarus-China: Avoiding the "Debt Trap" DOI: http://dx.doi.org/10.5772/intechopen.96858*

40–60% of the original, which was sometimes associated with changes that the customer made to the project. In addition, claims arose regarding compliance by Chinese contractors with construction and other national standards. To finance the construction of these facilities, Chinese commercial banks provided loans at a market rate of about 6%, sometimes it reached 8.8%. When the government changed in Sri Lanka in 2015, all these issues began to be discussed publicly. In early 2015, the country's finance minister said that to resolve debt problems with China, an agreement was reached with a Chinese bank on a large new loan at 2%, for refinancing an old loan at 6.9% [9]. Among the most publicly discussed projects were the airport and seaport. The project to build an international airport in the city of Mattala caused a public outcry when Beijing refused to take it for itself instead of paying off the loan issued for its construction [11]. According to the seaport project in the city of Hambantota, the Government of Sri Lanka, following negotiations related to difficulties in servicing the Chinese loan received for construction, announced to give the port to China for 99 years [12]. But by now Sri Lanka still keep this project under its control.

To conclude one needs to look away from popular media narratives and see the broader picture. As of 2019 China holds only 10 percent of Sri Lanka's foreign debt, Japan and the World Bank hold 11 percent each, the Asian Development Bank – 14 percent, private sector – 39 percent. As Sri Lanka did not defaulted on China's debt, this case seems to be publicly overheated.

### *2.1.2 Pakistan*

It is difficult to imagine a more favorable and 'all-weather' political relationship with China than that of Pakistan. The China-Pakistan economic corridor was positioned as a model project of the 'Belt and Road' initiative. For this purpose, investments of \$46bn were announced — comparable to 17% of Pakistan's GDP in 2015 [1]. Previously, a major Chinese project in Pakistan was the Gwadar port, which was under construction since 2000, having been leased to China in 2013. It seemed that the excellent political relations between Pakistan and China would create appropriate conditions for the implementation of joint economic projects. However, in July 2017, Pakistan's Prime Minister, Nawaz Sharif, was removed from power. In early 2018, Pakistan publicly rejected a \$14bn project with China to build a hydroelectric complex, due to unfavorable contract and loan terms offered by the Chinese. In September 2018, the media reported that the new government of Pakistan was discussing the possibility of reviewing the terms of construction of the China-Pakistan corridor. Debt relief was put on the bilateral agenda, but it did not stop Pakistan from attracting new loans from China. The Belt and Road initiative had found new life in Pakistan in 2020 with the signing of \$11 bln worth of projects.

Looks like the countries passed the phases of short-term debt challenges, overcame COVID-19 consequences and opened new chapter in bilateral investment cooperation.

#### *2.1.3 Ecuador*

On December 12, 2018, the President of Ecuador, Lenin Moreno, visited Beijing and met with Chinese Chairman Xi Jinping. A week before, Mr. Moreno announced that the goal of his talks in China was to reduce the \$6.5bn debt burden owed by the government of Ecuador. However, the projects built at the expense of Chinese loans (HPP, roads, bridges and hospitals) had not accumulated the necessary money to repay debts. For example, a large hydroelectric power plant built near an active volcano was operating at half capacity, and a loan from Export–Import Bank of

China for \$1.7bn (for 15 years at 7%) required maintenance of \$125 m per year [13]. At the same time, the government of Ecuador faced a drop in export revenue due to lower prices for oil - its main export product, so the country's authorities also had difficulties in repaying the loan [14]. The meeting between Moreno and Xi resulted to a new loan of \$900 m to refinance the part of existing one. In September 2020 Ecuador has reached another deal with Chinese Eximbank to delay a \$474 m loan payment due 2020 and 2021 until 2022. This case shows that even if Chinese "debt trap" exists it has its ways out.

These three cases raise the question: why some developing countries choose to attract Chinese loans and get into so called Chinese "debt trap". To answer this question, several parts of "debt trap" mechanism should be analyzed sequentially.

#### **2.2 Parts of the "debt trap"**

#### *2.2.1 Project choice*

The "debt trap" is related to project lending, so the project itself (for example, the construction of a power plant, a road, or a factory) is of primary importance, rather than being the source of its financing. China does not initially offer a loan, but participates in a tender for the construction of a project, together with a loan. The main question is who chooses the project, and how. In practice, it's the customer who proceeds from a business plan and feasibility study. The choice of an infrastructure project is often made at the request of authorities, compared with other countries, and very often is not based on an assessment of the potential demand for the object. The expectation that planes and ships fail to come to Sri Lanka just because there is no airport or seaport there is wrong. Other conditions are also important, such as security, service, price, and the so called friendly business environment. Therefore, the problem of choosing a project by the state is not only a matter of business planning and preliminary assessment, but also the overall quality of economic policy and the competence of the state apparatus.

Developed countries are less prone to the "debt trap", not because they have their own funding for projects, but because they have different decision-making procedures, checks and balances, and political responsibility. Before accusing China of undertaking projects that are ineffective, it is important to answer two questions. The first is whether there are still problematic projects in the country that were implemented by non-Chinese companies. The second is, are there any successful projects that Chinese companies have implemented in the country? If both questions are answered in the affirmative, then it should be concluded that the problem is rooted not in China, but in the customer or in the project itself.

#### *2.2.2 Contractor choice*

Accusations that the services of Chinese contractors are expensive and do not meet standards should take into account that the choice of a contractor is usually based on an international tender. An exception is the case when China provides a preferential loan, then the tender is held among Chinese companies identified by the Ministry of Commerce of the PRC. However, the main question is why a Chinese contractor wins an international tender. Does this happen because of price, technology, brand, stated deadlines, or corruption? Chinese contractors sometimes mention that "it is impossible to get a Lexus car for the price of an Opel car". However, this is often what the customer from developing country expects. Therefore, low price and high speed are often accompanied by cheaper prices, due to the Chinese contractor ignoring national norms. Forcing a Chinese contractor to comply with

#### *Belarus-China: Avoiding the "Debt Trap" DOI: http://dx.doi.org/10.5772/intechopen.96858*

national standards during the construction of a project sometimes leads to a higher cost. It is also important to take into account that the cost of the commercial offers by Chinese companies was lower than of their competitors during tenders, but was growing annually. For example, from 2005 to 2008, Chinese offers were 40–50% cheaper than those of competitors but, from 2009 to 2011, the figure dropped to 30%. Later, they were cheaper by only 5–10%, if available.

It is also important to note that choosing a contractor is a negotiation process, and the Chinese are skilled and experienced negotiators. They understand not only the technical details of the project, attracting the best engineers, and preparing contracts attracting professional international lawyers, but also the cultural issues and psychology of partners, primarily looking at the decision-making levels, subordination, and weaknesses of the other side. As a result, when choosing a contractor, Chinese companies beat not only their competitors, but also the customer. It's only possible to counter this with professionalism, which developing countries clearly lack.

### *2.2.3 Lender choice*

Tied export lending is an international practice and is usually offered by each bidder. In the Chinese case, the tied loan is long-term, up to 15 years, and usually covers 85–95% of the commercial contract, while 30–50% of the contract must be related to the work of Chinese builders and suppliers. All these provide three advantages.

Firstly, the borrower does not need to divert significant amounts of their own funds in the current period to implement the project: but only in the future — in around five years — to repay the loan within a usual 10-year period.

Secondly, as this loan covers 85–95% of the cost of projects, so the customer only needs to find the missing amount for advance payment. The targeted nature of tied loans implies that they cannot be used in the financial market, for example, to manage the exchange rate. Therefore, the risks of tied loans are limited primarily by the microeconomics of the project, and then by the country's macroeconomics. At the same time, the Government guarantee provided for a tied loan sometimes reassured the lender, who was less concerned about the project and more about the state's solvency.

Thirdly, as 30–50% of the cost of a commercial contract would be covered by Chinese companies, the remaining currency, up to 50–70% of the contract value, was spent on the purchase, the main equipment of a Western brand, and payment to domestic designers and builders. If a Chinese tied loan is preferential (at the rate of 2–3%), then the Chinese share must exceed 50% of the contract (60% from 2019). If it is commercial (at a market rate and linked to the LIBOR, with insurance), then the share must be at least 30%.

The cost of commercial Chinese credit provided by such banks as Export– Import Bank of China, China Development Bank, ICBC, China CITIC Bank, and others depends on the country's internal rating and funding opportunities of the banks themselves, and ranges from 5–9%. This should be supplemented by an insurance of the China Export and Credit Insurance Corporation, Sinosure, with a premium of 6–9% — which is less than the insurance of Western insurance companies for developing countries with a premium of 8–12%. In the case of preferential Chinese loans provided by the Chinese Government through Eximbank of China, insurance is not required, while the interest rate ranges from 1–3%. In general, the final rates of Chinese loans are competitive, and, given cheaper insurance, the borrower is inclined to choose financing from China. To avoid the "debt trap" concern, customers can use their own resources to finance a project: i.e. attracted untied

loans from the international market (for developing countries, the rate — depending on the rating — ranges from 4–7%, which is comparable to Chinese commercial loans) or borrowed from international financial institutions (the rates of the IMF, and the World Bank can be 1%–2.5% which is comparable with the rates of concessional loans by the Chinese Government). Overall, the choice of a lender, as well as the choice of a project and a contractor, is the right of customers and depends on their competence.

Accordingly, the "debt trap" is a concern for weak borrowers who are not able to stop building up their debt in time, or are not ready to show skill in managing it. All these problems of the developing country's government — as a customer of the project and a borrower — are actively used by the opposition in the political struggle. The latter tries to solve problems of external public debt, not by changing internal procedures and economic policies, but by accusing the current government first, and then, when it comes to power, external forces - in this case China, as a major creditor.
