Belt and Road Initiative: Debt trap and legal resolutions

As a country intending to benefit from the China-led Belt and Road Initiative (BRI) and its development potentials, Nepal needs to consider the criticisms regarding China’s practice of “debt-trap diplomacy.” Nepal also needs to work out the necessary strategies to avoid or escape a debt trap, if it indeed is a substantial threat. Under “debt-trap diplomacy,” borrower countries are unable to pay back to creditors the hefty loans with interest, and creditors are in a position to exert influence over national matters. If this is the case, the next issue is how the law and legal mechanisms may assist Nepal when adopting debt financing for heavy infrastructures.

Firstly, the nature of the debt problem must be understood properly. It is more of a financial issue rather than a legal one. In the BRI strategies, China is, and will continue to grow as, a planner in addition to a leading investor in infrastructure projects that promote greater connectivity and trade. Many BRI countries in Asia, Africa, and Latin America are not only resource-rich or strategically-located, but oftentimes, struggling with weak social, political, and economic institutions. However, these are also the countries that desperately need an economic boost through mobilization of internal and external investment opportunities. They lack the infrastructures to facilitate trade, generate energy, promote the movement of goods and people, and stimulate societal growth, among other things. Needless to say, Nepal falls under this category.

Foreign debt has remained a major issue in international development. Due to the myriad of economic, social, and political obstacles facing such countries, debt trap becomes a major issue when large-scale investments are financed by foreign investors. For a country like Nepal, which has a history of dependence on foreign direct investment and aid, high corruption rates, and slow development, it is important to evaluate the risks of participating in projects under the BRI, as noted above, because the inability to pay back loans can result in a crippling economy, a loss of political power, and, in the worst case, a loss of sovereignty.

Foreign debt has remained a major issue in international development. Due to the myriad of economic, social, and political obstacles facing such countries, debt trap becomes a major issue when large-scale investments are financed by foreign investors. For a country like Nepal, which has a history of dependence on foreign direct investment and aid, high corruption rates, and slow development, it is important to evaluate the risks of participating in projects under the BRI, as noted above, because the inability to pay back loans can result in a crippling economy, a loss of political power, and, in the worst case, a loss of sovereignty.

What does the debt trap look like?

The Center for Global Development’s policy paper entitled “Examining the Debt Implications of the Belt and Road Initiative from a Policy Perspective” (CGD paper) examines the likelihood of problems related to debt sustainability (i.e. rising debt-to-GDP ratios) in 68 borrower countries; it found that eight were particularly vulnerable to debt distress (this did not include Nepal). Among these eight is neighboring Pakistan that has allegedly been charged a 5 percent interest rate on the China-Pakistan Economic Corridor projects that amount to approximately $63 billion, of which $33 billion is invested in infrastructure projects.

Similarly, lawmakers in Myanmar are increasing pressure on the government to pay back its $4 billion debt (with a 4.5 interest rate) to China. Most of the debt is said to have accumulated from 1998 to 2011, when Myanmar was struggling with West-imposed sanctions and only China was willing to lend capital. The debt has caused the government to scale back parts of the Myanmar-China Economic Corridor as well as reexamine the terms of a $10 billion, China-funded port project.

Among the critics of the BRI, Sri Lanka has become an example of how developing countries fall into China’s “debt trap.” In late December 2017, Sri Lanka handed over its Hambantota port and 15,000 hectares of the surrounding land to China on a 99-year lease to pay off $1.1 billion in debt. According to a New York Times investigation, large sums of money “flowed directly to campaign aides and activities for Mr. Mahinda Rajapaksa [(the previous president)], who had agreed to Chinese terms at every turn and was seen as an important ally in China’s efforts to tilt influence away from India in South Asia.” Additionally, Sri Lanka continued to accumulate debt to China with interest rates higher than those offered in the international market. Many questioned why the funding was approved when preliminary reports indicated that it was not a profitable project.

Indian scholars argue that the debt trap is caused primarily because of China’s high interest rates, and that countries, like Sri Lanka that handed over the China-funded Mattala Rajapaksa International Airport (MRIA) to India to operate, could benefit from low-interest loans of 1 percent from India. Additionally, Indian critics, like Brahma Chellaney, are especially fearful that China’s “imperial giant’s velvet glove cloaks an iron fist – one with the strength to squeeze the vitality out of smaller countries.”

How does China handle debt trap?

These issues beg the question of how China has and will approach projects that face issues of debt repayment. The CGD paper explains that China has largely dealt with the issues in a case-by-case manner. This has included writing off debt in exchange for disputed territories, forgiving or restructuring debt, and debt-for-equity swaps. However, if China officiates a single, integrated approach, smaller countries will gain more confidence regarding avoiding the issues of a debt trap.

China is also encouraged to join, rather than just observe, as it is doing currently, the Paris Club. The Paris Club is a “non-institution” institution comprising of 22 permanent members that are largely western, creditor nations. The objective of the Paris Club is to “find workable solutions to payment problems faced by debtor nations” that demonstrate a need for debt relief and a willingness to implement the International Monetary Fund’s (IMF) suggested economic reforms. The Asian Development Bank, where China has the third highest voting power, is also an attending member. At the least, China is advised to coordinate its efforts of handling debt with the Paris Club and show transparency in its lending. China’s presence certainly shows that China takes the allegations seriously.

How can Nepal approach the problems of debt traps?

Despite these “debt traps,” countries, including Nepal, will continue to approve China’s investment. Sri Lanka and China are expected to sign a free-trade agreement this year to encourage Sri Lankan exports to China. The Sri Lankan ambassador to China has emphasized that the BRI is a great opportunity to make Colombo Port city a financial center in South Asia. Moreover, China and Singapore are in negotiations with Sri Lanka to invest $1.1 billion in cement and steel plants.

There are various measures that Nepal can implement to prevent debt trap from becoming a reality. For domestic debt, in The Debt Trap in Nigeria: Towards a Sustainable Debt Strategy (2002), authors Okonjo-Iweala et al. argue that the inability of a weak legal and institutional framework, especially at the local levels, to handle public resources can lead to the mismanagement of economies and the problems related to debt overhang (p. 11). Legal reforms should focus on encouraging “effective and efficient utilization of present and future public resources [and] would ensure probity in public resource use, due diligence, transparency, and accountability …” (p. 16). The logic applies in the case of international investment as well.

Additionally, the existence and safeguarding of legal protections are also necessary in ensuring that assuming foreign debt is seriously considered by both the government and the public; for example, the Constitution of the Philippines allows the President to contract foreign debt only at the approval of the Monetary Board, and local laws ensure public participation via governmental representatives.

The CGD paper suggests that China needs to engage in multilateral lending practices of debt sustainability (e.g., transparency and concessionality) that is largely lacking in its bilateral lending practices. It furthers two recommendations to China: “1) to finance technical legal support to developing country borrowers, through new and existing multilateral mechanisms; and 2) to offer debt swap arrangements in support of environmental objectives” (p. 24). Additionally, Nepal itself needs to ensure the right funding plans, whether that’s grants or soft loans, are in place for large infrastructural projects like the trans-Himalayan railway or the Budhigandaki Hydropower Project.

Borrower countries will accumulate significant debt if the projects do not produce anticipated profits. Therefore, it’s important to study and evaluate which infrastructures are essential to the country’s development and will stimulate the economy via, for example, trade, employment, and further investments. For example, in the Philippines, the “combination of domestic economic demand, diversity in aid funding, and a contentious political culture and civil society make a Chinese-dominated debt trap unlikely.”

Furthermore, the current administration in the Philippines is ensuring that China has no sway in deciding which projects the Philippines ought to pursue; additionally, only after gaining project approval from the National Economic and Development Authority Board can the government of the Philippines take its proposal to the Chinese government. Typically, the government of the Philippines asks for at least three bidders nominated by the Chinese government, so that it is also involved in the process of picking the bidders and can be held accountable.

For countries that find themselves entrapped in debt, debt restructuring (i.e., reconsidering the terms and due dates of debt toward the advantage of the debtor) is a common tool used for resolution. In 2018, China engaged in talks about debt restructuring with Zambia after warning from the IMF about an impending debt distress. (27 percent of Zambia’s external debt is owed to China.) Scholars recommended that Zambia should increase transparency of its debt and perform a review of and strengthen its existing debt-management system. Moreover, others argue that, unlike the Western approach of measuring a project’s “success” in five years, the return on investment on China-funded infrastructure projects should be considered in a longer term of one to two decades.

What can we take away for Nepal?

Some experts opine that the debt traps caused by China’s investments counter China’s own interests and are not motivated to gain influence; in many cases, China is the only available lender of construction services or capital (as was the case with Myanmar). Debt traps would also pressure China’s foreign-reserve exchanges, as investments in infrastructure projects are funded by said exchanges. With BRI projects’ cheap financing and Chinese companies’ willingness to take on unprofitable projects, China would lose more if debt traps are widespread.

Additionally, some argue that corruption and political interests, not Chinese investments, are major factors in projects turning over a loss and entrapping governments in unsustainable debt. Even still, the BRI has been accused of enabling and sustaining corrupt authoritarians who accept bribes or embezzle funds so that the country eventually goes into severe debt. Demanding transparency about the funding agencies and discouraging anonymity of investors will be important solutions in this regard.

Criticisms about debt trap vis-a-vis China-funded projects often originate from Western media and, in the case of Nepal and other smaller South Asian countries, India. Recently, US Vice President Mike Pence criticized China for drowning borrower countries in debt from loans they cannot afford. In response, China has emphasized that BRI projects have helped with development and improved livelihoods. (Currently, the US is promoting the Asia Pacific Economic Co-operation (APEC), a counterpart of the BRI, to promote free trade in the region.)

On a positive note, China has defended the BRI and demonstrated its support for multilateralism and global governance standards. The Center for Strategic and International Studies estimates that the infrastructure needs of the developing parts of the Asia Pacific will require $26 trillion by 2030, and China has only pledged $1 trillion; this clearly indicates that the BRI is an opportunity for multilateral and private investors from the West, and not a Chinese hegemony. Therefore, Western critics and nations also have an equal opportunity to invest and demonstrate what they preach.

Moreover, critics accuse the West of misrepresenting cases that supposedly exemplify China’s practices of “debt-trap diplomacy.” While the New York Times suggestively claimed that China forced Sri Lanka to “cough up a port” to pay back a part of its loans, local coverage of the exchange shows that it was Prime Minister Ranil Wickremesinghe who suggested the exchange during talks of debt restructuring, and it was largely perceived as a positive development. Similarly, others point out the requirements of IMF’s loan conditionality has hurt Pakistan’s economy and required multiple bailouts by IMF itself, further indebting Pakistan.

Lawrence Freeman, a political-economic analyst, stresses that the accusations of debt trap are Western “propaganda and gossip” against China; he points to the British Jubilee Debt Campaign’s 2018 brief entitled “Africa’s growing debt crisis: Who is the debt owed to?” which shows that the maximum debt owed to China by African countries is estimated at $100 billion or 24 percent of the total debt. The rest is owed to a combination of other creditor groups: members of the Paris Club, the World Bank, the IMF, other multilateral institutions, and the private sector (excluding that of China).

Debt trap is definitely an important consideration for Nepal as it joins the BRI. As of early 2018, foreign debt comprised of 16.9 percent of the total GDP and was owed largely to multilateral institutions like the World Bank and the Asian Development Bank followed by Japan, China, and India. The CGD paper does not consider Nepal to be at risk of debt distress, and Nepal has actively engaged in talks with China about bilateral lending for infrastructure projects. As far as China is concerned, it has always been considerate in its engagements with Nepal. This relationship is a major strength in dealing with a debt-trap scenario.

Debt trap is definitely an important consideration for Nepal as it joins the BRI. As of early 2018, foreign debt comprised of 16.9 percent of the total GDP and was owed largely to multilateral institutions like the World Bank and the Asian Development Bank followed by Japan, China, and India. The CGD paper does not consider Nepal to be at risk of debt distress, and Nepal has actively engaged in talks with China about bilateral lending for infrastructure projects. As far as China is concerned, it has always been considerate in its engagements with Nepal. This relationship is a major strength in dealing with a debt-trap scenario.

Every investment assumes a reasonable level of risk. Most importantly, Nepal needs to carefully evaluate the process of selecting projects, of creating an investment portfolio (including considering the debt-to-equity ratio), and complying with the established laws and policies. The decision-making process must be based on the rule of law and the transparency of transactions. A competitive bidding process must not be compromised either. Additionally, the Nepali public should demand the opportunity to bring forth its concerns and actively engage in the process of finalizing important deals. Successful outcomes will depend on how well Nepal is able to negotiate the process of securing loans, resolve arising issues, and cultivate an environment that is conducive to sustainable investment and growth.

Dr Bipin Adhikari is a constitutional expert and is currently associated with the Kathmandu University School of Law. Bidushi Adhikari is associated with Nepal Consulting Lawyers, Inc as a research assistant.