Assessing China’s most comprehensive response to the “debt trap”: the Belt and Road ‘Debt Sustainability Framework’

Ma Xinyue argues that debt financing along the Belt and Road is as much a “trap” for debtors as it is for China

One of the most significant and anticipated outcomes of the second Belt and Road Forum held in Beijing this April, was the Debt Sustainability Framework for Participating Countries of the the Belt and Road Initiative (BRI-DSF) issued by China’s Ministry of Finance (MOF). Developed on the basis of the IMF/World Bank Debt Sustainability Framework for Low Income Countries (LIC-DSF), the framework offered some response to the barrage of accusations of China’s use of “debt diplomacy” along the Belt and Road.

Behind the politicized and moralizing tone of the “debt trap diplomacy” narrative is a question over “debt sustainability”, a question which concerns the economic health of both borrower and lender. Before labeling China’s Belt and Road financial behavior as a “trap,” this complex issue deserves diving into.

This prompts us to ask some sets of questions. Firstly, is China actually creating debt sustainability issues? If so, what’s the scale and nature of the problem? Secondly, how does the BRI-DSF absorb and differentiate from the existing debt sustainability frameworks? How sound is this framework? And lastly, what is the implication of this framework on China’s overseas presence? Will it solve the problem and alleviate risks of debt sustainability? If not, what else does it take?

“Debt trap” or “creditor trap”?

China’s debt financing to other countries in the world have mounted since the end of the financial crisis in 2009. In the energy sector alone, China Development Bank and the Export and Import Bank of China have lent $245 billion to other countries between 2009 and 2018, based on calculation from Global Development Policy Center. A newcomer to the scene of development finance, China indeed brings striking volumes of loans and investment.

The “debt trap diplomacy” narrative interprets China’s overseas finance behaviors as state-driven political leverage to gain influence over other countries by bankrupting its partners and bending them to its will (see for example, John Pomfret’s 2018 opinion piece in the Washington Post). A “snappy phrase invented by an Indian polemicist”, as Chas Freeman, the former U.S. diplomat to China puts it, the narrative has been popularized by media and politicians, especially in the U.S., criticizing the Belt and Road (e.g. Mike Pence, 2018; John Bolton, 2018). The most frequently referred to case is the Hambantota Port project in Sri Lanka, which was handed over to a Chinese company on a 99-year lease. Concerns about Chinese loans have also been raised in regards to the Maldives, Pakistan, Venezuela, and many more.

Such arguments have been refuted by the Chinese government as well as some recipient country governments. Both the Central Bank of Sri Lanka and Government of Pakistan that these two countries’ debt to China are only about 10% of their external debt, a fair share of which are concessional loans lower than market rates. Officials from the Philippines, Uganda, and Sri Lanka – to name a few – have also publicly defended their debt from China. Some scholars have also exposed the narrative.

The Center for Global Development – a Washington D.C.-based think tank – made the first systematic attempt to assess the debt implications of the BRI. Using a list of BRI lending pipeline deals compiled from public sources, they estimated immediate marginal impact of potential BRI projects on countries’ debt to GDP ratio – a “worst-case scenario of future debt,” and identified eight countries where debt to China might push their debt to GDP ratio beyond thresholds of 50-60% of GDP. It also listed a compilation of debt renegotiation and relief given by China since 2000, which were further explored by reports from Rhodium Group and Oxford Africa China Consultancy – even though the debt cancelation is said to have only been for overdue zero-interest loans, which are part of China’s foreign aid program.

The China-Africa Research Institute at Johns Hopkins University (SAIS-CARI) and the Global Development Center at Boston University (BU-GDP Center) published similar but empirical analyses of the debts of Africa and Latin American and the Caribbean countries to China based on their debt profiles and recorded debts to China. These reports found that, in the majority of cases, debt to China takes up a small share of countries’ total public debt, although in a handful of debt troubled African countries (Zambia, Djibouti, for example), debt to China does take up a significant share of their external debt, and they are also among the biggest borrowers from China.

Xinyue Figure 1 v2
Figure 1. Changes in PPG debt by source for Bolivia, Ecuador, Guyana, and Jamaica 2004-2016, Source: Rebecca Ray and Kehan Wang’s calculations using Gallagher and Myers (2019), World Bank IDS and MDB annual reports

The shared conclusion from these reports is that BRI will not likely be plagued with widescale debt sustainability problems, even though it is also unlikely that the initiative will avoid any instances of debt problems among its participating countries. A more recent working paper published by the World Bank also attempted to evaluate the long term debt dynamics impact of China’s loans, taking BRI investment related growth into account. Availability of credible data remains a constraint for these papers. Yet of the 30 countries included in their long-term debt dynamic simulations, in only in 2 countries BRI debt financing would result in increasing debt vulnerability.

Worth noting, however, is that debt relief and restructuring is both relatively common (recorded instance of relief so far reach $9.8 billion) and tends to favor the borrower country. In this light, the “debt trap” might seem more of a “creditor trap” for China than for the borrowing countries, as Stephen Kaplan puts it when analyzing the case of Venezuela. Indeed, from a geopolitical perspective, it is strategic for China to hold leverage in security choke points in case of fundamental disruption of global stability or an outbreak of war. However, financial leverages do not automatically translate into political leverages. Venturing to confiscate its debt-financed assets would mean risking all credibility and reputation for any other international engagement.

On the contrary, China faces more risks giving away debts in financially vulnerable countries. In cases of real financial distress such as Venezuela, China’s debt renegotiation might come with more loans issued in the same country in the hope of generating revenue and recovering the previous loans. Deutsche Bank was recently reported to have confiscated 20 tons of  gold that backed Venezuelan debt, but we don’t see Chinese financial institutions making similar moves.

The Challenge for Development Finance

Public debt financing is a common practice in all countries across the world, even though typical practice of each country varies by a great deal. For example, according to IMF, as of 2017, the general government debt to GDP ratio ranges from 9% (Estonia) to 238% (Japan). As stated in the Addis Ababa Action Agenda, borrowing is an important tool for financing investments critical to sustainable development and covering short-term imbalances between revenues and expenditures. Government borrowing can also allow fiscal policy to play a countercyclical role over economic cycles.

Nevertheless, whether high debt to GDP ratios have an impact on a country’s economic performance is much-debated. Most economists agree that there are no certain thresholds or ideal levels of debt to GDP. Rather, it is the dynamics of debt that matters more. The simple logic of debt sustainability is that, as long as the rate of public debt increase does not continuously exceed the growth rate of the government fiscal balance, public debt is sustainable and will not affect economic activity in general.

Then comes the dilemma: given the urgent need to address the Sustainable Development Goals, public expenditure has to increase, but in many countries, the government’s fiscal space is cramped. Scaling up public expenditure requires debt finance, which in many cases would consume primary balance that could have been used for urgent public investment such as physical and social infrastructure development. But if done right, such financing should serve to strengthen the primary balance by facilitating economic and social development and by increasing tax revenue in the long run.

Debt Sustainability Frameworks for the Belt and Road

To “promote economic and social development of Belt and Road countries while maintaining debt sustainability”, China’s Ministry of Finance published its Debt Sustainability Framework (BRI DSF) at the April Belt and Road Forum. The BRI DSF is almost exactly based on the 2017-reviewed version of the IMF/World Bank framework for debt sustainability analysis.

As part of the IMF’s efforts to better detect, prevent, and resolve potential crises, the Fund introduced a formal DSF in 2002. To guide borrowing activities in low-income countries (LICs) in a more nuanced manner, the World Bank and IMF also launched a joint framework for debt sustainability assessment for LICs in 2005. The World Bank and IMF now jointly produce Debt Sustainability Assessments (DSA) for the applicable countries at least once every calendar year, and provide templates for these exercises. Chinese lenders could therefore use the IMF/World Bank assessments as a baseline to guide their activities.

The IMF/World Bank DSF – to which the BRI DSF is aligned – operationalizes debt sustainability management by assigning different thresholds of multiple debt indicators for groups of countries according to their debt carrying capacities, and provides risk ratings based on evaluations of the baseline projections and stress tests relative to these thresholds combined with indicative rules and staff judgment. The 2017 revision adjusted the thresholds with an effort to eliminate conservative bias. It incorporates more factors into the country classification methodology to estimate countries’ debt-carrying capacities.

All of these improvements are also incorporated in the BRI DSF. The only difference in the BRI DSF is in the stress test element. The BRI DSF includes an additional “new borrowing shock” stress test, adding greater stringency to the test.

Both frameworks adopt the same standards for identifying low income countries (based on their eligibility for concessional financial resources). As of May 31, 2019, 47 of the 131 countries that have officially signed BRI cooperation agreements with China are included in the List of LIC DSAs for PRGT-Eligible Countries. The graph below shows the distribution of debt stress risk ratings of these LICs from low to in distress. In addition, another 11 BRI countries not in risks of debt distress have been assigned suggested debt limits in General Resources Account (GRA) arrangements.

BRI Main map (v2)
Figure 2. Risk Profile of BRI Countries with IMF/WB Debt Sustainability Assessment, Source: IMF

For countries in debt stress or at high risk of debt stress, including some countries with moderate risks of debt stress, IMF and the World Bank would advise them to avoid or limit non-concessional borrowing (NCB) (or only accept in exceptional cases), and provide limits for concessional borrowing to some countries, leaving space for grants. For countries with moderate or low risks of debt distress, borrowing would be advised to be assessed on a loan by loan basis, with the option to request borrowing ceilings.

Of the 39 BRI countries subject to IMF/World Bank Group debt limits conditionality, 15 are subject to zero-NCB limit, 8 are subject to non-zero NCB limits, and another 16 are not subject to debt limits or have targeted debt limits, showing a rather balanced risk distribution. (Note that this does not represent the amount of loan granted to each group country, and thus does not accurately reflect actual risk portfolio of China’s overseas development finance.)

The Future with “Cautious Capital”

The DSF risk assessments already inform lending policies of other creditors including many Multilateral Development Banks (MDBs). With the issuance of the BRI DSF, China seems ready to adopt the mechanism too. For China, this is unequivocally a critical step in risk management for Chinese creditors and constructive response to the debt trap diplomacy theory.

According to very rough estimates using the available second hand compiled databases for the stock of China’s overseas debt finance, about 14% to 18% of China’s overseas development finance in BRI countries goes to LIC countries with debt limits, while the number of these countries (39) account for 30% of the BRI countries, indicating that those countries already receive less finance on average from China than non-LIC countries. Given that these estimates are based on flows of commitment rather than debt outstanding, some of these loans are likely to have already been paid off. Nevertheless, considering the sheer volume of China’s overseas finance, this would have been enough of a risk portfolio for China to manage, and also significant enough debt burdens for the recipient countries as well. Future credit making will require much prudence so as to gradually improve these situations.

Such caution has already been shown in the recent trend of China’s overseas development finance flows (See Figure 2 taking China’s overseas development finance in the energy sector as an example). Observers have witnessed a clear downward trend in China Development Bank and Export-Import Bank of China’s overseas energy finance since the peak in 2016. Where there is relatively reliable data, similar trends are also seen in the cases of all-sector official loans from China to Africa and Latin America. This trend also coincides with recent downward trends over all in the emerging markets and development countries, China’s stagnant FDI flows and overseas contracting activities, as well as strengthening domestic and cross-border financial and capital account regulations.

China overseas finance trend
Figure 3. China’s Annual Overseas Development Finance in the Energy Sector (million$), Source: Boston University, Global Development Policy Center, China’s Global Energy Finance Database

While the strengthening risk-management mechanism demonstrates China’s willingness for responsible engagement with the Belt and Road countries and better alignment with multilateral efforts, this trend also further stresses the inherent challenge of development finance, which carries the crucial function of correcting market failures and providing countercyclical financial resources while maintaining the ability to provide financial resources sustainability. As global financial regulation mechanisms such as the Basel Accords and credit rating agencies step up their scrutiny over development finance in the same way as commercial finance, it seems to be increasingly hard to channel sufficient financial resources to places and in times that need them the most – places where risks are also often higher.

Meanwhile, there is probably no perfect framework for debt sustainability analysis. As the effort of a DSF is to provide judgements about future macroeconomic dynamics in a scenario of debt stress, estimates of the discount factor and feedback effects of fiscal policies would inevitably be subjective, even if empirical analysis of historical data is full incorporated.

Moreover, a framework alone is far from enough. At the end of the day, what sustainable debt positions and sustainable development in general requires is nothing but soundness and sustainability of projects – financially, socially and environmentally. Risk management mechanisms cannot ignore project and social risks, as well as potential physical and policy impacts of climate change, which pose substantial risks to a bank’s carbon intensive energy portfolio

Instead of hindering the scaling up of development finance, risk management should enable development finance to strengthen vulnerable economies and generate multiplier effects over the long term to improve the status of public finance, and insure timely debt repayment. This is by no means an easy task, and requires coordination and trust between governments and the private sector.

Even though debt to China remains a relatively small share in the public debt portfolio of most countries, China has emerged as an important international creditor as the Belt and Road Initiative unfolds, and deserves to be part of the multilateral engagement in debt sustainability control. Meanwhile, given the challenges and imperfect nature of development finance risk management, a diversity of approaches could create healthy competition to get it right.

Xinyue (Helen) Ma is the China Research and Project Leader at the Global Development Policy Center (GDP Center) at Boston University. Ma has experience researching different aspects of China’s international investment with China’s National Development and Reforms Commission (NDRC), Control Risks, and China Daily. She received her Bachelor’s degree in International Politics and History from Peking University, Beijing, and her M.A. in International Economics and Energy, Resources and Environment from Johns Hopkins University, School of Advanced International Studies (SAIS), with a specialization in Infrastructure Policy and Finance.

Special Monthly Round-up: BRI 1.5

The 2nd Belt and Road Forum in Beijing ended with a set of software patches to BRI 1.0

The 2nd Belt and Road Forum ended on Apr 27 with one message that everyone watching seemed to have picked up: change is needed. In the official parlance of the Chinese government, change is expressed in terms of traditional Chinese painting: from a big stroke, impressionist approach (大写意) to a style of precision and craftsmanship that focus on minute details (工笔画). In the words of Christine Lagarde, the head of IMF, change means “BRI 2.0”, with a focus on increased transparency, open procurement with competitive bidding, and better risk assessment in project selection. And in the words of Pakistan’s Prime Minister Imran Khan, a recipient country leader, change points to a new phase of the signature China-Pakistan Economic Corridor (CPEC) that places “greater emphasis on socioeconomic uplift, poverty alleviation, agricultural cooperation, and industrial development.”

BRF2

International coverage of the high-profile event depicts such rhetoric as a sign of China “allaying fear” of the BRI or “rehabilitating” the initiative’s image. Indeed, President Xi’s keynote speech at the forum indicates that China is responsive to external views of the initiative and its policies in general. In fact, the second half of his speech was widely read as sending messages to the West on key trade-related issues. In that sense, the shift can be regarded as an operational system upgrade responding to customer demand. But rather than a major upgrade as Lagarde’s 2.0 metaphor suggests, the changes made are far from a complete overhaul or reinvention.

For one thing, contrary to what leading BRI pundits and think tank experts have been advocating, there is still no sign that China is going to develop an actual “operating system” (permanent institutional structure with explicit mandates/rules) for the trillion-dollar initiative. Those advocates argue that the “under-institutionalized” BRI will be too easily hijacked by narrow economic interests of players involved. And the only thing close to an institutional upgrade coming out of the Forum is a set of recommendations made by the international advisory board to the Belt and Road Forum, which suggests China to consider turning the liaison office of the Forum into a full-blown secretariat for the BRI, or following the examples of G20, OECD or the Financial Stability Board to set up inter-sessional mechanisms to ensure coordination and continuation during intervals of the biannual Forum.

Absent of a major shift of the BRI’s modus operanti, the dozens of initiatives announced at this year’s Forum are more like patches to fix “bugs”. Below are some of those patches.

Framework for debt sustainability

Among the outcomes of this year’s Forum, the Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative published by China’s Ministry of Finance is probably the most obvious attempt to fend off criticism of the BRI, in particular accusations of it pushing excessive debt burdens onto other developing countries.

The new analysis framework was developed based on the IMF and World Bank’s Debt Sustainability Framework for Low-income Countries (LIC-DSF). It rates a country as low, moderate, or high in terms of its risks of being in debt distress, taking into account its debt coverage, macroeconomic projections, debt carrying capacity, among other factors.

Despite being modelled on the IMF-World Bank framework, the MoF tool applies some customization to the methodology that carries a distinct “BRI signature”. For example, when it comes to the relationship between public investment, economic growth and debt, the MoF framework is distinctively bullish about the potential for productive public investment to drive up economic growth in the long run, “while increasing debt ratios in the short run.” In comparison, the IMF, in a 2017 Guidance Note about the LIC-DSF, sounded more cautious on that same topic:

“Proponents of scaling up public investment maintain that productive investment, while increasing debt ratios in the short run, can generate higher growth, revenue, and exports, leading to lower debt ratios over time. At the same time, high economic returns of individual projects do not always translate into high macroeconomic returns. DSF users should therefore carefully assess the impact of a scaling-up of public investment.”

The view that large-scale debt-driven infrastructure investment is “worth the buck” is at the center of a Chinese developmental model that is being promoted through the BRI. And it is not without its value as Bretton Woods institutions like IMF and World Bank moved away from large-scale infrastructure building, leaving a gap in the developing world. And China’s engagement with established multilateral financial institutions is in fact less antagonistic than conflict-filled news reports tend to depict. In April 2018, the People’s Bank of China launched a capacity building center in collaboration with the IMF, providing training for leaders and officials from countries involved in the BRI. One of the training courses the Center offers is on managing debt sustainability. According to the People’s Bank’s website, countries responded very positively to the course, in particular those that are already using the LIC-DSF: Bangladesh, Cambodia, Ghana, Ethiopia, Djibouti, Tajikistan, Uzbekistan, Myanmar and Vanuatu.

But like other patches that are offered at the Forum, the MoF’s framework is a voluntary tool. It is not clear how the analysis can be integrated into lending decisions in the future, except for the possibility that a Multilateral Cooperation Center for Development Finance might adopt it.

Environmental governance of the BRI

Another area where the Forum is clearly responding to external pressure is how it handles the BRI’s massive environmental footprint. “Green” elements were given very little attention two years ago at the first BRI Forum. But the situation is noticeably different this time, as “green” elements were reflected in both the leaders’ speeches and the final ‘list of deliverables’. While criticism of China “lacking real will to address the challenge of climate change as it relates to the Belt and Road” still abounds, climate factors are being incorporated into initiatives announced at the Forum, albeit (again) on voluntary basis.

The “Green” updates rolled out this time include the formal launch of the International Coalition for Green Development on the Belt and Road and the signing of the Green Investment Principles.

The controversial Coalition, first conceived by the Chinese Ministry of Ecology and Environment in collaboration with the UN Environment, was one of the green highlights this year. Consisting of 26 countries, 8 international organizations, 65 non-governmental organizations and academic institutions, and 30 businesses (as of Apr 2019), the Coalition is an “open, inclusive and voluntary international network” to ensure that the Belt and Road brings “long-term green and sustainable development” to all concerned countries, according to the UN Environment’s description.

China’s environmental policy for the Belt and Road has been criticized for being vague and rhetorical. The formal launch of the Coalition at least provides some articulation on what aspects of “green” is China considering for the BRI. According to a Terms of Reference (ToR) circulated to participants of the Forum, the Coalition’s main mission consists of the creation of 3 platforms: a platform for policy dialogue, a platform for environmental information, and a platform for green technology transfer. The activities (divided into core and thematic) are mainly facilitative in nature: policy dialogue workshops, sharing best practices, publishing regular “BRI green development reports”. The structure of the Coalition, with its 10 thematic partnerships, opens a channel for external stakeholders to influence the environmental governance of the BRI on issues from climate change to biodiversity. After all, China’s Minister of Ecology and Environment is its co-chair. But actual mechanism for it to give policy inputs or affect project decisions is unclear. As one participant puts it: “All the measures will probably lead to more green projects, but not necessarily less bad projects.”

BRIGC
Structure of the International Coalition for Green Development on the Belt and Road, from the Coalition’s Terms of Reference

The Green Investment Principles, co-developed by the China Green Finance Committee and the City of London, and signed at the Forum, follow the same facilitative style. According to a People.cn report, the initiators of the Principles will establish a secretariat that offers services for the signatories, which has the China Development Bank, China Exim Bank and Silk Road Fund among them. The services include a database for green projects under the BRI, a carbon emission calculator for development and investment projects, and a knowledge sharing platform.

Project portfolio

One of the most direct tests of all the upgrades and safeguards would be an examination of the actual portfolio of projects that China is supporting in the countries involved. The 2nd Belt and Road Forum provides a glimpse of where BRI is heading in this regard, even though it is understandably too soon for all the initiatives announced at the Forum to translate into tangible influence on project decisions.

Wang Yan from Greenpeace’s China office created a nice list of project deals signed during the Forum. Not surprisingly the list tilts heavily towards conventional infrastructure, comprised of mostly energy projects (concentrated in coal and hydro), railway and urban complex development. It is worth pointing out, though, that within the full list of outcomes, items do show renewable energy projects in the pipeline (e.g. a trilateral cooperation agreement signed among China, Ethiopia and Sri Lanka on renewable energy development).

The thing with infrastructure is that their long shelf life means projects built today will have long lasting effect for decades to come. Well-intentioned policy initiatives and safeguards are only useful if they kick in as early as possible in a project’s lifecycle. Five years and hundreds of projects into the BRI, we are getting a major update from the App provider that will likely only fix bugs of future features if components of the update get activated in a timely fashion.