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China holds key to Sri Lanka’s debt restructuring to ease economic crisis

China may become the key factor in deciding the timing of the International Monetary Fund (IMF)’s loan disbursement for Sri Lanka to ease the ongoing unprecedented economic crisis, local and international analysts say.

Colombo (08/09 – 75.00) China may become the key factor in deciding the timing of the International Monetary Fund (IMF)’s loan disbursement for Sri Lanka to ease the ongoing unprecedented economic crisis, local and international analysts say.

China has agreed to help Sri Lanka in facing the economic crisis, but so far has not committed for any debt restructuring plan, government officials who are dealing with the debt structuring told EconomyNext.

The completion of debt restructuring – either through a haircut or rescheduling the debts – is mandatory for the approval for the IMF loan from the global lender’s Executive Board.

China has, instead, proposed a refinancing strategy: more lending by China to Sri Lanka in order to repay Beijing’s own debts in the past.

However, this move is not accepted by Western nations that are members of the Paris Club – a group of mostly Western nations which have a well defined and unified process accepted by the IMF for dealing with defaulted nations.

Following the preliminary staff level agreement with Sri Lanka, the IMF last week said even if one creditor does not agree to restructure debt, it would “indeed deepen the crisis here in Sri Lanka and would undermine the repayment capacity”.

Japan is the only country in the Paris Club among Sri Lanka’s main creditors. Other key creditors like India and China are not members.

“The IMF executive board is not likely to agree to disperse the funds until the [Sri Lankan] government is able to present a plan to get its debt back to sustainable levels, which means coming to an agreement with creditors, both private and bilateral,” Akhil Bery, Director of South Asia Initiatives at Washington-based think tank Asia Society Policy Institute, told EconomyNext.

“That means Sri Lanka needs to make progress with its negotiations with China before the executive board votes to release the funds.”

Bery said the worst case scenario for Sri Lanka on debt restructuring with China is that no agreement is reached and Colombo continues to be frozen out of international markets and the economy continues to stagnate with inflation soaring further.

“In a best case scenario, China comes to an agreement with the Paris Club and other creditors on a debt restructuring framework which would unlock the IMF programme as well as additional bilateral and multilateral financing which can help bridge the financing gap,” he said.

Clue from Zambia’s debt restructuring

International analysts say China’s conduct with Zambia’s debt restructuring offers insight on what Sri Lanka can expect in a debt restructuring deal with China.

Zambia defaulted in November 2020 and got an IMF staff-level agreement in December 2021, but got the IMF Board approval only last week with China agreeing only to reschedule its over 5 billion US dollars of loans.

“The two key factors important for the recovery of Sri Lanka’s economic crisis are when will the IMF lend and what does China do,” a London-based debt market analyst told EconomyNext asking not to be named as he is not allowed to speak to the media.

He said China was involved in lending to Ethiopia, Zambia, and Suriname – all of whom defaulted sovereign debts in the last two  years.

“China has dragged it in all these other places,” the analyst said.

Beijing has consistently rejected accusations by the US that it had pushed poor countries into a debt trap and says it works out solutions with individual governments when they struggle to repay loans.

“As a traditional friendly neighbor of Sri Lanka and a major shareholder of the IMF, China has been always encouraging the IMF and other international financial institutions to continue to play a positive role in supporting Sri Lanka’s response to current difficulties and efforts to ease debt burden and realise sustainable development,” a spokesman for Chinese Embassy in Colombo said after the IMF comments last week.

“As to the bilateral financial cooperation, shortly after the Sri Lankan government announced to suspend international debt payments in April 2022, Chinese financial institutions reached out to the Sri Lankan side and expressed their readiness to find a proper way to handle the matured debts related to China and help Sri Lanka to overcome the current difficulties,” he said.

“We hope Sri Lanka will work actively with China in a similar spirit and work out a feasible solution expeditiously.”

Chinese Foreign Ministry Spokesperson Zhao Lijian responding to questions raised by journalists at a media briefing last week said China has paid close attention to the difficulties and challenges faced by Sri Lanka.

“We have provided help to Sri Lanka’s socioeconomic development to the best of our capacity. China supports relevant financial institutions in consulting with Sri Lanka for proper solutions. We are ready to work with relevant countries and international financial institutions to continue to play a positive role in supporting Sri Lanka’s response to current difficulties and efforts to ease debt burden and realise sustainable development,” Lijian said.

However, analysts and Western diplomats say Beijing has not committed itself to debt restructuring.

“This means the whole debt restructuring process will get delayed and Sri Lanka may not get the IMF support it desperately needs,” a Western diplomat said.

“If China is going to be stubborn about refinancing, then other creditors also will not agree on a common platform to restructure Sri Lanka’s debt. That will result in more and more consultative processes and time, but more importantly it is going to delay Sri Lanka’s speedy recovery from the economic crisis.”

Sri Lanka has already hired financial and legal advisory firms Lazard and Clifford Chance LLP to support its debt restructuring programme as the country is on the brink of bankruptcy. Lazard was the legal advisor in Zambia’s debt restructuring programme where creditors included China, which did not agree to a haircut.

Local analysts say delay in debt restructuring by China could compel the government to go for a restructuring of local rupee-denominated bonds. They say the government may use maturity extensions, coupon reductions, and principal haircuts in local debt restructuring if they are compelled.

“The principal haircut could trigger a collapse of the banking sector as most of the banks have invested a significant chunk of their savings in government securities,” Sanjeewa Fernando, head of Research at CT CLSA Securities said. 

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