New $4.5 bn Sinopec deal comes amid debt restructuring, BRI lending shift

HONG KONG -- Surging investment from China, including a multibillion dollar oil project late last year, is leaving a giant question mark over Sri Lanka even as it tries to restructure towering debt and recover from its worst economic crisis as an independent nation: Just how much leverage does Beijing have over the island country?

China is the largest bilateral creditor to Sri Lanka, which in May 2022 became the first Asian lower-middle income country to default on its sovereign debt in two decades. Chinese loans had financed a string of large infrastructure projects, including highways, an airport and a port in the country.

Sri Lanka's debt has been soaring since 2009, as the government embarked on a borrowing-financed endeavor to enhance the country's infrastructure as it emerged from civil war. A supporter of China's giant infrastructure Belt and Road Initiative (BRI) from as early as 2013, Sri Lanka has frequently been depicted by China critics as falling into an alleged Chinese 'debt trap,' enticed into accepting unsustainable loans for infrastructure projects and allowing Beijing to gain strategic or military influence by seizing assets in times of financial distress.

China has repeatedly denounced claims that it is operating a debt trap. "We have never forced any party to borrow money or pressed any country to accept debt. We do not attach any political conditions to the loan agreements and do not seek any political self-interest," a Chinese Foreign Ministry spokesperson said last year.

While China has indicated its readiness to restructure Sri Lanka's $36.4 billion in outstanding foreign loans, it is also extending direct investment in the country.

In late November, Sri Lanka approved Chinese state-owned oil giant Sinopec's proposal to build a $4.5 billon refinery in the southern port of Hambantota, the single largest investment in Sri Lanka since the economic crisis of 2022. The approval came after commodities trader Vitol, the only other shortlisted bidder, dropped out.

"If successfully done, this investment can help Sri Lanka in the long run," said Toshiro Nishizawa, a professor at the Graduate School of Public Policy of University of Tokyo, referring to the country's problems with fuel shortages. In addition, "It could be crucial leverage for Beijing in China's access to Sri Lanka's economy."

That is because Sri Lanka's sole oil refinery, built in 1969 by the state-owned Ceylon Petroleum Corporation (CPC), has been struggling to meet domestic demand as economic growth in the island of 22 million people surged before the crisis hit.

Over the years, there have been plans to expand Sri Lanka's refining capacity to reduce its reliance on imported fuel. These efforts have attracted potential investors from China, the U.S. and India. Colombo is trying to take balancing measures by seeking other partners, particularly India, to "hedge the risk of China's over-dominance and [to] seek to maintain its bargaining power with major partners," said Nishizawa.

India and the U.S. are already moving in to counter Chinese influence. Early in November, the U.S. announced it would lend $553 million for the development of a container terminal in Colombo operated by Indian tycoon Gautam Adani.

Ganeshan Wignaraja, visiting senior fellow at the Overseas Institute in London and former director of research at the Asian Development Bank Institute, said the debt crisis of 2022 has cruelly exposed Sri Lanka's energy security problem and lack of foreign exchange. And an inefficient CPC has "led to fuel shortages and hardships for the Sri Lankan people."

"Foreign investment by China's Sinopec in petroleum refining and distribution may be a means to improving energy security in Sri Lanka, provided the energy market is open to all investors and a strong competition policy is adopted," he said.

"If not, Sri Lanka could be vulnerable to problems of a private monopoly under Sinopec, with higher fuel prices and variable fuel supply," Wignaraja said.

According to Nishizawa, it remains questionable whether Chinese investments by operators like Sinopec will help or hinder the Chinese government's goals in Sri Lanka. "Chinese actors in the field have their own motivations and risk perceptions to achieve commercial goals that are not always fully aligned with the national agenda," he said.

"The central government's inability to micromanage commercially motivated actors and projects, and a compartmentalized governance structure, do not allow Beijing's strategic ambitions to be automatically attainable," Nishizawa said.

Meanwhile, the process of restructuring Sri Lanka's debt continues. While an agreement in principle was reached with a group of 14 creditor nations -- China didn't join -- in late November, a deal with external private creditors is still pending.

In October, Sri Lanka reached a preliminary debt restructuring agreement with the Export-Import Bank of China to cover about $4.2 billion of the country's outstanding debt, a crucial step for Sri Lanka to get the second tranche of a $2.9 billion bailout package approved in early December by the International Monetary Fund.

Deborah Brautigam, a professor of international development at Johns Hopkins University in the U.S., said once Sri Lanka's economy is stable and growing again, Chinese foreign investment is likely to pick up. But Chinese lending is unlikely to expand, as most banks tend to avoid countries that have defaulted.

"It's not just Chinese banks, the market has dried up more generally. Very few low- and middle-income countries have been able to issue bonds recently. Countries are going to have to postpone the infrastructure they had hoped to build with Chinese finance," she added.

For all China's touting of the Belt and Road Initiative as a huge success at a 10-year anniversary conference last year, lending through BRI has fallen since 2017 and the value of new BRI projects has remained stagnant.

The average size of deals in recent years has also been smaller compared with the pre-pandemic period. Meanwhile, Beijing is relying less on policy banks such as the China Development Bank and China Eximbank, and more on state-owned commercial banks.

From 2000 to 2021, Chinese official-sector institutions lent $1.34 trillion to 165 low- and middle-income countries, according to AidData, a research group based at William and Mary's Global Research Institute. With global interest rates rising in the past few years, developing countries are having to make higher debt repayments to Beijing.

A November report by AidData found that Beijing has increased short-term, emergency rescue lending. The share of rescue loans provided by China to low- and middle-income countries has rocketed from 5% in 2013 to 58% in 2021. That ensures that major BRI participants have enough cash on hand to service outstanding infrastructure project debts.

Meanwhile, in cases where borrowers face difficulties repaying their loans, Beijing has begun "paying itself" by withdrawing dollars and euros from cash collateral accounts, and requiring financially distressed borrowers to replenish these accounts in exchange for easing of repayment terms, according to AidData.

China's appetite for outward direct investment has grown in the past few years, even as it has become more cautious in BRI lending, according to the University of Tokyo's Nishizawa.

"Such a trend is considered desirable to reduce the risk of a double-edged debt trap that both China and BRI debtors can equally suffer. There are no winners in a debt trap situation, as the debtor, trapped with unsustainable debt, leaves its creditor with lost claims," he said.

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