China Spent Years Lending to Low-Income Countries. That’s Becoming a Problem

After eight months of negotiations the International Monetary Fund (IMF) announced last week that it would work with Pakistan to provide debt relief, boosting confidence in the country, which has been experiencing its worst economic crisis since its formation in 1947.

As a result of its growing debt burden to Western and Chinese lenders, Pakistan’s government struggled to balance its basic functions, and its national grid has at times been forced to turn off power generation units to reduce fuel costs. That burden, along with record high inflation, put a huge strain on the country’s economy at a time of political upheaval. In February 2023, Pakistan’s annual rate of inflation was 31.5%, the highest inflation rate the country had seen in nearly 50 years.

Pakistan is not the only country in the Global South being forced to make tough choices due to its debt obligations. In April this year, the Kenyan government failed to pay its employees for the first time since its independence in 1963. Instead, the money that had been earmarked for government employees went to fund Eurobond payments that the Kenyan government owed money on—part of the country’s ever-growing debt to Chinese and Western lenders. And in April 2022, Sri Lanka’s debt default led to a major political crisis, during which thousands of protestors stormed its presidential palace. Later that year Ghana said it would not service its debt to external lenders, and in May this year the country agreed a $3 billion loan deal with the IMF.

In December 2022, the World Bank reported that low income countries are reaching debt levels not seen in 25 years. According to the IMF, 60% of all lower-income countries are in debt distress, or at a high risk of debt distress, meaning a country is unable to make its loan repayments.

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Countries in or at risk of debt distress tend to have less money to spend on public services like education or health, and infrastructure projects. This could impact the long-term economic and political stability of these countries and have consequences that reverberate across the globe, says David McNair, executive director for global policy at the anti-poverty organization OneCampaign. Low and middle income countries tend to have younger populations, meaning that in the future, people in these countries will become a larger share of the global workforce, he says.

By 2035, Africa alone is expected to add 450 million to its working-age population, according to the World Bank. The working-age populations of Western countries, on the other hand, are growing at a much slower pace. Europe’s working-age population is actually predicted to decline by 35 million by the year 2050, according to the European Union.

“If you’ve got educated young people with opportunities, then that’s going to be a driver of massive economic growth,” says McNair. “If you’ve got young people that aren’t educated and don’t have opportunities, then that’s a potential recipe for instability.”

In the past, when developing nations found themselves in severe debt distress, Western creditors would usually work together to create some form of debt relief, says Tony Addison, a professor of development economics at Copenhagen University. This could mean lengthening repayment terms or forgiving some of the principal loan. However, debt relief has been complicated by the growing presence of China as a major international lender.

The rise of China as a lender

In the early aughts and 2010s, China’s rapid economic growth allowed it to build up increasingly large foreign exchange reserves, giving it much more lending power than before. Lending to low and middle-income countries at high interest rates, became a significant part of the Chinese government’s investing strategy. This also gave China increased access to new markets for materials, according to Addison.

Read More: How China Became a Global Lender of Last Resort

“China’s desire, particularly since 2000, is to gain access to resources, particularly to resources in Africa like metals, oil, and so forth,” says Addison. “For example, if you look at metals markets, more than half of the world’s copper is being exported to China.”

In some cases China provided commodity-backed loans to certain African nations that enabled borrowers to make repayments directly in metals, oil, or minerals. Other times, Chinese lenders built relationships with African governments and gained access to commodity opportunities as a result of networking, says Addison.

“For example, if China is investing in a mine, and the Chinese state bank lends to have a railway built between the port and the mine, then in effect this sort of debt becomes part of the investment relationship,” Addison says.

During this time, as China was trying to gain better access to commodities markets, many governments in developing countries were seeking to borrow more money as their populations grew rapidly, says Addison. While European and American investors were willing to lend funds for health and education, they were reluctant to lend money for infrastructure projects like public transportation. Western loans to developing countries are often partially subsidized by Western taxpayers, making approval a political issue, he says.

The idea of a loan to fund a “health program for rural women in Kenya” is more palatable to voters such as those in the U.K. than, for example, a “very large loan for Kenya’s infrastructure and public transport system,” says Addison. “Because frankly, somebody from Manchester could stand up and say, Well, what about our public transport system?”

This left a gap in the market that Chinese banks were happy to fill. Over the past decade China is estimated to have spent over $1 trillion funding infrastructure projects through its Belt and Road initiative in Latin America, Asia, and Africa, building trains, airports, and other infrastructure. China was Zambia’s biggest external creditor when it reached a debt restructuring with the IMF in 2022, according to the Financial Times.

Stalemate

While in many ways loans from China were similar to commercial contracts from Western private lenders, there are some key differences that gave Chinese lenders more protections, according to Anna Gelpern, a professor of law and international finance at Georgetown University. She helped analyze 100 Chinese debt contracts with foreign governments for a paper she co-published about the findings in 2021 in Economic Policy.

“Chinese institutions in many cases negotiated better contracts that gave them more levers in the relationship than other creditors might have,” says Gelpern. “However, something that gets lost all the time is just because they have the levers doesn’t mean they exercise them. Just because your landlord can evict you for being a week late with rent, doesn’t mean they will.”

However, the protections included in these contracts puts Chinese lenders in a strong negotiating position when compared to other creditors dealing with distressed borrowers, says Gelpern.

When a distressed debtor has multiple different creditors, these lenders will have competing interests, says Addison. All creditors are trying to avoid being the first to provide debt relief, since the creditor that provides relief first will be most likely to see its own return on investment dented, says Addison.

Poor countries pay the price

This has left lower- and middle-income countries paying the price, says McNair of the OneCampaign.

“Part of the reason why there hasn’t been a systemic solution is that it keeps getting caught up in these geopolitical tensions,” he says. “A lot of commentators in Washington are basically saying it’s China’s fault. [Western lenders are] not going to offer anything until China moves. And then China is saying that it’s the private creditors’ fault, most of which they see as Western institutions.”

In 2021, the G20 Common Framework was initiated to create a more structured process for individual distressed countries to bring their creditors together to negotiate relief. However, so far only Ghana has seen significant success with it, according to McNair. Other countries, like Chad, Ethiopia, and Zambia were actually downgraded by the credit system after applying, making the cost of servicing their debt—interest rates—even higher, says McNair.

“The major problem is that there’s just no incentive for those with the power to move these things quickly,” says McNair. “They’re dragging their heels and in the meantime, the countries [in trouble] don’t have a resolution. And then they’re stuck in these impossible situations where they have to decide whether to pay the interest on their loans or whether to pay teacher salaries or whatever it might be.”