For China

Our findings show that a continuation of business as usual for bilateral Chinese lending in the Pacific would quickly give rise to potential debt sustainability problems. China will therefore need to reconfigure its approach significantly if it wants to disprove the debt trap accusations made by its critics.

China has begun exercising greater caution over the potential debt sustainability implications of the BRI and taken a number of initial steps to address this. China has supported an IMF training centre to help improve the debt management capacity of countries involved in the BRI, and China’s Ministry of Finance has agreed with major multilateral financing institutions to establish a new cooperation platform.[61] In 2017, China also committed itself to the G20 Operational Guidelines for Sustainable Financing and in 2019 to the G20 Principles for Quality Infrastructure Investment, both of which contain debt-related provisions including complying with World Bank and IMF policies for countries where debt sustainability is already a concern.[62]

Concrete action from China to operationalise these commitments is now required. China’s Ministry of Finance has issued a new BRI debt sustainability framework (BRI-DSF), modelled on that of the IMF and World Bank, to guide BRI-financing activities in less-developed countries. Yet, the BRI-DSF remains a “non-mandatory policy tool” and provides little guidance as to how Chinese financial institutions are expected to alter their behaviour in response to identified debt sustainability risks.[63]

To remedy this, China should adopt formal lending rules similar to those of the MDBs. These could mandate the use of the BRI-DSF by China’s policy banks, notably EXIM Bank, when undertaking sovereign lending to less-developed countries, and require the provision of more concessional financing to countries at greater risk of debt distress. For example, where countries are deemed to be at low risk, standard concessional EXIM loan terms might be appropriate. For those at moderate risk, more concessional loans could be provided, involving a larger interest subsidy from the Ministry of Finance. China could also employ alternative approaches, such as blending EXIM loans with grants from the Ministry of Commerce (MOFCOM) or replacing EXIM loans with interest-free MOFCOM loans (an existing instrument). For countries at high risk, China would ideally only provide grants via MOFCOM.

Implementing such formal lending rules would offer certain advantages for China. By applying only to China’s policy banks and MOFCOM, it would be relatively straightforward to implement and require only modest additional coordination efforts. This approach would cover the majority of what might be considered Chinese development finance, therefore bringing China into a substantially more analogous position to traditional development financiers. It would also encourage much greater cooperation and coordination between China, the IMF, and other official creditors — with greater information sharing also potentially helping to reduce some of the geopolitical tensions surrounding the BRI.[64] Ideally, the results of the BRI-DSF would be made publicly available to enhance overall transparency.

Adopting formal lending rules would also help to support more sustainable debt management by borrowing countries. As elsewhere in the developing world, China’s state firms often engage directly with political elites when seeking agreement for new projects. In weaker governance environments, this can mean effectively bypassing or otherwise sidelining local finance officials normally responsible for advising on such matters.[65] In a recent example, Vanuatu agreed to another large Chinese EXIM loan in late 2018 on terms that appear to violate the finance ministry’s desire to borrow only on more concessional terms.[66] While final decisions will always rest at the political level, such practices undermine effective debt management by Pacific nations, despite many governments having formal rules designed to protect fiscal sustainability. Clear rules anchoring Chinese lending to a formal assessment of debt sustainability could help address these issues by effectively mandating early engagement with the finance officials of recipient countries on any new lending plans.

Ad hoc debt restructurings (as has been China’s approach globally[67]) are also not a panacea should future debt problems emerge. Uncertainty about future debt restructuring can itself undermine prudent management. The case of Tonga is an example, in which China has twice agreed to defer debt repayments, but in a way that risks creating short-term debt-servicing problems only a few years down the track.[68] To reduce these problems, China should set out a clear policy framework for its approach to debt restructurings, and cooperate closely with other official creditors in its approach. Ideally, China should join the longstanding Paris Clubgroup of official creditors[69] (currently it is an observer) or establish some new arrangement.[70]

The most important conclusion from our scenario projections is that China cannot remain a major lender in the Pacific at the same scale as in the past without fuelling significant debt sustainability risks in most of the countries in which it is currently active. Even the provision of more concessional loans would likely prove problematic if at the same scale as the past. While China has begun to provide more grant financing to the Pacific, it is starting from a low base (Figure 9). If China wants to remain a major financier in the region without fulfilling the debt trap accusations of its critics, it will need to shift dramatically to provide far more grant funding than loans.

For Australia

Australia, like China, needs to avoid lending to countries that are already facing a high risk of debt distress, and provide more concessional financing instead. The AIFFP appears to have adopted rules along these lines, with the AIFFP Design Document indicating the facility will not lend to countries already assessed by the IMF to be at high risk of debt distress. It will also follow the debt limit policies of the World Bank and IMF in other cases where potentially unsustainable borrowing is a concern.[71] Meanwhile, EFA already adheres to such rules through its commitments to OECD sustainable lending rules for export credit agencies.[72]

Protecting debt sustainability in Pacific countries will also require Australian loans to be as concessional as possible, given elevated debt risks and the often limited economic viability of many infrastructure projects in the Pacific. This reinforces that the EFA’s role in the region should remain relatively niche, given its commercial nature, and that it should direct its focus to Asia.

That would leave the AIFFP to play the primary role in the Pacific. According to the AIFFP Design Document, AIFFP financing terms will include pure loans, grants only, or a mixture of both (effectively blending the two together to create a more concessional loan). For sovereign lending, the terms of the pure AIFFP loans will be benchmarked against the non-concessional loan terms of the MDBs. As discussed above, given low global interest rates at present, this would mean a grant element of around 50 per cent — technically well above the OECD minimum for concessional loans. This, however, means AIFFP loans could be marginally more expensive than equivalent Chinese concessional EXIM loans, depending on the specific loan terms used for individual projects. The exception is where loans are blended with grants, although the AIFFP design indicates this will not be in all cases.

The AIFFP has indicated that its key differentiating quality will be its emphasis on high standards.[73] This means ensuring prudent project selection and design, competitive open procurement, transparency and good governance, and strong environmental and social safeguards. Such commitments are appropriate and necessary for an OECD donor, and are the same high standards to which the MDBs adhere. However, while the MDBs are good at ensuring quality, this typically comes at the expense of speed and responsiveness — creating a key gap that China has been able to fill.

The AIFFP’s intention may be to operate in a more nimble manner than the MDBs while still adhering to high standards; however, its prospects of doing so are uncertain at best, at least in the short to medium term.[74] Its institutional capacity will have to be built up. In the meantime, using loan terms similar to the non-concessional loans already available from the MDBs could hinder the ability of the AIFFP to compete effectively with Chinese financing. This merits consideration of more concessional financing terms, including more blending with grants. More concessional financing terms would also clearly assist in preserving debt sustainability. Even if the AIFFP restricts itself to ‘high-quality’ projects, the limited ability of infrastructure to sustainably catalyse faster growth in the Pacific means highly concessional financing remains critical.

All of this implies that Australia should also rethink the size of its overall aid budget. Following a series of deep cuts earlier this decade, Australia’s total aid budget has stagnated in nominal terms. Today, Australia’s strategic goal of doing more in the Pacific is boxed in by a limited aid budget, the desire to avoid cutting back on other important development priorities (such as health and education, or aid to countries outside the Pacific), and the need to avoid causing debt sustainability problems by relying too heavily on non-concessional lending. If Australia wants to do more, one of these constraints needs to be relaxed. Increasing the overall aid budget would be the most desirable option. Finally, China itself might begin providing substantially more grant financing to the Pacific. In that case, a stagnant aid budget would increasingly place Australia at a geostrategic disadvantage.

For Pacific nations

Pacific governments are clearly in the driver’s seat as to whether their own borrowing policies are sustainable and in using their limited debt space wisely for the best projects on the best terms. The major priority lies in strengthening their own fiscal and infrastructure management institutions, for which development partners can also usefully provide technical support, capacity building, and policy-linked budget support to reinforce reform. Pacific nations also have an opportunity to use the current climate of competition among major powers to their advantage, for example by pushing for more concessionality (including more grants), better project management, and more responsiveness to local priorities.

However, care will also be needed. For example, at the time of writing a newly formed government in Papua New Guinea appears to be looking to both Australia and China to secure sizeable general budget financing support.[75] On the one hand, such support would provide immediate fiscal relief at a domestically critical moment and help to restructure the government’s debt profile away from its current reliance on expensive market-based financing. However, whether this ultimately proves beneficial for PNG will depend on whether it uses this opportunity to push forward with reforms to put its fiscal and economic trajectory on a more sustainable path, as opposed to avoiding difficult reforms and facilitating ongoing fiscal profligacy. Similarly, external players have a responsibility to avoid overly geopolitically-driven financial assistance that risks prioritising short-term wins at the expense of undermining the incentives for reform and better governance that are critical to sustainable development. Amid rising competition for influence, the risk of inadvertently creating long-term ‘governance traps’ instead is an equally if not more concerning risk than the potential for debt traps.[76]