I have been recently reading several warnings about the “China Debt Trap.” The most frequently mentioned example is Sri Lanka. Recently, there have several warning about the same debt phenomenon and Pakistan.

Perhaps, the warnings may be exaggerated. But, then again economic managers may learn a few lessons as we begin to negotiate the multi-billion dollar projects that China is offering. It should be noted that these projects are not free but will be financed by debt.

This dilemma was highlighted in a recent BBC News article with the title “Sri Lanka: A country Trapped in Debt.” Here is an excerpt from that article:

“China is investing billions of dollars in infrastructure and development in Sri Lanka but may local citizens feel the country is being sold to the Chinese....Hambantota was built by a Chinese company and funded by Chinese loans. But now Sri Lanka is struggling to repay that money and so has signed an agreement to give a Chinese firm a stake in the port as a way of paying down some of that debt. “

Here is an excerpt from an article from the Economic Times that I just read about the same project.

“ China has provided Sri Lanka with over $5 billion between 1971 and 2012 and most of it has gone into infrastructure development with China investing $1 billion into a deep water port at Hambantota and billions into the Mattala Airport, a new railway and the Colombo City Project.

Sri Lanka’s estimated national debt is $64.9 billion of which $8 billion is owed to China – this can be attributed to the high interest rate on Chinese loans. For the Hambantota port project, Sri Lanka borrowed $301 million from China with an interest rate of 6.3%, while the interest rates on soft laons from the World Bank and the Asian Development Bank are only 0.25 – 3 % or even less in some cases.

China’s strategy to grab land in smaller, less developed nations is simple: it gives them loans at high rates for infrastructure projects, gets equity into projects, and when the country is unable to repay the loan, it gets ownership of the project. The Hambantota deal is an example of this strategy.”

In another article by Brahma Chellaney, there is a warning about China’s Debt Trap Diplomacy: “ If there is one thing China’s leaders excel, it is the use of economic tools to advance their country’s geostrategic interests. Through its $1 trillion “ one belt, one road” initiative”, China is supporting infrastructure projects in strategically located developing countries often by extending huge loans to their governments. As a result, countries are becoming ensnared in a debt trap that leaves them vulnerable to China’s influence.

Of course, extending loans for infrastructure projects is not inherently bad. But the projects that China is supporting are often intended not to support the local economy but to facilitate Chinese access to natural resources or to open markets for low cost... Chinese goods. In many cases, China even sends its own construction workers, minimizing the number of local jobs that are created.”

During the past three decades, the world has been subjected to frequent financial crisis. Each of this crisis resulted in a “boom and bust “ economy which meant countries would experience economic prosperity and then suffer severe economic decline including recessions and higher unemployment. The rise of populism all over the political world has been one of the major results of this economic phenomenon. Economists have been looking for ways to detect early warning signals to detect another impending financial crisis.

One obvious thing is that credit crisis are linked to debt. In his book The Rise and Fall of Nations, Ruchir Sharma wrote that one warning signal of economic trouble is a period when borrowers and lenders get caught up in a credit mania. A financial crisis is often preceded by a sustained boom in borrowing. He adds: “ After the Asian financial crisis of 1997-1998 it was all about the danger of borrowing heavily from foreigners...because foreigners had suddenly cut off lending to Thailand and Malaysia when their problems became clear. These varying explanations resulted in much confusion and contributed to the general failure of most big financial institutions to see the credit crisis looming before 2008.”

Sharma, in his book reiterates that rising debt levels can be a sign of healthy growth, as long as debt is not growing too much faster than the economy for too long. The level of debt may matter at some time in the future but the pace of increase is the most important and clear sign of a shift for the better or for the worst, and the first sign of trouble often appear in the private sector, where credit manias tend to originate. The psychology of a debt binge not only encourages lending mistakes and borrowing excesses that will retard growth and possibly lead to a financial crisis. But also leaves a mental scar that can last long after the crisis has passed.

The other aspect of borrowing and investment that other developing countries have learned is to study carefully the projects that are being offered. Real estate mega projects may seem glamorous but will not benefit the economy in the long run. Investments in manufacturing and agri-business may seem dull and uninspiring but will generate permanent employment and solidify the foundations for a sound economy.

Borrowing need not be a “ kiss of debt,” if it is done wisely and prudently without placing unnecessary burdens on future generations.

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