Debt Defaults Are a Stress Test for China’s Soft Power Strategy

The biggest sovereign lender to the developing world is finding itself at the negotiating table as countries like Zambia struggle to pay what they owe.

After watching the four giant turbines churn water from the Kafue River, Zambia’s president, Hakainde Hichilema, delivered a message that might have come as a surprise on a tour of a dam project so integral to the future of his country’s economy.

Speaking in front of China’s ambassador to Zambia, Hichilema thanked Beijing for its assistance with the hydropower plant, which could turn the African nation into a regional electricity exporter. Then he very publicly questioned the $2 billion cost in front of the man whose country had bankrolled it with loans Zambia was trying to renegotiate.

President Hichilema speaks after touring the Kafue Lower Gorge Power Station on July 21.Photo: Xinhua/Shutterstock

That awkward diplomatic moment in July reflected the scale of the challenge Zambia faces, trying to right its finances after becoming the first African country to default during the pandemic and experiencing a subsequent plunge in its currency. But it also illustrated how China has found itself on the front line of an unfolding international debt crisis after becoming the largest government creditor to developing countries during the past decade.

Largest Lenders to Emerging and Developing Countries

After building railways, bridges, dams, and power stations from Peru to Pakistan, China’s flagship “Belt and Road” initiative has entered a new, hazardous chapter. The global energy price shock and rising interest rates have crippled the ability of some nations to service the debt they owe. In response, China is overcoming internal political hurdles to join with the Paris Club of rich creditor nations to negotiate debt relief.

The scale of individual nations’ total external debt—$16 billion in Zambia’s case—is trivial relative to China’s economy and the balance sheets of private lenders. Yet the speed and size of that relief will determine whether some of the world’s poorest countries can continue to invest and grow or suffer the stagnation that followed previous debt crises.

Zambia’s External Debt

As share of GDP

The number of countries with sovereign debt trading at distressed levels has more than doubled in the past six months, reaching 19 nations that are home to more than 900 million people, according to data compiled by Bloomberg. Some 60% of China’s overseas lending is to countries that are now in debt distress, according to economists. “China hasn’t been in a situation where they face large-scale defaults,” says Deborah Brautigam, an expert on Chinese lending at Johns Hopkins University. “It’s starting to happen now.”

Debt in Low- and Middle-Income Countries

China’s outstanding loans to developing countries totaled $157 billion when the pandemic hit—but the actual amount is probably significantly higher, because countries are patchy on reporting debt. The good news is that Beijing is willing to join other creditors in debt workouts, speeding up the process since each creditor can see how big a haircut others are willing to tolerate.

A month before Hichilema’s visit to the dam, Zambia’s finance minister held an online meeting with representatives from China and 22 Paris Club members. After a second meeting in July, those countries agreed to reduce Zambia’s debt, part of the $8.4 billion of payment relief it needs over the next three years, according to the International Monetary Fund.

The IMF projection for the country’s new debt arrangement should allow creditors to maintain the face value of their claims, while delaying payment. That’s been the favored method for China on previous occasions, as well as its treatment of domestic debt. That matters for other countries—from Ethiopia, Ghana, and Kenya to Pakistan—that are seeking to renegotiate their debt. Sri Lanka’s recent IMF loan agreement states that it must restructure its debt with foreign creditors, and the Paris Club has said it’s ready to work with nonclub members such as China. (The IMF requires talks to start with creditors to unlock emergency assistance.)

“One can expect other countries to treat Zambia as a template,” said Gyude Moore, a former minister of public works in Liberia and now a fellow at the Center for Global Development, a Washington-based think tank. The bad news is that the debt talks involving China, Western countries, and private lenders are a slog, delaying freeing up scarce dollars that poor countries desperately need. As a result, other countries may prefer to talk to their creditors one-by-one.

The terminal building at the Kenneth Kaunda International Airport in Lusaka, which Chinese lenders financed.Photo: Xinhua News Agency

China’s top leaders are preoccupied with domestic issues and relations with major economies like the US, and no one is clearly in charge of overseas lending. Poor coordination among different banks and government ministries in Beijing meant it took more than a year to come to the table with other countries after Zambia defaulted on its foreign debt in 2020. Lack of trust in other Paris Club countries played a role, too, after years of US public denouncement of Chinese lending overseas as a “ debt trap.” That’s evident in the case of Zambia, said Yufan Huang, a researcher at Cornell University. “You have people arguing that the restructuring led by the IMF and World Bank is a plot by the West to hurt China,” Huang says. “Deteriorating US-China relations only made it harder for people in Beijing to justify that such multilateral cooperation is in China’s interests.”

Indeed, China’s ambassador to Zambia, Du Xiaohui, seemed to underscore that point when speaking in August at a conference center that China built as gift for Zambia to host an African Union summit. “We think that friendly bilateral cooperation is the best way to deal with the debt between two friends,” he said.

There’s no doubting the urgency, however the relief may come. The current global debt crisis has elements in common with the turmoil of the 1970s and ’80s, when dozens of developing countries in Latin America and Africa defaulted on debts to richer nations. There are fears that the current debt renegotiations could drag on like those of the ’80s, which resulted in a decade of lost growth before rich nations eventually admitted the debt was unsustainable and started to write it off.

The triggers for further defaults look the same: energy price shocks that mean more dollars are needed for imports, and US interest rate hikes that make banks less willing to lend dollars overseas. That’s on top of the legacy of corruption and wasteful investment. But unlike in those crises, Western governments are minor holders of developing world debt after getting burned. They pivoted to financial aid instead. The largest creditors to poorer countries are a mix of commercial banks, asset managers such as BlackRock Inc., and hedge funds that piled in after the global financial crisis in pursuit of higher returns—followed by China.

To get Zambia’s Kafue dam project off the ground, Chinese banks lent $1.5 billion in 2017—about three-quarters of the eventual cost. The government funded the rest with some proceeds of its debut dollar bond sale, and it also borrowed from the Johannesburg-based Development Bank of Southern Africa. China was officially co-chair of Zambia’s creditor committee, with France, but in reality it was the key player. Overall, Zambia owed $6 billion to China, compared with just $1.3 billion to the entire Paris Club, according to IMF figures. The country owed about $5 billion to Eurobond holders and commercial creditors.

The Kafue Lower Gorge Power Station, under construction earlier this year.Photo: Xinhua/Shutterstock

Zambia couldn’t manage the burden. In November 2020, it bowed out of a $43 million Eurobond payment, becoming the first African country to default in the pandemic. Panic among foreign lenders helped push its currency to a historic low in 2021, stoking double-digit inflation. That year, Zambia’s per capita income declined 10%, to $1,040.

But it took until this year for China to agree to join the committee with other government lenders. The decision came shortly after Hichilema urged China to act in a May 31 phone call with Chinese President Xi Jinping. In a sign that Beijing could continue to support multilateral debt talks, some Chinese banks are changing the way they write loan contracts, dropping clauses ruling out debt restructuring with Paris Club members, according to Brad Parks, executive director of AidData, a research lab at the College of William & Mary in Virginia that tracks global lending.

There are still wrinkles, of course. Beijing worries that less-needy countries could take advantage. There’s also the prospect of a backlash at home. China periodically forgives a small category of its lending by turning interest-free loans to low-income countries into aid. The latest round of forgiveness in August, likely amounting to less than 1% of its loans in Africa, came as Chinese mortgage payers were going on strike over unfinished housing projects. Online posts angrily asked why the same relief hadn’t been extended to Chinese borrowers.

Much hinges on the restructurings for developing countries, not least because they need to keep China onboard. Their desperate need for infrastructure will be harder to meet if Beijing turns cautious. The European Union and the US have both touted their own alternatives to the Belt and Road initiative, but the reliance of both schemes on private lenders means their prospects are uncertain.

The 750-megawatt Kafue dam project is a prime example. During the past decade, Zambia has faced chronic power shortages and blackouts lasting up to 18 hours a day. Other African nations, including the Democratic Republic of Congo and South Africa, also face shortages and are eager to import more electricity from Zambia. Du, the Chinese ambassador, called the facility “a money printer made in China,” potentially earning $1 million a day.

“The country was in a very desperate situation for electricity, and it was very evident that we need to have this project,” said Kenneth Konga, Zambia’s energy minister under the government that initially signed the deal to build the project. “China was the best option, because you could talk to them and they could reason.”

Since coming to power a year ago, Hichilema has moved closer to Western powers such as the US and the UK. In Kenya, William Ruto was elected president in August, partly on a promise to renegotiate the Chinese loans taken out by his predecessor. But most of the developing world is still likely to seek close economic relationships with China, the world’s largest commodity consumer.

China is the biggest customer for Zambia’s main export, copper, and ties between the two nations have weathered turbulent periods since China built the Tanzania-Zambia Railway in the 1970s to link copper mines with the port at Dar es Salaam. In August, Hichilema formally opened a park commemorating the line and the Chinese workers who died building it. As they toured a museum at the site, ambassador Du was again by the president’s side when they posed under a banner reading, “Long Live the Friendship Among the Peoples of Zambia, Tanzania, and China!”

Authors: Tom Hancock, Matthew Hill, Bloomberg

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