Minxin Pei is professor of government at Claremont McKenna College and a nonresident senior fellow of the German Marshall Fund of the United States.
When it comes to China's economic engagement with the developing world, the most controversial aspect has been the massive lending programs that have pumped hundreds of billions of dollars of loans into poor countries over the last 15 years.
Critics have denounced Beijing's overseas lending practices as a form of sinister debt trap that ends up turning loan recipients into economic vassal states. Today, however, the other side to this narrative is that China itself has fallen into the debt trap it dug for others.
Following Russia's invasion of Ukraine, high inflation, rising interest rates and a looming recession in the U.S. and Europe, many poor countries are facing the worst economic crisis since the near-meltdown of the global financial system in 2008.
As they struggle with capital flight, food shortages and plummeting commodity prices, except for oil and gas, governments in low-income countries will find it increasingly difficult to service or repay their Chinese loans.
Although there are no official data on the loans Beijing has extended to developing countries, China is now the largest official creditor to developing countries. In all probability, actual Chinese loans may be significantly larger than most estimates suggest.
A close examination of Chinese overseas loans conducted by economist Carmen Reinhart, now the chief economist of the World Bank, and her colleagues in 2018 found that unreported Chinese loans to overseas borrowers, mostly developing countries, amounted to 15% of these countries' gross domestic product on average.
As the clouds continue to darken over the world economy, Beijing should brace itself for a debt crisis of its own making.
The recent economic collapse of Sri Lanka is the proverbial canary in the coal mine. The South Asian country's foreign debt has reached $38.6 billion, about 47% of its GDP. Roughly 10% of this amount is owed to China.
In early 2022, Sri Lanka could not repay the nearly $7 billion debt that came due. After Beijing failed to offer debt relief, Sri Lanka in April chose to suspend repayment on some of its foreign debt pending a restructure. Shortly afterward, massive protests toppled Sri Lanka's government.
Demonstrators shout slogans during a protest rally against the economic crisis in Colombo on April 19: Sri Lanka is the proverbial canary in the coal mine. © AP With global economic conditions bound to deteriorate further, many other developing countries are, like Sri Lanka , expected to default on their foreign loans. Many of these are countries that have received hundreds of billions of dollars of loans from China and will present a nearly impossible challenge to President Xi Jinping.
Under Xi's rule, China has vigorously promoted itself as an alternative to the West and generously funded risky projects in developing countries. But now hundreds of billions of dollars worth of loans China has made to poor countries are at risk because the strings attached make them especially vulnerable to economic downturns.
First, while 55% of loans and grants by Western governments and international financial institutions fund social programs such as health, education and humanitarian programs, nearly two-thirds of Chinese lending has gone to infrastructure.
During an economic downturn, finished infrastructure projects such as toll roads, ports and power plants will generate less revenue because of less traffic and power consumption, making it harder for the projects themselves to generate the income needed to service the loan.
Second, because Chinese loans are often collateralized by resource-generated revenue, the default risks rise significantly during times of recession because lower demand typically depresses commodity prices, except oil this time, because of the sanctions on Russia over the war in Ukraine. This adds up to another drag on the revenue needed to cover debt repayments.
China has few good options to climb out of this hole it has dug for itself. Pressuring insolvent governments such as Sri Lanka to service loans in the middle of an economic crisis will be futile and counterproductive. China will not only lose its money but trash its reputation in the process. Still, writing the debts off altogether will devastate the balance sheets of China's state-owned banks, which made these loans and Beijing will end up having to cover their losses.
China's best option is to adopt a multipronged approach that can salvage its image and cut its losses.
The first prong should be debt forgiveness for the poorest countries. As low-income countries sub-Sahara Africa account for about half of China overseas loans, they should get priority if Beijing plans to write off a substantial portion of their debt.
The case for debt forgiveness for these countries is especially strong because they are likely to be hurt the most by the global food crisis. China will suffer irreparable reputational damage if it keeps pressing these countries to repay their debts when there are bread riots in the streets.
The second prong should be debt restructuring. China should cut interest rates, temporarily suspend debt servicing and extend loan maturity in order to stave off the short-term threat of further loan defaults.
The third prong should be working with other international donors and lenders. As the world's largest official lender, China has real leverage. If it can use a debt relief program to encourage other lenders to do the same, China can potentially lead an international effort to help developing countries weather the pending global economic storm.
The result is that this may be a historic opportunity for China to demonstrate its international leadership. Ironically, it was China's financial recklessness, not its strategic foresight, that created this opportunity in the first place.