Pacific islands avoid China's 'debt-trap' diplomacy for now

In October, the New York Times reported that China had leased the island of Tulagi, prized for its deep-water harbor, from the Solomon Islands, which lie northeast of Australia. While the Solomon Islands government has said such a lease is illegal, it set alarm bells ringing internationally, coming less than a week after the country severed relations with Taipei and turned to Beijing.

It appears that China had offered investment to the Solomon Islands as an incentive to switch. There was a rumored $500 million package of aid for the country, but no targets have yet been confirmed beyond the commitment to continue some of Taiwan's projects, such as a new national stadium in the capital, Honiara. A Chinese company also reopened a gold mine -- considered by many not to be economically viable -- to great fanfare.

This type of investment makes officials in Australia and the U.S. anxious. They fear China is engaging in "debt-trap" diplomacy, using predatory lending practices to sink Pacific nations into unsustainable debt and then swapping debt forgiveness for geopolitical concessions, ranging from ports to natural resource rights.

The numbers do not tell quite this story -- yet.

If China were to be engaging in so-called debt-trap diplomacy in the Pacific, we would expect four criteria to be fulfilled. First, China would be causing debt sustainability risks in the region to rise, meaning countries would find it harder to meet their debt obligations. Second, China would position itself as the dominant creditor or source of new loans to the Pacific.

Third, Chinese loans would be much more expensive than other official lenders. And finally, we would expect Chinese lending to be skewed toward countries already facing elevated debt risks.

The latest Lowy Institute report, which I co-wrote with Roland Rajah and Jonathan Pryke, looks at these questions, assessing the impact of Chinese loans on Pacific debt sustainability now and into the future by drawing on data collected from our Pacific Aid Map and the International Monetary Fund.

According to the IMF, debt sustainability risks in the Pacific have been rising over the past decade. Among the 14 countries analyzed, only two were at high risk of debt distress in 2011. In 2018, there were six, and no country was considered at low risk.

However, rather than being fueled by Chinese loans, this has been driven by domestic economic mismanagement, growing debt from other sources, natural disasters and technical changes to how the IMF measures debt sustainability.

Similarly, China has not become the major creditor to the Pacific. Traditional donors, such as the World Bank or the Asian Development Bank, remain the dominant loan providers to the region, accounting for 53% of all loan distributed. In most countries, China is not operating at the scale needed to exert the leverage that Western observers are crediting it with.

Regarding cost, while it is true that China's overseas lending in Asia, Africa and Latin America often comes through Chinese commercial banks at market rates, it appears that, in the Pacific, Beijing has been more careful.

Most loans to the region are administered by the Export-Import Bank of China and China Development Bank, where the terms are much more generous and only marginally more expensive than the traditional lenders to the Pacific.

While the value and quality of the projects for which the money was borrowed can certainly be questioned, the terms of the loan agreements -- such as rates of interest, grace periods and repayment periods -- are all reasonable.

Finally, is Chinese lending skewed toward countries already facing elevated debt problems? Our analysis finds that 90% of Chinese loans were given to countries where there was scope to sustainably absorb such debt.

The 10% remaining were loans made to countries at high risk of debt distress, which signals a potential problem with China's overseas lending practices. More likely than this being deliberate strategy, it is probably a symptom of a lack of strong institutional mechanisms to prevent potentially unsustainable lending.

In summary, the evidence suggests that China has not been engaged in debt-trap diplomacy in the Pacific -- at least not yet.

Were China to continue its pace of lending over the next 10 years as it has over the past 10, we would see significant debt sustainability problems in countries like Samoa, Tonga and Vanuatu.

Ultimately, taking on debt is the sovereign decision of Pacific island countries and, in most parts of the region, governments have wised up to Chinese lending faster than the West. Lowy Institute data show that only Papua New Guinea and Vanuatu have taken on debt from China since 2016.

But China has also a serious role to play in this risky lending landscape.

It is true that Beijing has begun exercising greater caution over the potential debt sustainability implications of its trillion-dollar Belt and Road infrastructure program and has taken a number of steps to address this. Last year, Beijing supported an IMF training center to help improve the debt management capacity of countries involved in the BRI.

Earlier this year, it committed to the G-20 Operational Guidelines for Sustainable Financing and to the G-20 Principles for Quality Infrastructure Investment.

But China must go further. For instance, the new BRI debt sustainability guidelines from China's Ministry of Finance remain a non-mandatory policy tool for Chinese financial institutions. They must be implemented in all of China's lending activities if Beijing wants to continue avoiding debt-trap accusations.