Colombo is a charming city compared to traffic-clogged and polluted South Asian metropolises like Dhaka, Delhi or Karachi. So far, Colombo’s public transport has held up well. But city dwellers and those living in residential areas outside will gravitate towards cars to quickly and comfortably get about to work, to school or run errands as incomes rise. It’s estimated than half of Colombo’s motorized trips are done on public transport – 3.4% by rail and 48% by bus.
University of Moratuwa academics estimated the average speed of travel in Colombo at 12 kilometers an hour, which implies that during rush hour, traffic is near gridlocked. Colombo’s rush hour traffic didn’t get to a snarl unpredictably. In 2014, a comprehensive urban transport plan emerged, which included the option for Light Rail Transit (LRT) and significant investments in existing rail, bus and road infrastructure.
The LRT was to connect downtown Colombo to the suburbs to the East of the capital. Later sections would connect suburbs to Colombo’s North and South. More lines were planned to run across the city too. In a March 2019 agreement, the Japanese government agreed to fund the 15.7 kilometer line, Sri Lanka’s first LRT, connecting the Eastern suburbs to downtown Colombo. Over 200 international and local consultants were preparing detailed designs to float tenders among Japanese companies for civil works, electro-mechanical works and to buy rolling stock so that trains could be running by 2027, when a new government suspended the project in September 2020.
The Presidential Secretariat, from where the suspension order was issued, said the LRT was “not the appropriate cost-effective transport solution.” In developing countries’, the biggest financing need is for infrastructure. The Japanese government, through its lending arm Japan International Cooperation Agency (JICA), is the largest bilateral lender to Sri Lanka (see chart 1).
Outstanding loans to Japan total $3.4 billion. Only the Asian Development Bank, a multilateral lender, has more loans outstanding to Sri Lanka ($4.4 billion) than Japan. Crucially, all Japanese lending are soft loans, with below market interest rates and long repayment periods. For comparison, China’s soft lending to Sri Lanka is less than a fourth of Japan’s at $0.8 billion. Most of China’s credit is semi-soft, and provided by the ExportImport Bank of China (an EXIM bank). Together, China’s soft loans and semi-soft EXIM credit, total slightly below Japan’s lending. For instance, the $280 million LRT loan from Japan charged an annual interest of 0.1% on civil works and equipment costs, and 0.01% for engineering services. Sri Lanka had 40 years to repay with a 12-year grace period.
An independent think tank’s analysis of the largest 50 soft loans obtained between 2005 and 2019 for infrastructure has found that Japanese ones were the cheapest. Financing Infrastructure: The (non) Concessionality of Concessional Loans by Verité Research goes on to explain the conditions under which foreign loan concessionality is eroded, which in some cases, can make them as or more expensive than debt securities.
Since the year 2000, Sri Lanka has borrowed heavily to splurge on infrastructure, to subsidize loss-making state owned enterprises, and on public sector pay. In those two decades, the debt stock increased over ten times (see chart 1).
A government must find the right income balance between aid (or grants), concessional loans, borrowing (debt securities) and taxes. Sri Lanka has had a hard time raising the level of taxation. And as it’s no longer a poor country, Sri Lanka does not receive aid. As a result, in the last two decades, the country has increased its borrowings and also sought concessional loans (credit with lower than market interest rates). Other foreign creditors are multilateral institutions, mainly the Asian Development Bank and the World Bank and foreign governments, mainly Japan, China and India. Of roughly Sri Lanka’s Rs13 trillion in debt, half of it is in foreign currency or owed to foreigners.
The county diversified its creditors to grow the debt stock, by borrowings (rupee and foreign currency debt securities) and concessional loans (foreign currency). Sri Lanka issued its first International Sovereign Bond (ISB) in 2007 and by 2019 foreign bondholders held 42% of the island’s $35.2 billion (42% of GDP) foreign currency debt (see chart 2). Sri Lanka obtained $34 billion in foreign loans (soft loans and by ISBs’) during 2005 to 2019 and 81% of these, or $27.5 billion, funded infrastructure according to Verité.
In most years since 2000, the stock of foreign currency debt increased at about the same pace or faster than rupee debt (see chart 3).
Getting to, around, and out of Colombo is gradually becoming stressful for commuters. An LRT project evaluation by JICA highlights that over a million people flow in to Colombo each day. Commuters also compete with freight transport on Colombo roads. Over 40% of the GDP is generated in the western province, and 28% of the population lives there. JICA’s LRT evaluation observes that private car use will increase along with the population and economic growth. Once the share of private modes of transport increases, it will be difficult to encourage conversion back to public transport, it says. Urbanization’s greatest stress is the one on infrastructure, particularly on transport. The scope for private investment in transport infrastructure like roads and rail are limited in poor and lower middle-income countries. Addis Ababa, the capital of Ethiopia, a sub-Saharan country, is still poor and populous. Ethiopia’s economy is booming and in 2019 per capita GDP is estimated at $950. By comparison Sri Lanka’s per capita GDP is estimated to be $3,850.
Located in the centre of Addis Ababa is the country’s largest city and home to 4.8 million people. In 2015 it launched a 17km-long gleaming new LRT line, linking in the industrial areas in the South to downtown Addis Ababa. A second 16 kilometer east-to-west line was added a few years later. The LRT carries 60,000 passengers an hour with fares low enough for everyone to use it.
Cities thrive when people can get to their places of work, to schools and run errands fast, comfortably and at their convenience. Study after study proves that the number one contributor to urban quality of city life is efficient transportation. Naturally, Colombo’s residents are crestfallen about the state of urban transport and that a LRT that was readying for construction didn’t materialize. Morning and evening commutes are tiring, stressful and time-consuming. It’s quite normal that a 15 kilometre commute in the morning or evening can take two hours each way.
On the face of it, Japanese loans are the most beneficial for Sri Lanka because their annual interest rate of 0.7% and loan duration at 34 years are unsurpassed by Sri Lanka’s other major lenders, even multilateral ones like the World Bank and ADB (see chart 5). Japanese loan tenures on average are 35% longer than the next most generous major lender which is the ADB. Verité Research has adjusted for exchange rate changes in calculating the interest rate, as loans are provided in various foreign currencies and in various years.
While Japanese loans are the cheapest and offer the longest repayment periods, International Sovereign Bonds (ISBs) are the costliest and have shorter tenures. On average ISBs, which are all dollar denominated, cost 6.6% annually and have to be repaid in, on average, over eight years. China offers soft and semisoft loans to Sri Lanka. Interest rates on Chinese loans, while much lower than ISBs are among the highest of those providing soft loans.
Interest rates and the loan tenure are only broad indicators to figure if a loan is concessionary, or a soft loan. Verité’s publication identifies a two-step process for determining if a loan is a concessional one. The first is the grant element of a loan, the second is to examine if the loan is vulnerable, due to hidden costs, of slipping into non-concessionary territory. Nishan de Mel who heads Verité Research and is a co-author of the loan concessionality publication says these criterion are widely accepted to figure if loans are concessional.
In figuring if a loan is soft, Verité uses the IMF’s definition of a concessionary or soft loan; as requiring a grant element of at least 35%. The grant element of a loan is the difference between a loan’s nominal value and the discounted total of the future debt service payments.
Verité has chosen to discount the future debt service payments by 6.5% which is equivalent to what Sri Lanka pays in the international bond market currently. De Mel explains that the methodology allows it to get a high grant element due to the high discount rate. He says as the discount rate is high, it favors the country or institution lending to Sri Lanka.
“More loans are going to get evaluated as having a larger grant element by using a higher discount rate.” Of the largest 50 infrastructure loans obtained between 2005 and 2019, the Japanese loans have the highest grant element. Of the 50 loans analyzed, Verité says 33 had grant elements of above 35% using the 6.5% discount rate (see chart 6). Of the major lenders to Sri Lanka, on average ADB and Chinese loans didn’t meet the concessionary criteria, albeit by a narrow margin.
Says De Mel, “China’s grant element is 31% and does have a large loan quantum. This is the starting point for asking if this grant element of the loan can be eroded by the terms and conditions attached to the loan.” Hidden costs in loans, by what is referred to as a ‘tied’ element, is the second challenge. The tied element refers to conditions that prevent Sri Lanka from obtaining the lowest possible price by competitive bidding. “A tied element refers to the portion of the loan that is tied to the procurement of goods and services from contractors or agencies connected to the lending country,” De Mel explains. It’s a chain reaction. Tied procurement prevents competitive bidding, which in turn increases the risk of cost escalations.
Should costs escalate, the grant element of the loan will be eroded. Verité’s research director Subhashini Abeysinghe who is a co-author of the loan concessionality publication says the tied element occurs frequently in bilateral loans. “Many Chinese loans are unsolicited, with India’s lending the contractor is pre-selected sometimes, and Japan restricts bidding to companies from that county. Vireité’s researchers were able to obtain enough details on 28 of the 50 large loans to make judgement on any tied elements. These 28 loans were to disburse $11 billion. Of the $11 billion in loans ones worth $9 billion had tied elements and $4 billion of that had tied loans associated with unsolicited proposals.
“Why is a tied element a problem?” De Mel asks rhetorically. “It means the country can’t put up that procurement to the lowest value bids, it is in some way constrained. It also increases the risk of cost escalation.” Between 40 to 50% of the loan on average is tied, Abeysinghe says referring in general to the $9 billion of borrowing agreements Verité was able to examine. Again, Japanese loans have the most favourable procurement terms for Sri Lanka (see chart 7). As a result, projects like the new airport terminal and the suspension bridge across the Kelani river that links the airport highway to Colombo’s road network will carry lower risk. Chinese loans are the most restrictive ones of the 28 loans that Verité has analysed.
Nishan De Mel says there are some loans clearly at high risk of being averse to Sri Lanka. “That is, its highly probable and the cost escalation of the tied element not only brings the grant element to zero but actually exceeded it. Such that Sri Lanka may have been better off borrowing from international financial markets, rather than taking what looked like a concessional loan.” He says for some of the loans, a cost escalation of as little as 4% would completely erase the grant element. An example would be the $214 million loan obtained from China Development Bank (CDB) for the Moragahakanda project where the max cost escalation threshold was 4%. It would have been more advantageous for Sri Lanka to borrow at commercial rates in the global financial markets should costs escalate by more than 4%. The outrun of the project is unknown, however Sri Lanka has 15 years to repay the loan and a four-year grace period, which global financial markets will not allow. CDB is a policy bank and its loans are semi-soft, so they are often not cheap.
Already Sri Lanka’s largest bilateral lender and its most generous one, Japan, is grumbling about Sri Lanka’s callous disregard for a signed agreement and the cavalier announcement through the media the decision to reject the loan. It’s reported that under the contract agreement, if the LRT project is suspended or delayed due to renegotiations, the Sri Lankan government will incur a loss of around $100 million, in addition to penalties from JICA. Such terms are normal in such agreements. In June 2020, the Government announced that the LRT project would be carried out as a Private Public Partnership (PPP). Government officials also stated a Request for Proposal (RFP) for the project will be prepared by the year end.
Addis Abba’s light rail was funded by a Chinese loan, as most other infrastructure in that country and in many nations in sub Saharan Africa. Ethiopia’s first LRT line was built in a record three years, much faster than any Japanese funded LRT connecting downtown Colombo to the suburbs can be built.
Sri Lanka’s creditors today are more diverse and interest rates are higher. China’s role as a creditor is likely to grow if Sri Lanka is to make any aggressive bid to bridge the infrastructure deficit. China is the world’s largest official creditor. Its reported $700 billion in loans to developing countries is more than twice as big as the World Bank and IMF combined. However, China and international markets alone won’t be able to build everything Sri Lanka needs. Over relying on these two sources risks escalating costs and burdening the future with uneconomical and economic growth sapping infrastructure.
