What Is Debt Trap?
A debt trap means a vicious circle of debts that a weak nation or individual borrow to repay old loans until the debt burden goes beyond control to the level of bankruptcy. Powerful nations lend money to weak countries but also lay a trap to keep the borrower and its resources under their control.
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Rich, powerful lenders/creditors utilize it to control the strategic locations, infrastructure, and developing economy for their benefit. Third-world countries and the poorest people generally fall prey to the debt trap. It is a form of neo-colonialism by certain countries to colonize developing and underdeveloped countries.
Table of contents
- What is Debt Trap?
- Debt Trap Explained
- Chinese Debt Trap
- Debt Trap Diplomacy
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The debt trap refers to the policies of a powerful country that tries to capture the resources of a weaker country under the aegis of diplomacy of financial help at higher interest.
- Generally, the weaker countries lacking investors cannot control the loan. As a result, they fail to pay the interest. Hence, they get entrapped in the vicious circle of loans to the extent of bankruptcy.
- It is a way to enforce neo-colonialism in third-world countries.
- Diplomacy is a coating over the better pill of high-interest loans with conditions favoring the lender.
Debt Trap Explained
The debt trap meaning implies a trap laid out by a powerful nation for a weaker nation to salvage its natural resources in a colonial manner. They do it under the guise of diplomacy to develop infrastructure and innovation.
As per Brahma Chellany, an Indian academic, it is a strategy of China to engulf as many nations into the fold of its policy. China aims to create a middle kingdom through the belt and road (BRI) initiative. In a way, China sought political control instead of financial help through high-interest-laden loans to weak and financially unstable nations. As a result, these nations find a compulsion to consume loans to make up for the previous loans.
Under this strategy, the country providing credit lures the debtor nation diplomatically to develop its infrastructure for economic growth. Infrastructure development includes airports, bridges, ports, and high-rise office buildings. However, as soon the debtor country accepts its diplomatic help, the former forces it to sign a confidential agreement.
An example includes signing an agreement with the state-run Exim Bank of China. The clauses of the agreement are forbidden to be made public. So they may force the debtor country to undertake agreements forbidding them from seeking financial help from other countries.
It also contains clauses where the defaulting debtor country will have to hand over the developed assets or infrastructure to the lender country for use. As the debtor country lacks funds and revenues, the heavy loan and its interest become a huge burden. But the lender country’s state banks own an agreement signed to use the developed infrastructure and control in case there is a default on a loan by the debtor. Most often, borrowers default. Thus, in this way, a lender country like China successfully takes control over another country’s sovereignty.
Chinese Debt Trap
Chinese debt trap means tactics of neo-colonialism by China. It aims to build silk routes worldwide to make itself the richest and most powerful nation. China’s strategy is to credit third-world countries for developing their infrastructure. However, the huge credit comes along with a higher interest rate from Chinese government banks with a limited period for repayment.
If the borrower defaults, China takes control of the infrastructure. It primarily includes ports to control the trade routes for its trade advantage. The recent catastrophe of the Sri Lankan economy has directly resulted from the Sri Lanka China debt trap.
Initially, Sri Lanka got large sums of money in credit from Chinese government banks to build infrastructure like ports and bridges, which it did. All of these started contributing to the Sri Lankan economy, but the revenue generated was insufficient to repay the Chinese loans fully.
The Pakistan debt trap situation is similar to the Sri Lanka China debt trap as Pakistan followed Sri Lanka’s path. As a result, Pakistan may fall into a debt burden. When China demanded repayment of USD 55.6 million by 2023, Pakistan’s fragile economy faced a setback in 2022.
Hence, the Chinese government indirectly controls the key infrastructures of Sri Lanka, Pakistan, and other developing nations. It directs all trade to China. In a way, it’s a modified neo-colonialism where a rich, powerful nation tries to colonialize a developing country under the garb of huge loans to build its infrastructure. As a result, any loan default makes countries like China control the strategic infrastructure and control the host nations’ trade and economy.
Debt Trap Diplomacy
The debt trap diplomacy is based on strategically extending huge loans to economically weaker countries as a fund for developing infrastructure, which includes confidentiality clauses and a high-interest rate.
Indian academic Brahma Chellany first coned debt trap diplomacy in 2017 regarding China’s aggressive lending policy to poorer nations. It does so to control, for personal advantage, the strategic assets of that country in the event of default of a loan. Hence, China has initiated an empirical project called the belt and road initiative (BRI) to link 44 countries and create a prosperous trade route for every participating nation.
For this purpose, it diplomatically signed trade agreements with all the participating nations. But the researchers discovered that the agreement has to give manipulative prudence to China vis-à-vis other countries. These agreements between the Chinese state-owned banks and the borrowing nation gives sweeping powers to China to scrap loan unilaterally, demand full repayment of loans, prevent the passage of environmental safety laws, and influence the policies of the borrowing nations.
Moreover, the Chinese loan was exempt from restructuring multilaterally like that of the Paris club of official bilateral creditors. In a way, the Chinese debt trap diplomacy aims at making the borrowing nation fully dependent on it for every financial aid and resource, including debt relief.
Debt diplomacy forces a borrowing nation to hand over strategic assets to China under the clause of debt-for-equity swaps. As a result, Laos had to hand over the majority of the state-run national electric grid after its debt rose to 26 percent of its national GDP. Thus, the debt trap policy gets aptly termed the debt trap of China as it seeks to enforce its authority over the sovereignty of other weaker nations using its riches and power.
Frequently Asked Questions (FAQs)
Farmers take a loan for irrigating their farms and buying seeds, fertilizers, and pesticides so that they may grow large quantities of crops. However, when rains fail, or excessive rain happens, it destroys their crops, making them suffer huge losses. As a result, farmers sell a part of their land to close the loan, but they fail to do so. Therefore, they remain in the debt trap of bank loans forever.
The debt trap’s prime cause is a situation where a nation, person, or business with existing loans gets forced to take new loans from lenders to repay the older loan. As a result, the series of loans starts, and the debt keeps mounting to a dangerous level beyond one’s control. In short, it happens when countries spend more than they earn. Here, equated monthly installments (EMIs) exceed 50% of the income, and fixed expenses exceed 70%.
The best way to come out of the debt trap is to make a reasonable budget to minimize the expenditure and maximize the savings for closing all the old loans. And must undertake no new loan or extra expenditure before the resolutions of old loans. In addition, one must consider debt consolidation to lower the loan interest rates.
Yes, one can observe that credit cards are debt traps. Card users get the facility of making a monthly minimum payment. Due to it, they develop a habit of spending more than their required basic needs.
Recommended Articles
This article is a guide to What is Debt Trap and its meaning. Here, we explain the Chinese Debt Trap, Diplomacy and its FAQs. You can also go through our recommended articles on corporate finance –
- National Debt
- Bankruptcy
- Poverty Trap
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
