How Should Chinese Enterprises Overseas Respond to a 'Sovereign Bankruptcy'?

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Author: Lawyer Zhang Jingxinyue | PRC Practising Lawyer | Singapore Registered Foreign Lawyer

Note: On 6 July 2022 local time, Sri Lankan Prime Minister Ranil Wickremesinghe declared that Sri Lanka was bankrupt and that the situation would continue beyond the end of 2023. Several senior leaders, including the prime minister, subsequently resigned. In mid-to-late July 2022, former President Gotabaya Rajapaksa travelled from Singapore to Thailand to seek refuge, while Prime Minister Wickremesinghe became Sri Lanka's new president.

Why can a country become bankrupt? Sovereign defaults are not uncommon in history. Europe, the wealthiest region and also the region with the most sovereign defaults, has seen Germany default seven times since 1800, Austria seven times, Spain eight times, Portugal six times, Greece six times, and France and the Netherlands once each.

Since Sri Lanka declared bankruptcy, we have considered how Chinese enterprises operating overseas can minimise losses and protect their property rights when they encounter an economic crisis or sovereign default. This article explains what sovereign bankruptcy means, its consequences, its impact on Chinese enterprises operating in the affected country and the measures those enterprises should consider.

01 What Does Sovereign Bankruptcy Mean?

The concept of “sovereign bankruptcy” was proposed by the International Monetary Fund (IMF) in 2002. It refers to a situation where a country's financial and fiscal revenues cannot provide the foreign currency needed to pay for imported goods, or where its sovereign debt exceeds its GDP. For example, if a country's GDP is USD 100 billion but its external debt reaches USD 150 billion, it is insolvent. In simple terms, the country no longer has enough foreign currency to service its debt.

The IMF introduced the concept not to deprive a country of sovereignty, but to establish an international financial mechanism for “bankruptcy protection”, enabling heavily indebted countries to seek protection and emerge from crisis more quickly.

Sovereign bankruptcy generally occurs in three situations:

First, sovereign debt default. A sovereign state may be unable to pay principal or interest when due, or even unable to pay interest, because of economic or other reasons. It then faces a payment crisis and the risk of sovereign bankruptcy, as Sri Lanka did.

Second, a change of government. Normally, a change of government does not alter the previous government's credit commitments or the country's debtor-creditor relationships. If a new government questions the legitimacy of its predecessor, however, it may repudiate the predecessor's commitments and refuse to recognise its debts, creating a risk of sovereign bankruptcy. After the Soviet Union was established, for example, it repudiated the debts of the Tsarist and Kerensky governments.

Third, the disappearance of a state. In a strict sense, this is the most fundamental form of sovereign bankruptcy. Usually, when a state disappears, one or more successor states emerge and assume most of the predecessor state's debts and claims. If the successor state refuses to recognise those relationships, a complete sovereign bankruptcy occurs.

Since 2020, the COVID-19 pandemic has affected production and economies in many countries and sharply reduced foreign-exchange income. The number of countries unable to meet their debts has therefore continued to increase.

02 How Does Sovereign Bankruptcy Differ from Corporate Bankruptcy?

1. Sovereign Bankruptcy Does Not Cause the State to Disappear

Although both involve “bankruptcy”, sovereign bankruptcy is fundamentally different from corporate bankruptcy. After a company files for bankruptcy, its assets are liquidated and sold to repay creditors. Any remainder is distributed to shareholders, after which the company exits the market and ceases to exist.

After a sovereign default, no one liquidates the country. A state's sovereignty and territory have defined boundaries, and other countries cannot simply seize them. Sovereign bankruptcy is therefore primarily a nominal or credit bankruptcy, unlike the substantive dissolution of a bankrupt company. The defaulting country remains sovereign. Although sovereign bankruptcy does not destroy the state and government as entities, it seriously damages their credibility.

2. Debts Must Still Be Repaid After a Sovereign Default

After a company enters bankruptcy, the relevant persons generally no longer have to pay the company's debts personally; the company's existing assets are liquidated to repay creditors.

Does a country still have to repay its external debt after sovereign bankruptcy? Because its sovereignty, territory, economic industries and other assets remain, bankruptcy does not mean that the external debt disappears. Once the Sri Lankan government restores its economy and increases fiscal revenue, it will still need to repay its external debts.

03 Why Did Sri Lanka Become Bankrupt?

In April 2022, Sri Lanka announced that it would suspend payment of its external debt because it needed its foreign-exchange reserves to pay for imports. In May, it announced a sovereign debt default. Reports in July put Sri Lanka's total external debt at approximately USD 51 billion.

Image source: online. Sri Lanka's external debt obligations; yellow represents foreign bonds and blue represents other external debt (USD millions).

Since the pandemic, this South Asian island nation, which relies heavily on tourism, has suffered enormous losses. Revenue fell sharply and foreign currency nearly ran out. The Russia–Ukraine conflict also caused energy and food prices to rise. Almost all of Sri Lanka's major industries were connected to the situation in Russia and Ukraine and were directly affected.

More than 40% of Sri Lanka's food imports came from Ukraine; its energy imports relied heavily on Russia and Iran; and 30% of inbound tourists came from Russia, Ukraine, Belarus and Poland. Together with the pandemic, these factors caused exports—which generated 70% of the country's foreign exchange—to fall continuously, while tourism, which contributed 10% of GDP, approached collapse.

Sri Lanka thus became the first country to “fall” under the impact of the Russia–Ukraine conflict.

Since the declaration of bankruptcy, public services in Sri Lanka have largely stopped, schools have closed, public transport has stalled, and residents have been prohibited from purchasing petrol and asked to work from home.

04 How Does Sri Lanka's Bankruptcy Affect the State, Its People and Foreign Investors, Including Chinese Enterprises?

Impact on the State

The country's credit rating falls, making its debt issues less attractive and increasing government debt pressure.
The investment environment deteriorates, potentially causing foreign investors to leave and increasing the risk of domestic economic decline.
Exports fall and foreign-exchange income decreases further. Once a country declares bankruptcy, its economy and exports are likely to be affected, causing foreign-exchange revenue to decline further.
Serious inflation may result. As foreign currency falls, government spending pressure increases. The government may issue more currency to meet daily expenses, further aggravating inflation.
Unemployment may rise. An economy close to bankruptcy is unlikely to develop well, and poor growth combined with serious inflation may cause widespread unemployment.

In Sri Lanka, the first impact was on the domestic currency. The US dollars used to pay for imports have been exhausted. Sri Lanka has prohibited vehicle imports and imposed high import surcharges on various goods. Its central bank also raised interest rates by 850 basis points from the beginning of the year to address inflation. As US interest rates continued to rise, the Sri Lankan rupee depreciated sharply and foreign currency became scarce. Because its foreign exchange had been depleted, Sri Lanka had to stop importing various petroleum products. It then prohibited private vehicles from refuelling, except for public transport, which delivered another serious blow to businesses operating there.

The country also faced the double pressure caused by the pandemic. Since 2020, the tourism sector on which Sri Lanka relied has suffered unprecedented damage. Its collapse brought rising unemployment and falling tax revenue.

The sovereign default also triggered a series of negative domestic reactions. Demonstrations broke out in many areas, and electricity, rice and diesel became scarce. Sri Lanka was plunged into turmoil and hardship.

For Chinese enterprises in Sri Lanka, the most direct effects were the sharp increase in foreign-exchange risk caused by the rupee's depreciation and the inability to maintain normal production because of diesel shortages. Chinese companies had to arrange emergency shipments of food from China and obtain oil through various channels to maintain production capacity.

Colombo Port, Sri Lanka

05 Recommendations for Chinese Enterprises in Sri Lanka

In response to Sri Lanka's unstable situation, our overseas legal team offers Chinese enterprises the following recommendations.

1. Avoid Politically Sensitive Issues

Because Sri Lanka has many social and political risk factors, companies should avoid involvement in religious, political and other sensitive matters wherever possible.

2. Manage Performance Risk and Prevent Unpaid or Abandoned Goods

Because the rupee has fallen sharply, Chinese companies should guard against buyers abandoning goods because they cannot pay in foreign currency. They should also manage the foreign-exchange risk caused by rupee depreciation. Payments and receipts should, where possible, be made in US dollars or another foreign currency, and futures or other contracts should be used reasonably for exchange-rate hedging. Written evidence of dealings with foreign parties should be preserved. Credit sales are not recommended; goods should be delivered only after the buyer has paid 100% of the price, to avoid abandonment.

3. Monitor the Risk Rating of Sovereign Bonds

Investors and companies holding Sri Lankan International Sovereign Bonds (ISBs) should pay close attention to their risk rating. S&P downgraded the ISB rating from C to D and stated that Sri Lanka's sovereign credit rating remained selective default (SD), while its sovereign bonds were downgraded to D because interest payments had not been made. Sri Lanka remained in default on certain foreign-currency debts, including international sovereign bonds. The hidden default risk behind high interest rates requires investors to weigh the risks and benefits carefully.

4. Seek Arbitration in a Neutral Country

Because of the slow local judicial process, most foreign investors choose arbitration in a neutral country if a dispute unfortunately arises in Sri Lanka.

Sri Lanka has established the Institute for the Development of Commercial Law and Practice in Colombo to resolve commercial disputes quickly and economically (www.iclparbitrationcentre.com). The centre mainly handles commercial disputes between equal private parties. Disputes between foreign investors and the government generally cannot be resolved there.

5. Seek Embassy Assistance and Prepare to Leave

Because doing business in Sri Lanka currently involves high risks, companies facing shortages of essential supplies or local disputes should seek assistance from the local embassy immediately. China has provided food aid to Sri Lanka, but the country remains unstable. Investors should prepare a comprehensive exit plan so they can withdraw safely if the situation deteriorates.

6. Avoid Unfamiliar New Projects

If a company continues investing in Sri Lanka, Chinese enterprises should focus on acquiring, upgrading or expanding existing assets rather than undertaking unfamiliar new projects. They should also seek local stakeholders and form partnerships to protect their rights and interests to a certain extent.

7. Manage Risks in Trade with Sri Lanka

Chinese foreign-trade companies exporting to countries suffering from foreign-exchange shortages should guard against abandoned goods and collection risks. The following measures may help.

Maintain close contact with foreign customers

Keep informed about local conditions, the buyer's operations and personnel safety, and whether the industrial and supply chains are functioning normally. Follow up on the customer's performance arrangements and accelerate contingency planning.

Preserve written evidence of communications with foreign customers, including emails, faxes and confirmation letters, to protect the company's rights.

2. Control Collection Risk Prudently

When the importing country suffers a serious foreign-exchange shortage, payment by letter of credit is not recommended.

For orders not yet shipped, companies should request “advance T/T”, meaning that the buyer pays 100% before shipment. The goods should be shipped only after payment is received. If goods have been shipped before full payment, the seller should urge the foreign party to perform its payment obligations promptly.

If payment cannot be collected after a letter of credit has been accepted, the company should actively negotiate with the overseas buyer and seek other ways to reduce the loss.

3. Keep the Goods Safe and Under Control

For orders not yet shipped, communicate promptly with the overseas buyer and logistics provider and arrange shipment cautiously.

For goods already shipped, closely track their movement and control title as far as possible. Release the goods according to the contract only after confirming that the buyer is willing and able to take delivery. If the carrier or buyer clearly indicates that the goods cannot reach the port or cannot be collected, the seller should promptly arrange transshipment, resale or other measures to reduce losses.

Conclusion

In recent years, as the global economic downturn has spread, the number of countries experiencing or approaching sovereign bankruptcy has increased. The Wall Street Journal reported in May that the United Nations had warned that food, fuel and financial crises caused or intensified by the Russia–Ukraine conflict could destabilise poorer countries. More than 70 countries could follow Sri Lanka and face debt default. Since March, Türkiye, Egypt and Tunisia, among others, have experienced high inflation, sharp currency depreciation and debt-default risks. In early April, Lebanon declared that its central bank and central government were bankrupt.

In mid-August 2022, Sri Lanka's new president said that Japan would be asked to invite major creditors, including China and India, to negotiate bilateral debt restructuring. As explained above, sovereign bankruptcy will not cause Sri Lanka to disappear, but the Sri Lankan people will continue to bear the debt for a long time.