Australia sets the rhythm in a complex Pacific dance

The Pacific is receiving more development support than ever. Yet, this is increasingly in the form of loans at a time when debt sustainability across the region is a growing concern amid rising interest rates and escalating impacts of climate change.

In the midst of these pressures, Australia has aggressively replaced China as the most important source of new loans for the region. While this has allowed Australia to expand its development support and presence in the region, it also carries risks.

In 2021, the Pacific Islands region experienced an unprecedented influx of development support, breaking records with a staggering $7.6 billion in aid and other financing for its development partners. While this surge reflects a significant international effort to assist the region during the pandemic and its aftermath, a closer look reveals that most of this was in the form of loans, rather than traditional aid grants.

Grants play a vital role for Pacific Island nations in addressing immediate development needs without the burden of debt. Especially given their fragile economies and vulnerability to severe natural disasters including climate change.

Yet, aid grants to the Pacific have dwindled over the past decade after accounting for inflation. Even during the pandemic, while more grants were provided, the overall level was still barely above the 2011 peak in inflation-adjusted terms.

In contrast, loans have seen a significant upswing. China emerged as a major loan provider in the Pacific in the 2010s, funding substantial infrastructure projects like the Vanuatu Luganville wharf and the Kumul Submarine Cable Network Project in Papua New Guinea. However, in recent years, Chinese loan financing has dwindled as Beijing adopted a more targeted approach.

Yet, loans continued to increase, especially during the pandemic. While loan financing accounted for only 12 per cent of all development projects in 2008, it had quadrupled by 2021. China wasn't the primary contributor to this loan surge. Instead, Japan, the Asian Development Bank, and notably, Australia, emerged as the principal creditors in the region.

Australia has substantially increased its lending, offering one of its largest-ever budget support loans to Papua New Guinea in 2021, amounting to $650 million - under the auspices of an International Monetary Fund (IMF) stabilization and reform program.

This operation aimed to help PNG address its budget financing shortfall and navigate the ongoing health and economic impacts of the COVID-19 pandemic. What's more, Australia is also extending new loans to help meet the region's infrastructure financing needs.

Yet, all this comes at a difficult time when budgets are under pressure and the costs imposed by the increasing frequency of natural disasters continue to rise. Today, a majority of Pacific countries are considered at high-risk for debt distress by the IMF.

What does this mean for Australia's lending to the Pacific?

Australia replacing China as the leading source of new bilateral loans in the region should be seen as good news for the Pacific. While some Chinese projects have likely provided important development benefits, others have not and instead contributed to debt problems or undermined domestic good governance. Australia by contrast adheres to internationally agreed standards and can offer a more affordable and high-quality alternative.

Loans extended by Australia come at more favorable conditions compared to market standards. This is important given Pacific countries have underdeveloped domestic financial markets and very limited and expensive access to international capital markets.

Australian loans therefore present an important opportunity for Pacific countries to secure a greater scale of financing for development and climate-related initiatives at a more affordable cost.

Australia has also acted as an important source of financing at a time of financial volatility. This has mattered in PNG, one of the few Pacific countries with some ability to borrow from the market but with this now exposing it to high global interest rates and difficulties rolling over existing debt.

While this shift towards more loans may have benefits for the Pacific, it brings a significant risk for Australia.

Most of Australia's loans are directed to PNG. Its ability to repay loans depends on its economic stability and growth. As a resource-dependent developing country, it may have limited capacity to service debt if its economy experiences setbacks, such as declining commodity prices or natural disasters. Should such a scenario occur, Australia would find itself in a very complicated position.

The Pacific Islands region is currently at a crossroads, receiving an all-time high development financing yet facing a worsening adequacy of its support. As the Pacific grapples with growing debt and economic challenges, it's a complex dance that will determine the future of development financing in the region, and Australia could set the rhythm.