Addressing the triple threat of debt, climate, and development    

Failing to address this crisis threatens a humanitarian catastrophe in which the countries least responsible for the climate crisis will face its worst effects.

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SOURCEForeign Policy in Focus

As the world speeds past the target of keeping warming to 1.5 Celsius above preindustrial levels, developing countries are particularly hard hit by the triple threat of indebtedness, climate vulnerability, and underdevelopment. According to the IMF, 60 percent of low-income countries and 25 percent of emerging market economies are in, or at risk of, default. Debt servicing levels are at record highs, displacing spending on health, education, and social services.

The most indebted countries are also among the most vulnerable to climate change. Failing to address this crisis threatens a humanitarian catastrophe in which the countries least responsible for the climate crisis will face its worst effects.

At the global level, non-debt-creating finance can help developing countries escape the vicious cycle of indebtedness and underdevelopment. At the national level, developing countries should expand social spending and, where possible, implement green industrial policies that can put them on a path toward sustainable development.

The triple threat

The COVID-19 pandemic and interest rate hikes by the U.S. Federal Reserve have been major drivers of the growing debt burden of developing countries. The International Monetary Fund (IMF) was at the forefront of the pandemic response. Its meager emergency funding measures, however, failed to provide adequate relief to developing countries. These countries had to resort to borrowing from the IMF at higher interest rates and with surcharges. Over 70 percent of financing disbursed by the IMF to emerging and developing economies between March and July 2020 was at market rates and with strict rules governing repayment. In February 2022, meanwhile, the Federal Reserve began implementing the most rapid interest rate hikes since the 1980s, exacerbating the already intensifying debt crisis.

Efforts to address the debt crisis began in 2020 when the G-20 created the Common Framework for Debt Treatment (CF). Sovereign debt crises present a unique challenge because there is no mechanism to arbitrate between the diverse array of creditors and claimants. Sovereign debt is held by private institutional investors, banks, multilateral lenders, and bilateral lenders. Previously, the majority of bilateral lenders were represented by the Paris Club, a group of major creditor countries. However, China and other non-Paris Club countries are now significant players in bilateral lending, rendering even this flawed system unworkable.

The CF made some headway in bringing Paris Club and non-Paris Club creditors into a shared resolution process. However, it did not include multilateral lenders and failed to compel private creditors to participate in debt negotiation.

Tackling debt and climate

Other options for addressing the debt crisis include issuing more Special Drawing Rights (SDRs) and ending IMF surcharges. These steps are necessary and important. However, even without a new SDR issuance, existing SDRs can be leveraged to address the debt crisis as outlined by the Debt Relief for A Green and Inclusive Recovery Project. SDRs can be used to finance a guarantee facility. This facility would restructure and swap existing debts with green financial instruments. Participating in this debt swap would require all bondholders, including Multilateral Development Banks (MDBs), bilateral lenders, and private creditors to take haircuts—reduced rates of repayment—at the same level. This would ensure that these debt swaps offer genuine and deep debt relief. In exchange for these haircuts, private creditors would be offered guarantees on a portion of their debt. This debt swap would resolve existing debt burdens and unlock $250 billion in climate finance.

If the financing made available by these swaps is to truly support a green and just transition, the mechanisms of the green financial instruments that the proposal puts forth need to be considered more carefully. For example, the authors suggest that financing can be connected to countries’ Nationally Determined Contributions (NDCs) under the Paris Agreement. The Paris Agreement pushes countries in the Global South to use carbon markets to meet their climate commitments. These markets are fraught with fraud and backed by violent evictions of indigenous communities. Moreover, they often create opportunities for veiled emissions and bring the planet no closer to the goal of decarbonization.

Other suggestions in the proposal such as using sustainability-linked bonds should also be regarded with caution. Sustainability-linked bonds penalize issuers by threatening higher costs of borrowing should they fail to meet certain narrowly defined indicators. This would only pose further impediments for debt-distressed countries that are struggling to make a green transition by blocking financing when they need it the most. These disciplinary mechanisms are better suited to large corporations than debt-distressed countries, since they put these countries at further risk of indebtedness. All “green” financial instruments—including green, sustainability-linked, or ESG-linked bonds—subject developing countries to the shenanigans of rating agencies that are only now beginning to design methodologies for climate credit scores. In many cases, these ratings have been shown to consider climate vulnerability as a risk that could result in rating downgrades and impose greater borrowing costs on countries that need financing the most.

Ultimately, developing countries will need to undertake ambitious green industrial policies that protect vulnerable populations from the effects of the climate crisis and chart a path towards sustainable, redistributive growth. No single policy can address this daunting task on its own. However, well-designed debt-for-climate swaps can act as a building block by excluding both carbon markets and “green” financial instruments from their scope.

Debt justice

Partial standstills on debt payments, while helpful, may not suffice to encourage private creditor participation. The financialization of sovereign debt has created a plethora of financial instruments and creditor classes via secondary markets for sovereign debt. Many private creditors, especially vulture funds, are unlikely to be enticed into debt resolution. If even a small minority of private creditors refuse to participate in debt resolution they can impede the entire process via legal action. This famously happened in the case of Argentina, when private creditors holding only 7 percent of the country’s debt sued and impeded debt resolution.

To prevent private creditors from posing an obstacle to debt resolution, all claimants must be bound by a resolution reached by a majority of creditors. To ensure the integrity of such a process, this mechanism would need to be independent of any existing creditors. The United Nations could create an independent debt workout mechanism by passing a resolution or adopting a treaty to do so. In the long term, this would need to be supported by statutory reforms in New York and London that would codify a duty for creditors to participate under the mechanism, immunize debtor country assets during negotiations, and bind all claimants to a decision reached by a majority of creditors.

Even with these reforms, public financing from multilateral development banks (MDBs) would still be subsidizing private profit via guarantees. This trade-off is more than acceptable considering the existential stakes of the climate and debt crisis. However, in the future, debt crises must be prevented from spiraling out of control in the first place. The ostensible purpose of creating international capital markets was that states could use sovereign debt as a tool to finance economic development.

However, the market mechanisms that price risk fail to disincentivize unsound investments. Instead, they simply transfer these risks onto debtor countries by forcing higher costs of borrowing upon them. For example, even when Sri Lanka was on the verge of default, it still borrowed millions in capital markets to service existing debt. Markets were ready and willing to offer this financing —albeit at very high rates— because they were flooded with yield-seeking capital at the time. Ultimately, this problem will require a broader transformation in how international capital markets are understood, used, and regulated.

Climate finance targets

Helping indebted countries out of their hole is necessary but not sufficient in terms of meeting existing needs for climate finance. Debt-for-climate swaps can make $250 billion in climate finance available, but this would still leave a large financing gap. Estimates of climate finance needs vary greatly from as little as the OECD’s commitment of $100 billion per year to $1-3 trillion per year depending on who you ask.

Despite anxieties that shareholder governments are unwilling to facilitate this financing by recapitalizing MDBs, several options for MDB recapitalization remain unexplored. One option that has been proposed is rechanneling SDRs via MDBs. These SDRs could recapitalize MDBs by financing what are called hybrid capital instruments. These financial instruments are structured like bonds, which have scheduled interest payments but, like equity, have perpetual maturity. As such, they would recapitalize MDBs by serving as a permanent contribution to MDB resources. In response to advocacy efforts, the IMF has agreed to facilitate this process. However, they have capped the amount of financing to a total of SDR 15 billion which, if lent at a 1:5 ratio, could make SDR 75 billion in new financing possible.

Other proposals have explored the option of creating a new reserve asset. To mobilize $2.5 trillion by 2030, central banks can invest as little as 0.5 percent of their foreign reserves in these new reserve assets to recapitalize MDBs by approximately $60 billion per year. Lending at a 1:5  ratio, MDBs can expand lending to more than $2 trillion by 2030. MDBs must use this new lending firepower to expand grant-based and concessional financing to create policy space for robust regulatory regimes that can direct a green transition in the Global South.

Addressing the combined debt, development, and climate crises require a huge influx of financing. And this financing must be done without increasing the debt burdens of developing countries. A financing mechanism that relies on a new global reserve fund can play a significant role in addressing unsustainable sovereign debt burdens and generating the financing for a green transition in the Global South.

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