Climate, COVID-19, and the Developing Country Debt Crisis

Potential criteria for prioritising debt-for-climate swap support

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The triple COVID-19, economic, and climate crisis poses a growing challenge to debt sustainability and financing for climate action. There are growing calls to look for solutions for the three crisis together, notably through “debt-for-climate” swaps. Though not a general panacea, such proposals may represent an attractive option for both debtors and creditors. As an input into this ongoing discussion, this working paper proposes several potential broad criteria and proxy indicators as a starting point to identify countries where such debt swaps could be piloted, potentially with lessons learned to be expanded to a growing number of countries.

Main Findings:

The ongoing COVID-19 pandemic and the associated economic crisis are contributing to what the IMF has warned may become an emerging market debt crisis. While many industrialised countries have been able to mobilise sizeable stimulus packages, many emerging markets and developing countries will struggle to follow suit. Debt levels in many developing countries have outpaced economic growth, and the ongoing pandemic is pushing tens of millions back into extreme poverty undoing years of progress. Despite discussions about promoting “green recoveries” and helping to “build back better”, climate action is often a victim of a constrained economic environment. The situation has led to growing calls to tie debt relief to climate through “debt-for-climate” swaps (multilateral, bilateral, or with private investors) or a climate-informed reallocation of Special Drawing Rights at the IMF.

Such proposals may be attractive for both debtors and creditors. For fiscally constrained debtors they can represent an option to support both budgetary relief and help fund climate mitigation and adaptation action – something that is attractive not only to environment ministries, but also to finance and other line ministries. For creditors, who face significant debt write downs anyway, they may represent an option to help developing countries recover and promote climate friendly development at the same time.

Climate-for-debt swaps are however not a general panacea. Countries struggling with high debt levels will need help to address the immediate impact of the pandemic and measures for general macroeconomic stabilisation first, meaning that such debt-for-climate efforts must come “on top”. Further, to have impact, they must be significantly scaled up and broader in scope from the current examples of debt-for-nature swaps that have already set a precedent for such action.

To inform this ongoing discussion, we propose several potential broad criteria and proxy indicators as a starting point to identify a short list of countries where such debt swaps could be piloted, potentially with lessons learned to be expanded to a growing number of countries. As an initial long list, we consider heavily indebted poor countries, least developed countries, or countries that qualify for debt relief mechanisms such as the G20’s Debt Service Suspension Initiative.

We further consider four main criteria and proxy indicators to identify potential priority countries for a debt-for-climate swaps initiative, both from the creditor and debtor perspective: Economic indicators that reflect the need for debt relief; Emissions and fossil fuel indicators reflect potential for emissions reductions; Climate action indicators that are likely to indicate interest, willingness, and potential country ownership; and Governance indicators that indicate capacity to use the gained fiscal flexibility effectively.

We find that although a large short-list of countries could be considered for debt-for-climate swaps based on their macroeconomic situation and fossil fuel indicators; a much smaller number of countries also have established climate ambition and good governance. The criteria and proxies suggest that out of the possible candidates several SIDS – namely Dominica, Granada, Samoa, St. Vincent and the Grenadines, as well as Tonga – may be especially promising candidates for interest for debt-for-climate swaps. Although the criteria do not reflect climate vulnerability, these countries are also among the most vulnerable, face significant challenges in addressing climate change, and need additional financial resources to implement resiliency and mitigation measures. The non-SIDS countries of Bhutan and Rwanda may also represent especially good candidates.

There are however several limitations and trade-offs related to this exercise. The development status of these countries is associated with relatively low emissions, so although a debt-for-climate swap may have significant impact for these countries’ emissions and resiliency, in global terms, it may be a comparatively smaller impact on global emissions. Expanding a debt swap effort to include larger emerging countries may have the potential to have a larger impact on global emissions. Further, the data gathering exercise was conducted primarily in late 2020 is only a snapshot of a highly dynamic situation. Since then, the economic situation of many countries has worsened, and some institutions such as the IMF warn of larger capital shifts when interest rates rise in the US and or Europe as a potential taper tantrum like that of 2013. Lastly, an examination of countries according to good governance criteria, suggests that a large number of countries face significant challenges in the efficient and transparent use of funds underlying the need for climate diplomacy, outreach and engagement, accountability, and institution building in addressing the triple COVID-19, economic and climate crisis.

Contacts for further information: Katharina Lütkehermöller or Aki Kachi