Investments in climate will become almost impossible for developing countries at risk of debt distress.
Vital investments to re-ignite growth and progress on climate action in developing economies are doomed to fail if the current debt overhang remains unaddressed. While the international community is preparing to move from billions to trillions, efforts to translate these investments into the green transition will not succeed as long as developing countries continue to struggle with debt crises. Indeed, a large portion of the new cash flows would leak out as debt service, whilst economies in disarray will be unable to increase their investments in a sustainable future. It is, therefore, crucial to establish a bridge between the current crisis and a time when we can fully focus on saving the planet.
Most countries that are currently facing financial stress suffer from illiquidity, not insolvency. Insolvent countries should use the Common Framework, but it has so far been slow and uncertain. There have been numerous proposals aimed at improving it, which should be seriously considered. However, this paper addresses a different problem and a different set of countries. Debt distress due to liquidity tensions is a result of a rise in global interest rates, combined with maturing bonds and increased amortization of bilateral loans. For these countries, coordinating debt rescheduling among their diverse creditors is essential. Pre-emptive concerted rescheduling of debt would allow illiquid countries to bridge the gap and to start investing additional international support in the green transition while improving their prospect of servicing external debts.
This roll-over problem, the challenge to afford large redemptions coming due between 2024 and 2026, will be relevant for at least 20 low- and lower-middle-income countries in our estimates, of which 17 are recipients of IDA support. They represent about $1.7 trillion of GDP, $600 billion in external public debt, and $70 billion per year in debt service payments from now to 2028. With no access to markets and reduced bilateral flows, L&LMICs face years of negative net transfers, which is hurting their growth prospects and their ability to tackle the climate challenge. This double bind of rising negative net transfers and declining growth performance can eventually lead to insolvency, further delaying the green transition.
Debt service at risk for "illiquid-but-solvent" countries
A bridge for illiquid countries
This paper proposes a “bridging program” that unlocks net positive flows for countries facing liquidity constraints. The program operationalizes a tripartite deal: Multilateral Development Banks (MDBs) would boost their funding for new investments, particularly those linked to climate objectives; creditors would agree to reschedule their claims; and countries would commit to stabilizing their economies and engaging in efforts to promote recovery.
Those three blocks are tightly interlinked. If MDBs were to step up their funding, as they are already planning to do under the optimization of their balance sheets, the new funds would leak out to other creditors unless the program is adopted. Rescheduling is, therefore, essential. At the same time, existing creditors would only agree to reschedule if the debtors’ ability to repay does not deteriorate over time. This means that countries need to place themselves on a renewed growth trajectory with the support of new investments and positive net inflows.
Taken together, a standardized framework could be established to implement such deals. It would provide parties with incentives to participate and build trust progressively. The framework requires limited financial efforts compared to other alternatives. For countries, it builds on existing growth plans. For MDBs, additional funding needed to support the proposal is limited and would merely require accelerating existing expansion plans. Other creditors will require strong enough incentives – both carrots and sticks – to participate, but both could be mobilized if a broad political agreement emerges. Importantly, this note only puts forward a series of options, opening avenues for further concertation to define such incentives.
The proposal requires dedicated logistical and financial coordination. Ultimately, illiquidity is a crisis of coordination and expectations: a country is able to repay its loans if they were spread through time, but investors’ negative expectations ultimately force it into default. The aim is to facilitate collective action among debtors and diverse creditors. International financial institutions (IFIs) have evolved in recent years, preparing to scale up their funding, improve coordination among themselves, and expand their timetables to longer horizons. This proposal capitalizes on these reforms to deal more effectively with debt roll-over risks.
Such a program could begin immediately for some countries, demonstrating rapid progress on a narrative of growth and climate action. This would help overcome an overly pessimistic mood that has taken over the developing world, improving the momentum of both development efforts and the rise in environmental activism. It aims to address some challenges voiced by Kenya's President, William Ruto at the "New Global Financing Pact" Summit in Paris, on which he expanded in a co-authored op-ed with leaders of regional institutions. It could be seen as an enhanced Debt Service Suspension Initiative (DSSI), building on its successes and learning from its failures, or as a complement to the Common Framework, a second window dedicated to countries in need of rescheduling rather than deeper debt treatments.
There are many parameters to define, and this paper aims to open a conversation. Which countries should be eligible? What should be the parameters for a rescheduling? How can the private sector be brought in earlier in the discussions? All these questions will need to be solved to adopt such a plan. Our proposal does not solve all of them but provides key principles which could be discussed at the G20.
If left unaddressed, the ongoing liquidity crisis will no doubt lead to development and climate disasters. The global economy cannot afford a lost decade of growth in the developing world, nor further delays in tackling climate change. Growing out of the debt problem and providing protection against climate vulnerability are the best ways out of the current predicament. The international financial architecture is not equipped to manage such cases and needs to diversify and increase its toolbox. The bridge program we are proposing is made all the more necessary by the fact that the MDBs are gearing to scale up their funding, but these efforts might not contribute to new investments if debt service is not rescheduled with strong country-owned investment programs.