8 minute read | November.29.2023
As world leaders prepare for the UN Climate Change Conference (COP 28) beginning in the United Arab Emirates this week, new ideas may help advance solutions to the globe’s most challenging climate-related finance problems.
The problem of debt sustainability of developing countries has coincided with a need to finance climate mitigation and adaptation in these countries. The challenge of debt sustainability has intensified calls for debt relief from private finance institutions, while at the same time, those institutions are being urged to scale up climate-related financing, including in developing countries. A simultaneous solution to this twin challenge seems unworkable, no matter how hard governments of rich countries, typified by the G-20, exhort developing countries and private institutions to do more on their own.
The Institute of International Finance has noted a record $550 billion of sovereign debt in default. Debt strains are particularly pronounced among developing countries, with 39 of the 73 developing countries eligible for the G-20 Common Framework for Debt Treatment in or at high risk of debt distress.
Furthermore, the International Energy Agency projects that climate mitigation investment would need to increase to $2 trillion a year by 2030 in emerging market and developing economies, requiring an over three-fold scaling up from current investment levels. While one might quibble with the size of these projections, the key point is that these magnitudes are well beyond the stated capacity of the public sector. Significant crowding-in of private capital will be needed to make up the difference.
One possible solution: A grand bargain that would involve grants from rich countries to help alleviate medium-term debt service challenges of eligible developing countries, while at the same time preserving the emerging and frontier market asset class, thereby elevating the capacity of private institutions to finance climate mitigation and adaptation.
The International Monetary Fund, through the exercise of its technical and financial services mandate, is an obvious candidate for the administrator function to implement this proposal. The IMF could establish a trust – the “IMF Debt Service Trust” – to which rich countries would channel the Special Drawing Rights (SDRs), or the equivalent in hard currency, that the IMF allocated to them in August 2021 based on the assessed need for additional global liquidity during the height of the COVID-19 pandemic.
Given that the IMF treaty requires the IMF to allocate SDRs in proportion to weighted quotas, the IMF could not legally target the $650 billion of SDRs to the developing countries that needed liquidity the most. Accordingly, G-20 countries received around $440 billion in SDRs. While many of them have made political commitments to re-channel these SDRs, they have collectively fallen short of meeting those commitments. The grand bargain would rectify and go beyond this shortfall. The cost to rich countries would be minimal: The SDR floating interest rate (currently around four percent) on the stock of SDRs transferred to the IMF Debt Service Trust.
The IMF Debt Service Trust would be tailored to provide grants upon request to eligible developing countries. Those grants would help developing countries make principal and/or interest payments on their foreign currency private creditor claims during a defined period – say, five years from the initiation of the trust (potentially renewable by a further five years subject to financing and a review mechanism).
Current estimates indicate that the interest and principle payments on foreign currency debt due over the next five years exceed $310 billion across countries eligible under the G-20 Common Framework. Eligible debt will need to be contracted before a past cut-off date to safeguard against gaming the system. As the IMF legal framework does not provide for private finance institutions to be “prescribed holders” of SDRs, the hard currency equivalent of the SDRs will make the actual debt service payments.
Other than establishing the trust and disbursing the grants, alongside the IMF continuing to make assessments of debt sustainability, the IMF would not have any further role. Accordingly, the IMF would not be establishing conditionality associated with climate mitigation or adaptation as part of the trust’s operations. Such conditions would be established and monitored through terms of the new financing from private finance institutions.
Furthermore, the IMF Debt Service Trust would avoid the main pitfalls of the ill-designed G-20 Debt Service Suspension Initiative, which exacerbated default risk and conflated debt suspension with its liquidity objectives.
As a starting point, eligible countries could include those countries that are eligible for the G-20 Common Framework. However, participation in a “debt treatment” (i.e., restructuring) under the Common Framework would not be a condition to qualify for the grants. Eligibility would be limited to developing countries whose debt the IMF assesses to be sustainable, including countries engaged in IMF programs that require restructuring public debt to restore sustainability.
However, participation in an IMF program would not be a condition for access to the IMF Debt Service Trust, in contrast to the condition on access to the IMF’s Resilience and Sustainability Trust, which only provides loans alongside other IMF financing instruments.
Private finance institutions that receive debt service funded by the IMF Debt Service Trust would be required to commit new financing to developing countries either for earmarked budget support or for specific projects aligned with the countries’ National Adaptation Plans.
To the extent that private finance institutions are subject to legal limitations on their capacity to make long-term commitments on the use of their client funds, the commitments can be made on a periodic basis. Some private financial institutions would need to change the terms under which they manage asset pools for the commitment of climate-related financing to be feasible.
The commitment of such new financing should be tied to measurable use of proceeds covenants to safeguard the use of the funds towards the climate mitigation and adaptation objectives. However, the new financing would not be directed only to the public sector of the relevant developing country, but could be channeled to the corporate sector or through project financing. The use of these alternative channels could help assuage public debt sustainability concerns. Ideally, the amount of new financing would be multiples of the quantum of debt service funding received through the IMF Debt Service Trust, particularly where leveraged through other credit enhancement tools, such as guarantees from multilateral development banks.
Of course, implementation of this proposal would be subject to free-rider problems as some institutions may take the direct benefit of the debt service funding while not carrying out the commitment to provide new financing and there are few, if any, appropriate legal and policy tools to enforce such commitments.
However, to the extent that the grand bargain supports the emerging/frontier debt asset class, the market at large would benefit, notwithstanding individual free riders. And in circumstances where the relevant debt instruments contain collective action clauses, it may be possible to mitigate the free rider problem through conditioning the debt service funding to circumstances where a qualified majority of the creditors agree to the grand bargain.
The grand bargain is not intended to displace the whole of the international financing architecture. Instead, it would add a temporary tool within that architecture to help overcome the medium-term time inconsistency between debt payments and climate-related financing for developing countries.
Other legal and policy tools are needed to recalibrate the regulatory burdens that have curbed private capital flows to developing countries over the last decade or so. Furthermore, the grand bargain is not intended to replace every tool or resolve every debate in the global challenge of climate mitigation and adaptation. For example, room would remain for debt exchanges to replace vanilla bonds with sustainability-linked bonds and for financing instruments with contingent elements, or for insurance that would place sovereign borrowers and lenders in a more resilient position in the face of climate-related shocks.
Rather, a grand bargain could facilitate private capital to help accomplish what G-20 governments cannot do on their own in terms of providing the scale of financing needed for climate mitigation and adaptation in the developing world. In turn, rich countries could do what sources of private capital cannot do on their own in terms of safeguarding the emerging and frontier market asset class that is critical to climate-related finance and to sustainable development objectives in general. Developing countries could do what the rest of the world cannot do on their own in terms of contributing a crucial component to saving our common planet. This win-win-win solution is worth a concerted effort.