4 Steps of Debt Relief for a Green and Inclusive Recovery

By Katie Gallogly-Swan

The debt crisis is far from over in the Global South. While international capital has partially returned to developing and emerging economies, in many low- and middle-income countries (LMICs) debt service is impeding crisis response as third waves of COVID-19 devastate recovery efforts and exacerbate scarring to economies already squeezed by severe fiscal constraints.

In addition to the significant COVID-19 public health response, there is an urgent need to scale up investment in development and climate resilience. Many countries, including many Small Island Developing states, are suffering a triple crisis in debt, COVID-19 and climate change. The service of public debt crowds out room for crucial investments developing countries need to undertake to climate-proof their economies and achieve green, resilient and equitable recoveries.

The G20 Common Framework for Debt Treatments is not sufficient to tackle the debt problem facing many developing and emerging economies. It has crucial shortcomings that are yet to be addressed: it does nothing for middle income countries (MICs) in debt distress, and it has no mechanisms for encouraging private sector participation in relief efforts, though they hold a significant amount of LMIC debt. The international community and the G20 in particular need to agree on a more sustainable approach to have any hope of meeting collective climate and development ambitions, never mind mounting a sufficient assault on the coronavirus.

A new report from the Boston University Global Development Policy Center, the Heinrich Böll Foundation and the Centre for Sustainable Finance at SOAS, University of London proposes an ambitious blueprint for designing debt relief to secure green, resilient and inclusive development. Co-authored by Ulrich Volz, Shamshad Akhtar, Kevin P. Gallagher, Stephany Griffith-Jones, Jörg Haas and Moritz Kraemer, the report declares it is time for the G20 to be bold and revamp their approach, citing historic evidence that delays will only lead to more severe and even disastrous outcomes for debtors and creditors alike.

The report proposes four steps to transform the G20 Common Framework:

Step 1: Make debt relief available to all countries

Among the 72 countries identified by the United Nations Development Program as highly vulnerable to external debt distress, 23 are not eligible for the G20’s debt relief package. Furthermore, eligible countries have been hesitant to apply, as participating countries have been hit with credit rating downgrades. The report argues that rather than waiting for countries to come forward and apply for debt relief individually, the framework should recognize that a systemic crisis demands a systemic solution. The authors therefore urge the G20 to encourage all LMICs whose debt is considered unsustainable to participate in a comprehensive debt restructuring.

Step 2: Perform enhanced Debt Sustainability Analyses

Currently, climate and nature vulnerabilities and broader development priorities are not sufficiently considered in the Debt Sustainability Analyses conducted by the International Monetary Fund (IMF) and the World Bank, which instead prioritize repayment over long-term sustainability.

The IMF’s recent Review of the Debt Sustainability Framework for Market Access Countries marked an important milestone as it recommended incorporating “long-term macroeconomic implications of climate change” for “[c]ountries with existential or high vulnerability to climate change per exposure, susceptibility and adaptive capacity.”

The authors argue the IMF and the World Bank need to implement the recommendations of this review swiftly and comprehensively in DSAs for all countries, accounting for both physical and transition risks. This should include climate stress testing countries’ public finances and balance of payments under different scenarios, including a 1.5C scenario, like the one developed by the International Energy Agency.

To incorporate investment needs in building resilience and achieving the 2030 Sustainable Development Goals (SDGs), the report suggests the IMF start by building on estimates its staff have already produced for country-specific spending requirements in five key development areas central to the SDGs – education, health, roads, electricity and water and sanitation.

Step 3: Create a Guarantee Facility to incentivize private creditor participation

Adequate incentives are needed to ensure private creditors participate in debt restructuring where needed and bear a fair share of the burden. If an enhanced DSA asserts that a country’s sovereign debt is of significant concern, the IMF should make its programs conditional on a restructuring process that includes private creditors on a comparable basis.

The report argues securing participation of private creditors in debt restructuring will depend on them being convinced that participation is better than abstention. Experience with past debt restructurings suggests that a combination of positive incentives (“carrots”) and pressure (“sticks”) is required.

Drawing on historical antecedents, the authors propose creating a Guarantee Facility for Green and Inclusive Recovery to incentivize participation, managed by the World Bank. The facility would back the payments of newly-issued sovereign bonds that are swapped with a significant haircut for old and unsustainable debt. The facility would provide a partial guarantee of the principal, as well as a guarantee on 18 months’ worth of interest payments, analogous to the Brady plan. The credit enhancement and security of the new bonds has served as a “carrot” to bondholders in the past, especially when paired with “sticks” that penalize bondholders for not participating. According to the authors, this approach would not amount to a public bail-out of private creditors, as they would have to accept a significant haircut on their old debt.

To accompany this “carrot,” the IMF and the financial authorities of the jurisdictions in which the major private creditors reside could use the “stick” of strong moral suasion and regulations on accounting, banking supervision and taxation to improve creditors’ willingness to participate in debt restructuring.

Figure 1: Guaranteeing a Green and Inclusive Recovery

Source: Debt Relief for a Green and Inclusive Recovery, 2021.

Step 4: Build pathways towards green and inclusive recoveries

Governments participating in debt restructuring would lead the development of their own Green and Inclusive Recovery Strategy, in which they map out a set of actions to advance their development and climate goals. The Strategy would include a spending plan and policy reforms, and should be guided by a set of principles help ensure the recovery is in line with the SDGs and the Paris Agreement. Importantly, the Strategy plan should address vulnerabilities identified in the DSA, so as to enhance societal and economic resilience and hence, that of public finances.

The report suggests that this should be complemented by broader improvements in debt sustainability, with governments enhancing debt transparency, strengthening public debt management capacity, adopting sustainable borrowing practices where needed and strengthening domestic resource mobilization. To support this effort, the Green and Inclusive Recovery Strategy would define clear targets and performance metrics.

Some portion of the restructured repayments would be channeled into a Fund for Green and Inclusive Recovery (or an already existing national fund that could be used for this purpose) that would be used by the government for investment aligned with priorities expressed in its Green and Inclusive Recovery Strategy plan. The government would be empowered to decide how to spend the money from this Fund – thus avoiding conditionality – as long as it is helping a green and inclusive recovery and contributes to achieving the SDGs.

Beyond the current crisis: building toward long-term sustainability

This proposal is designed to address the immediate challenges facing indebted developing and emerging economies, but it could also provide a stepping stone towards establishing a new global debt architecture that is fair, transparent, efficient and cognizant of the needs of developing and emerging countries. The current crisis has underscored the importance of developing a multilateral debt workout mechanism that ensures participation of private creditors and provides predictable processes for borrowers and lenders alike.

The report concludes with the recognition that this plan will have the most impact if coupled with significant new financing mobilized from development finance institutions, facilitated by capital increases, enhanced exposure exchanges between multilateral lenders and possibly a new and ambitious allocation of Special Drawing Rights at the IMF in 2022 (on top of the agreed allocation that is expected for fall 2021).

Such a comprehensive and ambitious approach is the only way to provide the fiscal space emerging markets and developing countries need to face the crisis and truly build back better.