Debt Distress and Development Finance in the COVID-19 Era

The economic shock from the COVID-19 pandemic has set back the development agendas for emerging markets and developing countries. Many developing countries have suffered from severe economic contractions that derailed revenue generation and budget execution and created urgent financing needs. Servicing public debt crowds out fiscal space for investing in a green and equitable recovery and has exacerbated the triple crises of public health, rising poverty and inequality and climate disasters.

How can the Group of 20 (G20) leaders and international financial institutions (IFIs), like the International Monetary Fund (IMF) and the World Bank, act together to restructure debt of developing countries in a concerted manner to prevent and mitigate debt distress so nations can mobilize the financing necessary to achieve their climate and development goals? Leaders around the globe are struggling for answers.

Building on a recent Boston University Global Development Policy Center workshop, a new policy brief by Yan Wang, Ying Qian and Kevin P. Gallagher summarizes discussion and shares policy recommendations to the issues of debt distress and development finance in the COVID-19 era. Risks of a debt crisis continue to loom large, and for some countries, a new round of debt issuances may further undermine their debt sustainability. To ensure solutions address all aspects of the debt crisis, consideration must be given to the Paris Climate Agreement and collaboration between debtor countries, multilateral institutions and IFIs.

Policy recommendations:

• Multilateral institutions and IFIs need to assume more critical roles in debt restructuring: Despite significant improvement of international financial markets, the current low-interest market environment makes Brady-like transactions more complicated than they were 30 years ago. In addition, Chinese creditors have started playing a much larger role in debt restructuring negotiations. Intellectual support, policy dialogue and coordination among debtor and creditor countries and among different stakeholders is needed. The IMF and IFIs can be effectively involved in debt restructuring through the IMF’s Debt Sustainability Analysis (DSA) framework and policy dialogue at the macro-level, donor and creditor coordination on the mid-level and selection of the most appropriate transaction structure for debt restructuring at the micro-level.
• Debtor countries’ perspectives need to be fully considered: Developing countries involved will be sensitive towards policy conditionalities due to sovereignty or market reaction concerns. While benchmarks and monitoring mechanisms are necessary, these must be established in a way that respects debtor countries’ sovereignty and uses agreed-upon international best standards. More initiatives can be linked directly towards “pro-development conditionalities,” such as public asset management, sustainable development and green finance.
• Lowering debt burdens should be accompanied with commitments towards the 2030 United Nations Sustainable Development Goals (SDGs) and the Paris Agreement: As part of the debt restructuring and economic recovery process, stakeholders both in debtor and creditor countries should work together in line with the SDGs and Nationally Determined Commitments submitted under the Paris Agreement. Innovative approaches can be deployed, such as green and climate bonds and sustainability-linked notes (SLNs), as well as debt-for-nature swaps to help expedite the process.
• Proven and innovative approaches can be considered for debt restructuring: Leveraging public assets, utilizing natural hedges through state-contingent instruments including debt buy-backs with green and climate finance, debt-for-nature swaps and various forms of credit enhancements have all proven to be effective in helping debtor countries reduce distressed debt overhangs, raise credit worthiness and meet challenges on public health, climate, biodiversity and green and sustainable development. However, effectively using these tools will require creditor countries and development partners to help debtor countries improve their policy frameworks, technical know-how and financial market infrastructures.

At the time of publication, the IMF’s DSA framework for market-access countries incorporating climate impact has come into effect. From May 2020 to December 2021, the G20’s DSSI suspended $12.9 billion in debt-service payments owed by participating countries to creditors, according to the latest estimates (World Bank, 2022). The DSSI expired at the end of December 2021, leaving the G20 Common Framework as the only multilateral mechanism for debt relief in 2022. As the global pandemic protracts, IFIs and the G20 have a narrowing window to steer the world away from a more severe debt crisis. The important aspects and policy options discussed in this policy brief can support policymakers around the world in addressing these challenges.