April 22, 2022
Kevin P. Gallagher, Boston University
Fallout from the COVID-19 pandemic and Russia’s war in Ukraine will require large scale sovereign debt restructuring to prevent another lost decade of development for many emerging markets and developing countries; during the same ten years they urgently need to mobilize trillions of dollars to combat and adapt to climate change.
Just before the Russian invasion of Ukraine, the World Bank sounded the alarm that fiscal and monetary tightening in the advanced economies could lead to another sudden stop in capital flows to emerging markets and developing countries, followed by capital flight, exchange rate depreciation, and debt crises.
War only makes matters worse, as many emerging market and developing countries will suffer from skyrocketing oil, gas, and grain prices. Worse still, a default on Russia’s or Ukraine’s bonds could amplify that same cycle of depreciation and crisis.
A debt crisis could stymie the global recovery, cause a lost decade of development, and dash prospects of meeting climate targets in the Paris Agreement. Thus, debt relief efforts require urgent reinvigoration if they are to alleviate debt distress and unlock investments for a sustainable and inclusive recovery.
As the UN Intergovernmental Panel on Climate Change reiterated in March, global carbon dioxide emissions need to be slashed by over 40 percent in less than a decade, while at the same time countries need to invest in resilience and adaptation to worsening climate change impacts. To that end, the UN’s lower-bound estimates say an additional $8.8 trillion must be mobilized. The World Bank, OECD, and outside experts see that figure as closer to $30 trillion.
According to the International Monetary Fund (IMF), when done right, such investments can put the world economy on the right trajectory, in which growth becomes more robust, resilient, inclusive, and sustainable while avoiding catastrophic human, economic, and ecological costs.
The World Bank and the IMF have correctly called for a revamp of the Group of 20’s (G20) Common Framework for debt treatment. Almost two years into the G20’s attempt to create an emergency workout system during the pandemic, not one country has successfully completed the process. The lack of a success story and fears of credit rating agency downgrades and of losing access to private capital markets have resulted in few countries participating, despite their desperate circumstances.
Moreover, the Common Framework was not open to all countries facing debt distress, only the poorest, while the private sector and commercial actors from China balked at participating. Aside from the IMF’s Catastrophe Containment and Relief Trust, which provided $1 billion in relief for its debtors, multilateral creditors have not participated in debt relief, either. Worse, the G20 scheme does not link restructuring to resilient, inclusive, and low-carbon outcomes.
A robust and ambitious proposal linking debt restructuring with climate action came ahead of the 2021 United Nations Climate Change Conference (COP26) by ‘the Vulnerable 20 Group (V20),’ comprised of 48 finance ministers from the most climate-vulnerable emerging markets and developing countries. Similar to detailed proposals by outside experts, the V20 called for a “grand-scale climate-debt swap where the debts and debt servicing of developing countries are reduced on the basis of their own plans to achieve climate resilience and prosperity.”
Here’s how it could work. The IMF and the World Bank would reform their Debt Sustainability Analysis to incorporate climate risks and the spending needed to scale-up investments in climate resilience and the 2030 Agenda for Sustainable Development for each country. Such an analysis would determine if a country needs restructuring and the level of haircut provided. Eligible countries would then receive debt relief on their bilateral and multilateral debt. Bilateral debt restructuring would occur through the Paris Club and using exit instruments such as in China’s proposed ‘Shanghai Model’ to achieve sustainable outcomes. Analogous to the Heavily Indebted Poor Countries (HIPC) Initiative, multilateral creditors would sell gold to cover debts owed to them while maintaining their preferred creditor status.
Such action would be predicated on commensurate restructuring by private creditors and commercial creditors from other countries, like China. As a carrot, private creditors under a new scheme would receive ‘Brady-bond-like’ treatment through a guarantee facility at the World Bank designed to provide credit enhancements for new bonds linked to climate and development goals. These bonds would be swapped by private creditors and commercial creditors in China for old debt with a significant haircut. If debt service on the new bonds is missed, collateral from the guarantor would be released to the creditor, and the missed payment would have to be repaid by the sovereign to the guarantee facility. It is important to include guarantees as called for by the V20 to minimize the risk of credit downgrades as a result of restructuring.
As a stick, there could be a standstill on debt payments to all creditors during the negotiations, and lists of non-participating creditors could be published by the G20 to put a spotlight on their inaction. History has shown that the longer restructuring is delayed, the higher the costs borne by economies and livelihoods in the long run. And now we know that if we derail development and delay climate action, the costs of inaction could be catastrophic.
Debt restructuring is not a silver bullet against financial distress, economic contraction, and the climate crisis. It must be coupled with significant regulation of capital markets to better align with financial stability and shared climate and development goals. What is more, the IMF will need to issue regular allocations of Special Drawing Rights that are coupled with mechanisms to re-channel those allocations from countries that do not need them to countries that do. Multilateral development banks will also need to issue major capital increases and a redirection of their focus.
But without significant restructuring, there is just no way emerging markets and developing economies can withstand the costs of Russia’s war and recover from COVID-19 on a pathway that leads to greater resilience, heightened inclusivity, and closer alignment with the Paris Agreement. The IMF and World Bank have both called for reinvigorating the G20’s Common Framework, and the IMF’s Managing Director has pledged to deliver a debt-for-climate change proposal. It is urgent we add to this momentum and bake debt restructuring into climate change action.
There is just no time to lose.
Return to Debt Architecture Architecture, Suspended prompt.