The debt and climate crisis are escalating – it’s time to tackle both

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A major debt crisis is brewing in the Global South. Even before the coronavirus crisis, the IMF had sounded the alarm about growing debt sustainability problems in many low-income countries. More than two years after the start of the pandemic, the debt situation has deteriorated significantly. According to the IMF 60 percent of low-income countries are now at high risk or already in a debt crisis. In addition, a growing number of middle-income countries are also suffering from high debt service burdens. The number of emerging markets with government bonds trading at distressed levels – with yields more than 10 percentage points higher than US Treasuries of similar maturities – has more than doubled in the last six months. Monetary tightening in the US and other advanced economies is driving up debt costs and making international funding increasingly difficult for those countries that still have access to international capital markets. That Funding composition continues to evolve towards new, more expensive sources.

The Russian invasion of Ukraine further escalated the situation, creating a perfect storm. The war has sent Shockwaves through the world economy and caused the Biggest commodity shock since the 1970s. While oil, gas and grain exporters may get some temporary relief in the short term, many developing and emerging economies – including in sub-Saharan Africa – are net importers of fossil fuels and grains. The effects of the war in Ukraine are likely to significantly worsen the social and economic situation in many developing and emerging countries and further undermine debt sustainability.

High levels of public debt service and insufficient fiscal and monetary space have already constrained the crisis response of most low- and middle-income economies. While advanced countries have been able to implement extremely expansionary fiscal and monetary policies in response to the pandemic crisis, few countries in the Global South have had this option.

The precarious debt situation not only threatens repayments. It has also hampered much-needed investment in climate resilience. These investments are essential and urgent: Governments need to climate-proof their economies and public finances or face a worsening spiral of climate vulnerability and unsustainable debt burdens. in the several empirically studies those were replicated by the IMF and others, we have shown that physical climate vulnerability drives up the cost of capital in climate-sensitive developing countries. As climate risks are increasingly being priced in by the financial markets and global warming is accelerating, the already high risk premiums in these countries are likely to rise further. There is a risk that vulnerable developing countries will fall into a vicious cycle where greater climate vulnerability increases the cost of debt and reduces the fiscal space for climate resilience investments.

Figure 1. The vicious cycle of climate vulnerability and cost of capital

Source: Volz, “Climate change and the cost of capital in developing countries‘, Presentation at the Understanding Risk Finance Pacific Forum organized by the Government of Vanuatu and the World Bank Group’s Disaster Risk Finance and Insurance Program, 16-19 October 2018 in Port Vila.

The impact of COVID-19 on public finances could reinforce this vicious circle. In many countries, including many small island developing States, high levels of public debt servicing are crowding out critical investments needed for climate-resilient economies and enabling a green, resilient and just recovery. As the effects of the climate crisis become increasingly damaging economically, there is a great urgency to address sovereign debt issues head-on and empower countries to respond not just to short-term needs created by the pandemic and engulfment food price crisisbut also invest in much-needed climate resilience.

There is a risk that vulnerable developing countries will fall into a vicious cycle where greater climate vulnerability increases the cost of debt and reduces the fiscal space for climate resilience investments.

2020 we make a proposal for Debt relief for a green and inclusive recovery as an ambitious, concerted and comprehensive debt relief initiative that frees up resources to sustainably support economic recovery and enables governments to invest in strategic development areas, including climate-resilient infrastructure, health, education, digitization and cheap and sustainable energy. A key tenet of this proposal is that debt relief should not just provide a temporary breather. It aims to enable governments to lay the foundations for sustainable, climate-resilient development. As part of our range, debtor countries receiving debt relief would commit to reforms that align their policies and budgets with the 2030 Agenda and the Paris Agreement. Country commitments would be drafted by country governments with the participation of parliaments and in consultation with relevant stakeholders.

Ahead of the 2021 United Nations climate change conference in Glasgow, the V20 finance ministers – representing 55 climate-vulnerable nations with a total population of 1.4 billion people – have launched a Declaration on debt restructuring of climate-vulnerable nations, based on our suggestion. In the statement, the V20 finance ministers called for “a comprehensive debt restructuring initiative for countries constrained by debt – a type of large-scale climate debt swap, in which developing countries’ debt and debt service are reduced based on their own plans for climate resilience and prosperity.” to reach”.

With the debt and climate crises escalating, it is time these calls were heard. That Common framework for debt treatment that the G20, formed in November 2020 to deal with bankruptcies and protracted liquidity problems, has not delivered. Not only does it exclude middle-income countries, it also lacks incentives and mechanisms to bring debtor governments and private creditors together. As highlighted by the World Bank, “[t]The lack of measures to encourage private sector involvement can limit the effectiveness of negotiated agreements and increases the risk of private sector debt migrating to official creditors.”

Incentivizing the participation of private creditors – who hold more than 60 percent of all debt owed to countries in the Global South – in debt restructuring requires a combination of incentives (“carrots”) and pressures (“sticks”). In terms of incentives, we propose Creation of a new guarantee facility for a green and inclusive recovery intended to entice the commercial sector to participate in debt restructuring. The facility, which could be set up relatively quickly at the World Bank, would cover the payments of newly issued government bonds, which would be swapped with a significant haircut for old, unsustainable and privately held debt. Private creditors would benefit from a partial guarantee of the principal amount plus a guarantee of 18 months’ worth of interest payments, analogous to the Brady Plan that helped break the deadlock of the 1980s debt crisis.

In terms of pressure, the financial authorities of the jurisdictions that host the main private creditors (both banks and wealth managers) and that regulate the majority of sovereign debt contracts – most notably the United States, the United Kingdom and China – could exercise strong moral incentives and rules on accounting, banking supervision and taxation to improve the willingness of creditors to participate in debt restructuring.

Economic history teaches us that delaying the resolution of debt problems is very costly for debtor countries. In the absence of an adequate international sovereign debt restructuring mechanism, creditors and borrowers alike are on their knees. This is a long-standing problem that has repeatedly resulted in lost decades of development and avoidable human suffering. What makes things worse now is that the stakes are even higher with a developing climate crisis.

The international community – in particular the major advanced economies and China – must break the current deadlock and work towards a solution to the debt crisis that allows all countries to respond to the multiple crises they face. The consequences will be dire if they don’t.

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