Finding funds for climate action risks ending up as a pipe dream

To be sure, only a handful of LMICs have defaulted on their external debts, and many others still hope to re-enter the market when it reopens. But with their debt-service obligations having grown vastly larger than the official support they can secure, their fiscal space is being squeezed, leading to a silent development crisis. At the same time, global development and climate financing needs are estimated to have risen to $1 trillion per year. The gap between the world’s aspirations for poorer economies and the reality of their finances has never been so large, nor so corrosive to the legitimacy of the global financial system.

A series of international gatherings, culminating with the recent G20 declaration, has sought to reform the global financial and development architecture, with emphasis on scaling up MDB support. But if MDB funding rises before the current debt crisis is resolved, much of that additional money will go not to investments in LMICs, but to other creditors, as is currently the case.

During the pandemic, many observers foresaw that massive insolvencies loomed. While proposals were made for wholesale debt relief, world leaders failed to agree on ambitious solutions. Since then, the grinding difficulties of reaching debt deals selectively have demoralized the international community. Much of the opposition to debt relief came from China, the largest bilateral donor. It argues that LMICs’ external debts remain relatively low, averaging only 40% of GDP, compared to 100% just before the Highly Indebted Poor Countries (HIPC) Initiative was launched in 1996. China pushed for debt rescheduling, as happened earlier this year with the Zambia deal.

Private lenders have also resisted deep debt relief, even as they remain unwilling to provide liquidity. During the Latin American debt crisis of the 1980s, when liquidity rather than insolvency was seen as the problem, the few banks involved at least could agree on coordinated rescheduling. But now, the wholesale closure of the bond market reflects a collective-action problem that is all too characteristic of fragmented bond-holding.

While debt reduction is, understandably, a harrowing process, it should be much easier for countries that are only illiquid to build a bridge to a more financially sustainable future. The good news is that just a handful of countries are insolvent. Recent estimates show that 25 LMICs, of which 17 are in Africa, remain below the International Monetary Fund’s insolvency threshold, but exceed its liquidity threshold (with debt-servicing costs in the range of 12-15% of revenues). But the situation will worsen if these countries cannot refinance the principal on their outstanding debt when it reaches maturity. Consider Kenya. It has embarked on an ambitious programme of stabilization and reforms, backed by a large fiscal stabilization effort equal to 4% of GDP, and supported by the IMF and MDBs. But it has $2 billion in bonds maturing in 2024. If global capital markets do not allow for refinancing by then, repayment will require an additional fiscal outlay equal to 1.8% of GDP, and that will raise the risk of popular unrest, as happened recently in response to tax hikes and high inflation.

The alternative of default is equally unattractive, considering that Kenya’s external debt stands at only 38% of gross national income. To overcome this dilemma, the African Union’s Nairobi Declaration on Climate Change proposes that countries be allowed to reschedule debts coming due to create fiscal space for ‘green growth’ policies and reforms, financed by MDBs.

Our own proposal for a ‘bridging compact’ operationalizes this idea. Led jointly by the UN, World Bank and IMF, it would support not just insolvent countries in need of debt haircuts, but also illiquid countries in need of rescheduling. Countries that have experienced negative net transfers with big creditors could opt for an adjustment programme that postpones their debt obligations in exchange for a commitment to reforms. The goal is to create value through coordination, assuming that a country can grow out of debt if it is given liquidity and pursues policies for sustainable growth.

To be effective, this bridging compact must be anchored in a national renewal programme that includes measures to constrain budgets and reforms to move onto a new growth path. That will require more funding from the IMF and World Bank, with conditionalities extending beyond the typical three-year IMF package. Countries that avail of this option should be the first to benefit from a scaling-up of IMF and MDB funding, which in turn would help to prevent a systemic debt crisis that would hurt everyone.

To avoid leakages to other creditors, some debts would have to be rescheduled during the programme period. The interest rate used should be no higher than the growth rate envisioned under the renewal effort, so as not to exacerbate the debt situation. The approach should be accepted ex-ante by all creditor groups, but the obligation to reschedule loans that can’t be refinanced would have to be enforced by an IMF threat to lend into arrears. Finally, at the end of the programme, if external debt appears unsustainable, a debt reduction scheme would need to be devised (as under the HIPC initiative).

The world needs to make progress towards a more sustainable future. Our proposed approach would help bridge the great divide between our aspirations and realities by allowing the world’s illiquid countries to get in shape for the challenges. Else, the goal of mobilizing trillions of dollars for climate-friendly development risks remaining a pipe dream. ©2023/Project Syndicate