Linking Debt Relief and Sustainable Development: Lessons from Experience

Background Paper #2

By Aldo Caliari

The imperative of responding to the global challenge of climate change calls for scaling-up investments in climate change adaptation and mitigation. At a time when the ability of developing countries to make such investments was already in doubt due to rapidly rising debt burdens, the Covid-19 crisis has dealt a blow to their economies.

As the international community considers a menu of options to address the rising prospect of widespread debt distress and defaults in the developing world, it will be crucial that it weighs how such options can best contribute towards addressing the equally urgent climate crisis. Having that need in mind, the current paper examines the experience with debt-for-development swaps and major debt relief processes in order to draw some lessons that could help shape a debt-for-climate initiative (DCI).

In order to significantly expand the fiscal space and create the incentives for investing in climate change adaptation and mitigation, a DCI would have to be a transaction capable of combining debt cancellation and swaps in creative ways. Since the experience with swaps shows that their contribution to debt sustainability has been marginal at best, the transaction will need to include a meaningful debt cancellation component. The swap component could add to the foreign exchange savings inherent to plain debt relief those derived from the conversion to domestic debt, which some recipients may be in a position to also frontload.

In order to make scale and relevance feasible in the current landscape of creditors, the DCI would need to adopt a comprehensive approach involving bilateral, multilateral, and private creditors under principles of broad and fair burden-sharing. The DCI should take a programmatic approach to establish the climate link, requiring beneficiary countries to implement a comprehensive climate plan. This plan should be developed in participatory, transparent, and accountable processes, draw upon existing national climate and development strategies where these exist, and seek to address the interlinkages with poverty, inequality, and job creation.

The plan could include policy actions as well. Monitoring and evaluation should rely on homegrown processes and institutions, complemented by a commitment to have periodic reviews in a multilateral forum involving creditors and debtors. Though most likely the Bretton Woods Institutions will be central to the management of such an initiative, it would be desirable to also involve an international organisation with a climate mandate in a deciding role. Economic policy conditionalities should be kept to a minimum, have broad social acceptance in the debtor country, and exclude any form of tied aid.

To improve chances of long-term debt sustainability, the initiative should rely on debt limits and improved fiscal and debt management, but it could also add active components on promoting state-contingent loans and a requirement that comprehensive climate plans address economic diversification.

Published by Heinrich Böll Foundation, Center for Sustainable Finance (SOAS, University of London), and Boston University Global Development Policy Center as Background Paper to the Debt Relief for Green and Inclusive Recovery Project.