Dennis Essers, Danny Cassimon & Martin Prowse
Analysis and Policy Brief 43
The COVID-19 pandemic has further fuelled problems of debt sustainability in developing countries and has sapped the fiscal resources needed to finance climate mitigation and adaptation efforts. We examine whether “debt-for-climate” swaps, instruments whereby debtor countries are relieved from their contractual debt obligations in return for local climate-related spending commitments, may be helpful in tackling worrying debt levels and climate concerns simultaneously. We point out that debt swaps do not have a great historical track record but that common flaws such as their piecemeal nature, lack of additionality and creation of parallel implementation structures, could be overcome by scaling up and careful design. To realize swaps’ full potential, a distinction needs to be made between situations where debt is clearly unsustainable and where it is high but sustainable. In the former case, deep and comprehensive debt restructuring should be the primary focus, rather than closely matching debt service savings with increased climate spending; in the latter case, stand-alone debt swaps may be used to transfer resources from creditors to debtor countries that are committed to climate investments but lack fiscal space. Another helpful differentiation is that between middle-income debtor countries, where debt swaps could finance climate mitigation interventions, and low-income debtors, where investments in adaption deserve prioritization. Finally, debt swap proposals need to be mindful of creditor incentives, including positive reputational payoffs, and could achieve greater scale using a multi-creditor set-up.
Keywords: climate finance; debt restructuring; debt swap; debt sustainability; developing countries