Mitigating the Debt-Climate Trade-off

Hippolyte Fofack is Chief Economist and Director of Research at the African Export-Import Bank (Afreximbank).

CAIRO – The sharp, almost synchronized, pivot by most of the world’s major central banks in raising interest rates has highlighted the growth-inflation trade-off that most countries now face. But it has given rise to another significant macroeconomic challenge – the Herculean task of balancing debt sustainability with climate-change mitigation and adaptation. The challenge is especially formidable in the Global South, where the rising cost of servicing external debts has reduced countries’ fiscal space and ability to pursue climate action.

Global warming is intensifying, and its negative spillovers are disproportionately felt in low-income, climate-vulnerable economies. Although these countries have contributed the least to the looming climate catastrophe, they find themselves on the frontlines of a crisis that, by increasing the frequency and likelihood of large economic contractions, represents a major long-term development risk. For example, the economic and social costs of the floods suffered by Pakistan in 2022 resulted in an estimated output loss of 2.2% of GDP.

As aggressive monetary tightening pushes more developing countries into or close to debt distress, addressing climate change becomes even more daunting. Fortunately, innovative nature-based financial solutions that can help avert both climate and debt crises have emerged. Debt-for-nature swaps, for example, enable countries to restructure their debt at a lower interest rate or longer maturity, with the proceeds being channeled to carbon-abatement projects.

Interest in nature-based financial instruments reflects the global shift toward greater decarbonization commitments and the need to boost climate-related investment in low-income economies encumbered by sky-high borrowing costs. The fiscal space required for such large-scale and long-term investments is just not there – nearly 60% of climate-vulnerable developing countries are also at considerable risk of fiscal crisis.

For example, until recently, Ghana had been spending more than 50% of government revenues to service its external debt and has now defaulted. Ghana’s ten-year bond maturing in 2029 is trading at more than 28%, signaling that the country has been shut out of capital markets. More governments may face limited options for refinancing, which would greatly undermine their ability to respond to pressing development needs, including those triggered by the climate crisis, such as extreme weather-related disasters and food insecurity.

Low-income countries have it the worst. According to United Nations estimates, international finance flowing to developing countries to facilitate climate-adaptation programs is 5-10 times lower than what is needed. Moreover, the gap is widening, with annual climate-adaptation needs expected to reach up to $340 billion by 2030.

The good news is that nature-based financial solutions like debt-for-nature swaps and carbon credits, which broaden the intersection of sustainable development and debt sustainability, are gaining traction. Issuance of carbon credits from forestry and land-use projects increased by around 160% over the past year and accounted for more than one-third of total issuances in 2021, when global carbon-pricing revenues increased by almost 60%, to around $84 billion. And, by enabling creditors to provide debt relief, conditional upon governments’ commitment to fund conservation or green projects, debt-for-nature swaps create incentives for developing countries to address the climate crisis without undermining their quest for debt sustainability.

In the case of three climate-vulnerable countries, namely Barbados, Belize, and the Seychelles, these innovative financial instruments have boosted government revenues. Since 2016, debt-for-nature swaps have converted $500 million of debt into $230 million of money for conservation. Belize’s $553 million swap reduced its debt level by more than 10% of GDP while providing resources to protect the world’s second-largest coral reef.

The fiscal benefits of these swaps seem to have been significant enough to incentivize other developing countries contending with debt crises and the effects of global warming. The government of Gabon, for example, has signaled its plan for a $700 million debt-for-nature swap to fund marine conservation.

But the positive impact of these swaps on climate resilience and debt sustainability will be amplified if combined with carbon credits. Together, they would increase the flow of resources to climate-vulnerable countries and expand the intersection of climate resilience and debt sustainability, resulting in a more inclusive and environmentally friendly globalization process. Long-term projections show that Africa alone could retire 1.5 gigatons of carbon credits annually by 2050, which would mobilize capital totaling $120 billion.

In a clear signal to market participants, the International Monetary Fund is supporting countries adopting carbon pricing and recently revised its debt sustainability framework to include the impact of natural disasters and climate change. But more should be done to encourage the growth of these financial instruments, including developing secondary markets to minimize price increases as debt is bought back. Donor countries should extend partial guarantees to reduce the costs of financing debt buy-backs and channel more climate financing to the Global South.

More critical still is developing a robust regulatory and governance framework that fosters consistency, transparency, accountability, and traceability of carbon-offset transactions. Since the inception of carbon markets, market failures – most notably reflected in the proliferation of carbon-pricing schemes and market segmentation – have undermined their efficiency and development impact.

These failures have also given rise to “carbon cowboys” who exploit loopholes at the expense of environmental causes and reinforce climate injustice in the process. Just as so-called vulture funds undermine the transition from debt distress to debt sustainability by preying on low-income countries, carbon cowboys subvert the transition to a net-zero economy and weaken the development impact of carbon credits and debt-for-nature swaps.

Despite the current risk of carbon leakage, nature-based financial instruments are increasingly emerging as a highly promising way to overcome the trade-off between climate action and debt sustainability. We cannot allow another market failure to undermine their unique ability to shore up developing countries’ climate resilience and reduce their debt burden.