By: Hernan Carlino, Director of the Torcuato di Tella Foundation.
The debt-for-climate action swap is an innovative idea that for the first time makes it possible to articulate three vectors of change that are indispensable today: 1) alleviating the external debt of low- and middle-income countries; 2) transitioning to carbon neutrality; and 3) reducing inequality and poverty.
Looking at investment financing instruments, climate swaps can be considered among the type of debt instruments that involve public and private investors, as they involve an investor purchasing a foreign currency debt security from a creditor country, followed by the swap of this security to a debtor country for the implementation of climate projects.
There are several channels through which debt-for-climate action swaps have positive effects, and are expressed in three dimensions:
- It directly alleviates the external debt of many countries, which is today aggravated by the consequences of the pandemic and the response measures,
- Facilitates green recovery, with particular emphasis on the transformation of the national economies that access this swap instrument, and
- It reduces inequality and poverty by expanding fiscal space to implement progressive income redistribution policies.
These issues are closely intertwined, since they are based on the premise of protecting the climate system and biodiversity, avoiding environmental degradation, and at the same time, combating poverty, thus generating a response to the difficult situation faced by many developing countries with record levels of external indebtedness.
Is a response to the triple crisis possible?
Indeed, in the aftermath of the COVID-19 crisis, the external debt stocks of developing countries reached their highest historical level ever,[1] quadrupling the levels of the year 2000, while short-term debt rose to slightly more than a quarter of the total (UNCTAD, 2021). A joint report by the International Monetary Fund and the World Bank warns of the high risk of external crisis associated with the indebtedness of a considerable number of countries, even in the case of middle-income countries.[2] Private indebtedness has also grown rapidly in many cases.
This initiative will surely arouse criticism and opposition from different spheres of power, insofar as it aims to reduce asymmetries and disorder, and contribute to transforming the world economy, instead of merely focusing on symptoms. An initiative of this type would also seem to grant an allegedly lenient treatment to those countries that have not been able to maintain their fiscal discipline, nor have they managed their resources with austerity, which would have irresponsibly encouraged over-indebtedness.
For these reasons, it is advisable to develop a comprehensive analysis of the negotiation pathways and the development of specific modalities for debt-for-climate action swaps, The new system, which allows external debt payments to be made in local currency to finance climate actions under agreed conditions, instead of making the corresponding debt service payments in foreign currency.
How to turn the current external debt into a tool for transformation?
Among the main recommendations of international organizations, or in the position statements of many developed countries, the need for developing countries to implement socio-technical transitions, particularly in the energy sector, that make it possible to mitigate climate change with increasing ambition and efficiency, is frequently highlighted. The idea of promoting mitigation actions of progressively increasing ambition is, by the way, one of the cornerstones of the Paris Agreement.
Similarly, it can be argued that the systemic transitions demanded of developing countries (whether in energy, transport, agriculture or industry) should have their counterpart. To this end, international cooperation arrangements should be made viable to ensure a financial transition that will make it possible to convert the current external debt into a transformational tool that will make it possible to invest in sustainable infrastructure, create jobs, structurally modify key value chains, increase systemic efficiency, accelerate innovation, prudently manage natural resources and protect biodiversity, while decisively tackling climate change.
Progressive income redistribution policies result in a reduction of income concentration in national economies and on a global scale, allowing, in addition, to reduce greenhouse gas emissions, since the higher income segments of the population tend to have more carbon-intensive consumption.
Seen from a climate perspective, a possible counterpart to this scheme would be a commitment to increase mitigation ambition, expressed in Nationally Determined Contributions (NDCs) subsequent to the signing of the respective swap agreements. This proposal should take into account the situation of both upper middle-income and lower middle-income countries.
What should such an instrument consider including?
From the point of view of climate action, the proposed instrument should integrate two different elements: 1) A component consisting of a quasi-automatic access mechanism to debt swaps for countries with debt indicators above a certain threshold; 2) Higher debt swap ratios for higher levels of mitigation ambition.
To achieve a decisive impact in terms of climate action, their scale and scope should be significantly increased, avoiding being limited to individual projects by including programmatic initiatives as well as support for policy frameworks.
It is also advisable to prioritize countries' access to the swap mechanism on the basis of climate vulnerability, biodiversity at risk, mitigation capacity and manifest commitment to climate action expressed in terms of ambition, and also, complementarily, the level of indebtedness.
In turn, the implementation of climate swap processes would make it possible for international creditors to also contribute in part to achieving the goals of the Paris Agreement.
Objections to this instrument have been raised in relation to the potential inappropriate use of the resources generated in this way. It is clear that it will be necessary to establish a monitoring, reporting and verification (MRV) mechanism to ensure compliance with the commitments undertaken. a priori The international level will need to agree and establish an architecture to ensure compliance at the international level, the structure of which will need to be designed and agreed. This will require agreeing and establishing an architecture to ensure such compliance at the international level, the structure of which will have to be designed and agreed upon.
This monitoring procedure should also make it possible to verify that the reduction of external debt resulting from the swap is not used to allow a new cycle of external indebtedness that facilitates - as on previous occasions and in a considerable number of countries - the financing of residents' foreign asset formation (FAE), the placement of debt and speculative capital through the temporary use of interest rate differentials or the financing of economic policies of overvaluation of the domestic currency, for example, for the purpose of controlling inflation.
What challenges are foreseen for the materialization of this initiative to overcome?
Facilitating the completion of large-scale swaps, such as those needed, will require complex and efficient international coordination, as countries' debt claims may be controlled by multiple actors.
From an economic and fiscal perspective the potential implications of implementing climate swaps should be identified and explored in detail., including the following:
- Reduction of the current level of over-indebtedness and the consequent reduction of pressure on the long-term equilibrium exchange rate.
- Increased capacity to service external debt, in line with the reduction achieved.
- The reduction in the volume of debt services makes it possible to reduce its cost and attenuate the demand for foreign currency, relieving the pressure on the generation of foreign trade surpluses.
- Financing climate actions in local currency to reduce the impact of possible exchange rate fluctuations and international external shocks on long-term investment programs.
- Increased fiscal space for the debtor, enabling it to achieve the climate commitments contained in the nationally determined contributions and, more broadly, in its long-term low-emissions strategy.
- Allows the development of long-term project portfolios.
- Decrease of the exchange risk in those investments that include imported technology components.
- Revitalization of the national and subnational economy, by increasing aggregate demand with low carbon intensity, investment and job creation.
- Economic recovery without the correlative growth in emissions, which would make it possible to quickly adopt transformation paths in the immediate future.
[1] Nearly US$ 10.6 trillion in 2020 according to UNCTAD, and more than US$ 8 in 2019, as consigned by the International Debt Statistics 2021, from the World Bank.
[2] World Bank Group and International Monetary Fund Support for Debt Relief under the Common Framework and Beyond, 2021.
