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Climate resilience and sustainable sovereign debt

2022 is already a record-breaker in the number of climate change-related events, and developing countries must now pay for the repairs and remediation needed to combat the consequences. Although the international community pledged support at the UN Climate Conference (COP27), the costs of shoring up economies for the reality of a changing climate also fall on developing countries themselves and require supportive fiscal policies.

One key element underpinning those policies is sustainable sovereign debt.

‘Sustainable’ in this context has two meanings: first, it means maintaining sovereign debt at levels that the government can reasonably pay back; and second, it means taking advantage of sovereign green and sustainable bonds to finance development projects aimed at protecting environmental resources and building resilience to climate change.

Economic development requires sustainable levels of sovereign debt

In the World Development Report 2022: Finance for an Equitable Recovery, we discuss the risks to the economy —and to vulnerable citizens— of allowing sovereign debt to get and stay unsustainably high. Between 2019 and 2020, low-income and lower-middle-income countries increased their debt by roughly 7% of GDP. This trend accelerated after the onset of the pandemic due to new debts taken to pay for large support programmes.

Ongoing supply chain challenges, inflation, interest rate increases, and the Russia-Ukraine conflict have all contributed to a slow recovery. This has disproportionately affected the poor because low-income households spend a higher share of their income on basic goods, the price of which has surged. And, the poor are further affected when governments reduce spending on social programmes in education, healthcare, social services, and environmental protection to save money and pay down debts.

Governments need a sustainable debt analysis to know their risks

A critical first step to prevent or mitigate such outcomes is to know the risk of falling into debt distress. A debt sustainability analysis (DSA) —often conducted by international financial institutions— classifies debt risks and designs strategies for debt reduction. These analyses are only as useful as they are accurate (and realistic) about growth projections, expenditures needed to achieve development goals, and discount rates. With this information in hand, countries can take steps to either manage their debt to prevent debt distress or resolve their debt, for those already in distress.

Two approaches help sovereigns maintain sustainable debt

Countries at high risk of debt distress have two primary policy options to modify the structure of their liabilities and the schedule of future payments, with the goal of making their sovereign debt levels more sustainable: debt reprofiling and debt renegotiation.

Debt reprofiling can make payments more manageable

In debt reprofiling, the sovereign issues new debt to either change the timeline within which payments are due or change the currency exposure of existing debt. Debt reprofiling can be helpful when a country has multiple loans due in the same year. Reprofiling can also enable the sovereign to retire existing debt in one currency and issue new debt in another, more stable currency.

Debt reprofiling can make a country’s debt payments more manageable, but it typically will not reduce the debt stock and is therefore not a long-term solution for sustainable sovereign debt if debt levels are too high.

Preemptive negotiations can make debt levels more sustainable

Another option is to initiate preemptive negotiations with creditors to reach a debt restructuring before the country defaults. Evidence shows that preemptive restructuring leads to faster resolution, a shorter period of exclusion from global capital markets, and a lower decline in output.

Yet this option depends on the creditor’s willingness to negotiate, the debtor’s credibility, and agreement between the parties on the debtor country’s needs. The objective is to bring the debt stock to sustainable levels through reduced payments, extended maturities, or extended grace periods. Preemptive restructuring also requires transparency about who the creditors are and the terms of the credit, in order for the debtors and creditors to agree on the probability of debt distress and reach an agreement.

To finance green projects, sovereigns can now access sustainable bonds

Even as countries work to establish sustainable debt levels, the realities of climate change and the need to protect environmental assets requires new investments —which will require public financing. Sovereign issuers can include sustainable bonds in their medium-term debt management strategies to attract and expand the investor base.

The proceeds from sustainable bond issuance are used to finance, or refinance, green, blue, or social projects. A ‘green bond’ raises capital specifically to support climate-related environmental projects. The European Investment Bank issued the first green bonds in 2007, followed by the World Bank in 2008. The first corporate green bonds emerged in 2012 and in 2017 Poland issued the first sovereign green bond. Sustainable debt reached a new peak in 2020 of $732 billion across bond and loan varieties raised with environmental and social purposes. As of August 2021, at least 175 green and social sovereign bonds were issued worldwide.

Countries today need to juggle the simultaneous needs of maintaining sustainable levels of sovereign debt and investing in environmentally sustainable activities —many of which require new financing. Countries that face sharply increased debt burdens in today’s challenging economy have policy options for reducing the risk of falling into debt distress, including debt reprofiling and preemptive negotiations with creditors. At the same time, they can take advantage of the tools available to low-income countries to finance development goals. These include social, green, and sustainable bonds to maintain investments in climate-friendly and poverty-reducing activities in a context of sustainable debt levels.

Leora Klapper is a Lead Economist in the Development Research Group at the World Bank and Director of the 2022 World Development Report, “Finance for an Equitable Recovery”.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.