A Vicious Circle: the Interconnection Between Climate and Debt

The climate emergency has been with us for some time. Eurodad’s report A debt pandemic shows how the public debt of developing countries “has increased from an average of 40.2 to 62.3 per cent of GDP between 2010 and 2020”. The majority of this increase took place last year. This is particularly worrying when reflecting on climate impact, as there is a clear connection between indebtedness and climate vulnerability: the countries that struggle the most with debt tend to be more vulnerable to the impact of climate change; on the other hand, climate change impact exacerbates debt vulnerabilities. This is extremely problematic, as it creates a vicious circle.

Debt-induced climate impact High public external debt levels translate into more revenues spent on debt service. This means that those domestic resources are not used for other non-debt related expenditures, such as investments in climate adaptation and mitigation, or responding to the challenge of loss and damage. The fiscal space is reduced, and this makes it more difficult to react steadily to unpredictable and extreme climate events without further increasing debt levels.

The higher the existing debt, the more reluctant creditors will be to lend to a country already struggling with payments and if they do, the borrowing costs and interest rates will be higher.

When a country is facing debt unsustainability, it might look for solutions to repay its public debt by further exploiting its natural resources in order to increase exports and therefore revenues. This in turn contributes further to climate change.

Climate-induced debt

Over the last decade, climate finance has been mostly provided through debt-creating instruments. In fact, according to the Organisation for Economic Co-operation and Development (OECD), between 2013 and 2018 two thirds of the public climate finance was delivered through loans. The impacts of the climate emergency in the global south exacerbates the debt problems in climate-vulnerable countries. The International Monetary Fund (IMF) analysed 11 cases of major “natural disasters” in developing countries between 1992 and 2016, with a percentage of damage to their Gross Domestic Product (GDP) greater than 20 per cent. The results show that public debt increased from an average of 68 per cent of GDP in the year of the climate extreme event to 75 per cent of GDP three years afterwards.

An extreme climate disaster in an over-indebted country has direct effects in the present, because it prevents an immediate response to the consequences of the event. It also has impacts in the future, because it worsens the economic prospects for increasing revenues. It even affects elements from the past, because it makes it more difficult to pay the already existing debt service. In 2018, the Jubilee Debt Campaign UK published a report that exposed how debt sustainability indicators worsen after a climate-related disaster: in over 80 per cent of 21st century cases, government debt was higher two years after the disaster.

Climate vulnerabilities also increase the costs of borrowing. A recent report shows how climate risks increased the cost of debt for the Vulnerable Twenty (V20) group, adding US$ 40 billion of additional interest payments over the past 10 years – US$ 62 if we include the private sector. Over the next decade, the number is set to increase to US$ 168 billion.

Finally, the twin climate and debt crises are placed in a complex context, which causes them to affect other socio-economic sectors too. When analysing them, we cannot avoid considering intersectionality, which is reflected in the cumulative impact on women’s rights and gender justice, migration flows, human rights protection, etc.

Financial tools

Due to the huge implications of the debt and climate crises, this interplay should be considered as an urgent priority by our world leaders. Over the last decade, some tools have been put in place to address the impact of climate change and the financing needs that arise after a climate-extreme event. In 2015, the IMF launched the Catastrophe Containment and Relief Trust (CCRT) to provide debt relief to support recovery after “natural” or health disasters. However, the CCRT only covers IMF debts, and has very narrow eligibility criteria.

There are the World Bank funded insurance schemes, and the Warsaw International Mechanism for Loss and Damage (WIM). The latter is a first step, but its action and support working group was only established at COP25 (UN climate conference) in 2019, and this working group does not yet have a mandate to work on a financial mechanism. This group’s work will be defined by COP26 later this year. Indeed, the UK COP26 Presidency has included a number of debt elements as part of its public climate finance priorities.

In the context of Covid-19, the G20 and international financial institutions (IFIs) have promoted the Debt Service Suspension Initiative (DSSI) and the Common Framework for debt treatment – aiming to provide some debt relief and fiscal space for countries in the global south. However, both initiatives have important shortcomings. For example, its narrow eligibility criteria exclude many countries in need of debt cancellation. The level of income per capita cannot be the main indicator of a country’s need for debt relief or access to concessional finance. We need to start thinking in terms of multidimensional criteria to assess vulnerability: these should include climate vulnerabilities.

Furthermore, an interest-free and unconditional moratorium on debt payments immediately after a climate extreme event can free up resources that are already there, without the need for any additional loans. In addition, a pre-designed framework for restructuring the entire stock of existing public external debt in the impacted country should be considered.

Debt for climate swaps have been gaining more credibility as a possible alternative or an innovative solution in the discourse around debt and climate vulnerabilities. These entail an exchange: the creditor is willing to cancel a quantity of debt that is owed if the debtor commits to use that same reduced amount for an agreed investment, normally in local currency. It is understandable why this seems an easy and feasible option, and indeed debt-for-climate swaps can liberate resources for financing needs and provide liquidity. However, some issues need to be raised before jumping to any conclusions. First of all, these swaps usually entail long and complex negotiations, as well as high transaction costs, which means they are not the most adequate tool for a timely response to debt distress. Experiences in the past (e.g. Indonesia, 2011 and 2014; Philippines, 2013; Seychelles, 2016) showed that this instrument was not successful at significantly reducing debt burdens, as it generally covers too little debt relief. Finally, it has to make sure that the debt swap operations respect country ownership, not becoming a veiled form of conditionality, and that the resources freed up are additional to existing Official Development Assistance (ODA) and climate finance commitments.

Market-based options such as green bonds or hurricane clauses have also been put forward as climate finance tools for countries in the global south. A human rights based assessment of these tools reveals that they put the financial burden back on developing countries, increasing debt and worsening the fiscal imbalances; not to mention that they fail to enhance accountability and transparency. Instead, an inclusive response should consider debt, climate, gender justice and human rights aspects in order to tackle the multiple layers of these interconnected crises.

How to jointly tackle the debt and climate emergencies

In order to not only tackle the debt and climate emergencies, but to pursue a fair, feminist and sustainable recovery from the Covid-19 health and socio-economic crisis, here are some policy recommendations:

● Climate finance should shift towards non-debt creating financing. In summary, this means prioritising grants over loans; public over private; funds disbursed to governments and local/community-led non-governmental organisations.

● More ambitious climate finance commitments, that go beyond the US$ 100 billion target in climate finance and that are in addition to existing finance commitments. This should include devoting 0.7 per cent of national income as ODA.

● Debt payments suspension and debt relief in the aftermath of extreme climate events, as this has the potential to provide immediate access to resources that are already available.

● Creditors and IFIs should take action to agree to much more ambitious debt cancellation to bring developing country debts down to sustainable levels, compatible with the climate financing needs and human rights guarantee.

● Governments on the boards of the IMF and World Bank should promote an open review of Debt Sustainability Analysis (DSA), with UN guidance and civil society participation, in order to evolve towards a more adequate debt sustainability concept, one that includes environmental and climate vulnerabilities, together with human rights and other social, gender and development considerations at its core.

● IFIs and rich governments should provide sufficient additional resources to support developing countries to tackle the health, social and economic crises, favouring grants over loans.

● Governments and international organisations should support and work towards the creation of a permanent multilateral sovereign debt workout mechanism.

This article was written by Ilaria Crotti and is based on the Eurodad report A tale of two emergencies – the interplay of sovereign debt and climate crises in the global south by Iolanda Fresnillo. If you are interested in finding out more about these topics, you can also watch a video presentation on the A tale of two emergencies report online.