Four ways to tackle developing countries’ debt distress

If President Macron’s forthcoming global financial summit is to matter, it must address debt and climate finance – here’s how, write Creon Butler and Lilia Couto.

The World Today
4 minute READ

Lilia Caiado Couto

Former Research Fellow, Global Economy and Finance Programme

Emmanuel Macron, the French president, will host the Summit for a New Financial Pact in Paris on June 22-23. Announced at COP27 last year, the summit aims to tackle the impact of the climate, energy, health and economic crises on developing economies.

Macron devised the summit in part as a response to the disquiet among developing economies at the cost of western support for Ukraine’s resistance to Russia’s invasion.

The developing world fears that this spending will limit the West’s willingness to support them in dealing with the fallout from the war, as well as longer-term development needs. As of February 2023, financial, humanitarian and military support to Ukraine from western countries stood at €151 billion.

Growing momentum for reform

A further motivation is the growing momentum for reform of the multilateral economic system, most notably the Bridgetown Initiative led by Mia Motley, prime minister of Barbados. This reflects the shortfall in climate finance, but also the recognition that climate-linked extreme weather events pose an existential threat to some smaller states.

Macron’s summit will be boosted by the arrival of a new World Bank president, Ajay Banga, expected to boost efforts to close the global climate finance gap. It may also be helped by the apparent desire of America and China to tone down tensions.

Macron also faces considerable challenges. First is the wave of domestic protest over pension reform, which saps attention.

Second are the arguments between the G7 and some major emerging economies over whether to condemn Russia for its attack on Ukraine. This undermines the G20’s ability to deliver on its role as the ‘premier forum for international economic cooperation’.

Linked to this is uncertainty over China’s cooperation with the G7 in tackling global challenges where its role is essential and there are strong mutual benefits.

Third is the impact of international concerns over financial stability, which may reduce the private sector’s appetite for additional risks.

Finally, Macron will have to manage the awkward juxtaposition of the summit with the June 21 Ukraine Recovery Conference which has the aim of mobilizing international financial support for reconstruction.

The need to address debt distress 

Addressing the sovereign debt distress crisis in low-income and emerging economies is central to the summit goals. Without this, it will be impossible to deliver the additional $3 trillion to $6 trillion per annum of international climate finance required for net zero until 2050, a substantial part of which is needed in developing economies – a total of $2.4 trillion a year will be needed by 2030 in emerging and developing economies other than China.

Thanks to the pandemic and Russia’s invasion, the proportion of low-income countries in or at high risk of debt distress increased from 49 per cent in 2019 to 60 per cent in 2023.

Progress in delivering debt restructuring under the Common Framework has been painfully slow

Much of the climate finance needed in developing countries is for adaptation infrastructure which traditionally requires public finance because the benefits are spread widely across society. But many of these countries face urgent competing demands to finance education, health and social needs. Many also have low tax-raising capacities with low revenue-to-GDP ratios.

International public finance is therefore critical but is also scarce. Private finance is a potential alternative for mitigation and some adaptation projects but will only flow at scale to countries that are free from debt distress and where concerns over project preparation, governance and transparency are addressed.

Another consideration is the vulnerability of low-income and emerging economies to future extreme weather events. Increases in the mean temperature by 2050 could cause GDP losses of between 11 and 18 per cent globally. 

China is the world’s largest bilateral creditor for poor countries

The pandemic forced the international community to start addressing sovereign debt distress. In April 2020, the G20 agreed on the Debt Service Suspension Initiative to provide emergency debt relief to low-income developing countries struggling to cope with the economic fallout. In 2021, a further G20 agreement established a ‘common framework’ for multilateral debt restructuring to be deployed with countries facing an unsustainable debt burden.

In theory this tied all G20 creditors into the approach of the Paris Club of western creditor nations. Most importantly, it included China, which is now the world’s largest bilateral creditor for poor countries.

However, progress in delivering debt restructuring under the Common Framework has been painfully slow. This is largely due to China’s preference to work bilaterally with its debtors, although the bailouts provided by Chinese state-owned banks involve loans with low transparency and high interest rates.

A further problem has been the reluctance of private sector creditors to participate in the relief and restructuring process.

In February 2023, the International Monetary Fund, World Bank and India – which holds this year’s G20 presidency – launched a sovereign debt panel drawing together key debtors, the Paris Club, China and the private sector in an attempt to reach understandings on common standards, principles and definitions for how to restructure distressed country debts. However, this has yet to produce a significant change in policy.

The four ways forward

Against this background, the June summit should prioritize these four ways to alleviate developing country debt distress:

1 Shareholders and managements of International Financial Institutions (IFIs) should commit to increase availability and optimize use of international public finance. The preferred creditor status of the IMF and the Multilateral Development Banks (MDBs) means they can lend in countries facing debt distress and urgent needs such as climate adaptation.

The straightforward way to increase availability is through increasing shareholder capital, but strong opposition in the US Congress makes this unlikely at present. An alternative is to generate more lending from the existing MDB capital base, as proposed by the recent G20 Capital Adequacy Review.

There may also be scope to channel some of the remaining ‘unused’ Special Drawing Rights held by advanced countries directly to the MDBs. Lastly, MDBs should be encouraged to improve the speed of existing lending.

2 The G7 must persuade China to commit fully to the common framework mechanism for debt restructuring. There is no realistic alternative, and it is in China’s interest to participate.

Bilateral maturity extensions with increased interest rates and low transparency are unlikely to produce a sustainable outcome. China’s recent acceptance of the customary preferred creditor status of the IFIs may indicate a willingness to move in this direction.

International financial institutions could write down a country’s debt if it agrees to climate commitments 

3 The international financial institutions should continue pursuing financial innovations that may generate additional low-cost finance for countries facing debt distress.

One possibility is a programmatic approach to writing down a country’s debt in return for agreeing to climate commitments. This would reduce transaction costs relative to the traditional project-based approach to such swaps, but an international public finance contribution would still be required and incentives for private-sector participation may be relatively scarce.

4 IFI shareholders and managements should assist low-income and emerging economies in hedging against future debt distress caused by climate change – for instance, the IMF’s new Resilience and Sustainability Trust is designed to help these countries build resilience to external shocks.

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Another promising approach is for the MDBs to lend in local currency. This would help recipient countries hedge against exchange rate falls caused by climate shocks. Creditors could also include climate resilience clauses in future debt such as the UK Export Finance’s Climate Resilient Debt Clauses allowing low-income countries to postpone repayments if they are hit by climate-related or other natural disasters.

These four steps will not solve the problem of sovereign debt distress. But pursuing them will ensure the Summit for a New Financial Pact does not skirt the most important current issue in development finance.