The original sinS*: the intertwined climate and financial challenges of developing countries

Read the executive summary of the report below:

Developing countries are the hardest hit relatively by climate change. This is because adverse climate-related impacts tend to be concentrated in tropical regions, and because developing countries have fewer resources than developed countries to cope with the economic and social fallouts from climate-related physical impacts. This is despite their low historical contribution to global greenhouse gas emissions.

Developing countries also face a structural financial and macroeconomic constraint. One of the main reasons for this constraint is that incomplete financial markets impede developing countries (their governments and residents) from borrowing abroad in their currency. Therefore, a significant share of their debt is therefore denominated in foreign currency, which exposes them to currency mismatch (debt is denominated in foreign currency while assets or government revenue are in domestic currency). When economic conditions worsen, the exchange rate usually depreciates, which leads to higher debt service in local currency terms. This has been coined an “original sin” in economic literature, because the reasons for such an inability to borrow abroad in domestic currency lie in factors outside the control of developing countries.

We contend that developing countries’ climate and financial vulnerabilities can be deemed as “original sinS”: they have immense negative consequences for their development and stability, but the root causes originate primarily from variables independent of their actions and management.

Lack of adaptation to climate change and the financial vulnerability of developing countries strengthen each other. The destabilizing impact of climate change exacerbates the financial vulnerability of these countries. Reducing the destabilization potential of climate change in these countries requires substantial adaptation investments, which are hampered by their difficult access to financing. Therefore, the case for bringing together the international agendas for addressing climate vulnerability and financial challenges of developing countries appears strong, and strengthens as climate change accelerates.

This policy brief provides four arguments for actively intertwining these agendas. The combination of strong financial vulnerability of developing countries, as shown by the looming debt crisis at the time of writing this policy brief (argument 1); the negative impact of climate change on gross domestic product (argument 2); and high adaptation investment needs (argument 3) makes the financial outlook of developing countries quite preoccupying. Acknowledging that developed countries have a pent-up climate liability owed to developing countries (argument 4) can provide the moral basis for the former to provide debt relief to the latter in the form of adaptation-linked debt relief programmes.

Adaptation-linked debt relief programmes (ALDRPs) allow to link the agendas for addressing climate vulnerability and financial challenges of developing countries together. Such tools tie debt relief of a debtor developing country to adaptation investments, and therefore concurrently address its climate and financial vulnerabilities. Such tools still need to be standardized, which severely hampers their deployment. This policy brief provides guidance regarding the most important dimensions to consider when looking at implementing ALDRPs, in an attempt to ease and accelerate their rollout. These dimensions are:

• The identification of the most relevant countries for implementing ALDRPs: critical features for identifying countries most relevant to ALDRPs lie in their level of debt distress, their (lack of) resilience to climate change, the quality of the country’s adaptation planning, and the strength of its governance and public management.
• The type of debt to leverage for ALDRPs: the most important asset classes candidates for ALDRPs are Paris club debt and privately-owned bonds. The former is more relevant to tackle when debt is poorly risky, while the latter can be focused on when a country is at a relatively high risk of debt distress.
• The way to use the proceeds of ALDRPs: ALDRPs should foster country ownership over its adaptation strategy and operational implementation. Projects financed should maximize the impact on the macro-fiscal resilience of the country, and should be non-bankable or near-bankable projects. In the latter case, blended finance schemes should be considered. Official Development Assistance, Non-Government Organisations or philanthropies interventions can support the rollout of adaptation projects financed through ALDRPs. Transparency over the use of proceeds is key to enabling democratic accountability.
• The financial structure of ALDRPs: several financial structures are possible for ALDRPs. When implementing ALDRPs with private creditors, debt exchange operations can enable to swap existing debt with an adaptation-linked bond, which a development institution can enhance. This enables to attract private investors. When implementing ALDRPs with public creditors, a restructuring tied to adaptation investment conditions seems to be more efficient than implementing a debt exchange.

The rollout of ALDRPs would also benefit from a series of initiatives and actions on the part of the international community, relevant to each of the four dimensions highlighted above. This policy brief highlights nine actions and initiatives which could be implemented by developed countries, development banks, creditor organizations, and other institutions to contribute to this objective:

• Developed countries could incentivize private financial institutions to contribute to ALDRPs through fiscal and regulatory incentives for financial institutions to take part in ALDRPs.
• Bodies grouping bilateral and private creditors to developing countries could provide guidelines regarding the implementation of ALDRPs in an attempt to strengthen standardization.
• Aid donors, recipient countries, development banks, and relevant international and private organisations could foster the development and convergence of metrics and protocols to monitor adaptation outcomes.
• Development banks and trust funds could publicly state their will to support the development, implementation, and monitoring of adaptation projects resulting from ALDRPs. Development institutions could publicly state their interest in providing credit enhancement as part of ALDRPs.
• The development community could develop a global, publicly-available database highlighting the benefits, key performance indicators, monitoring and information systems, achievements, and potential blended finance schemes used for ODA-funded adaptation projects.
• The newly created G20 Common Framework for Debt Treatments could be enhanced by introducing adaptation investment conditions, which could then be financed through debt write-offs, two features it currently leaves aside. The Framework could also provide for the introduction of clauses in bilateral debt contracts highlighting ALDRPs as a tool for debt relief.
• Multilateral development banks and trust funds could develop a certification of ALDRPs, which could contribute to attracting private financing.
• Developing countries should require the introduction of collective action clauses in bond agreements. Such clauses can facilitate the implementation of ALDRPs.
• The IMF and World Bank should include climate risks analysis in Debt Sustainability Analyses. As the IMF usually plays a central role in debt restructuring operations, such analyses could provide a basis for implementing ALDRPs.

ALDRPs can contribute to debt sustainability and adaptation investments in developing countries. However, they can only palliate some of the structural deficiencies of the international monetary system, which are conducive to debt distress and lack of adaptation:

• The international monetary system features procyclical tendencies, limiting the effectiveness of governments and central banks’ countercyclical policies in developing countries. The international financial safety net available to developing countries to manage crises resulting from busts is thin. Most of them are, for instance, excluded from central banks’ swap networks, and the lack of a global debt workout mechanism results in inefficient debt restructurings when a debt crisis hits a (developing) country. Yet, climate change will strengthen developing countries’ macroeconomic instability, making these deficiencies even more tangible.
• The international monetary system also hampers climate adaptation of developing countries in several ways. Developing countries must acquire hard currencies to sustain liquidity in a crisis and to service external debt. Therefore, they focus on short-term, export-led strategies at the expense of long-term development strategies, including climate adaptation strategies. Hard currencies accumulated as reserves cannot be traded against local currency to finance adaptation (or other public good) investments locally. Finally, currency mismatch between assets and liabilities of developing countries, due to their inability to borrow abroad in their currency, induces a risk which is compensated for via higher interest rates, constraining public finance which is the primary type of finance for adaptation projects, because many of them are non-bankable.

Therefore, adequately addressing the original sins and linking the agendas for addressing climate vulnerability and financial challenges of developing countries requires reforming the international monetary system. As part of such a reform, several changes could be envisioned:

• Special Drawing Rights could have a more significant role as reserve assets. Higher SDR allocations to developing countries would reduce the need for developing countries to hold precautionary reserves in hard currencies, which fuel global imbalances and lead to short-term extractive strategies fueling climate change.
• Special Drawing Rights could constitute a new source of funding for climate adaptation. As adaptation finance is severely lacking, due to the public good nature of many adaptation projects and public finance constraints, their use would fill a critical gap.
• Developing countries could use capital account regulations more extensively. They have been found to favor macroeconomic stability, which will be increasingly challenged by strengthening climate change impacts in developing countries.
• The international community should build a global debt workout mechanism. It is an indispensable tool to enable prompt and efficient debt restructurings, while climate-related shocks will likely fuel sovereign debt risk.