How the Debt Crisis Affects the Climate Crisis in Developing Nations

After years of pandemic, a global recession, and intensifying droughts, floods and other climate change impacts, many developing countries are operating on increasingly tight budgets and at risk of defaulting on loans. And while debt isn’t inherently bad, it’s becoming a bigger challenge by the day for developing countries, including those most vulnerable to climate change.

Constrained budgets limit nations’ ability to invest in economic development, social protection, pandemic preparedness, emissions reductions and building resilience to the mounting impacts of climate change. More frequent and severe disasters fueled by rising temperatures can exacerbate other hardships in health, food insecurity and economic outlook. Tax revenues and productivity can then decrease, and long-term growth prospects diminish. Sovereign credit ratings then fall as a result and borrowing costs rise, making for costlier public investments.

This vicious circle is known as the “climate debt trap,” and vulnerable nations are increasingly getting stuck in it. As Belize’s Minister of State for Finance Christopher Coye said, “How do we pursue climate action? We are fiscally constrained at this point.”

It’s a complicated problem — one that has compounding and interrelated causes and demands innovative approaches. Here, we unpack the dynamics between sovereign debt and climate change and point to potential solutions for escaping the climate-finance doom loop.

When Does Debt Become a Drag for Climate Action?

Sovereign debt refers to government debt, which is borrowed from  “creditors” (e.g., local private institutions and households, other countries, development banks or multilateral institutions, and private investors) who purchase a country’s bonds or lend to them. Governments borrow from creditors in this way in order to confront hardships and invest in public goods and services that support development — things like education, healthcare and energy systems — complementing revenues from domestic or international sources.

Governments can also “guarantee” debt for other entities, meaning they promise to pay the loan if the debtor becomes unable. Publicly guaranteed debt is used strategically by governments to lower costs for investments that support their policy objectives. Much of the finance available to sovereigns boils down to the size of the economy and their capacity to collect revenues and issue debt, but this capacity varies significantly by country.

Debt accumulation can turn sour when governments cannot repay the money owed to creditors in a given period, also known as “debt servicing.” High-interest rates, short repayment periods, and national circumstances such as the coexistence of multiple crises (like a pandemic paired with natural disasters) can all make it difficult for governments to meet their debt servicing obligations.

Furthermore, when countries’ vulnerability to climate change goes up, so, too, do their borrowing rates. Without proper adaptation, countries’ exposure to climate change’s impacts increase, necessitating even more finance to address risks and damages from floods, droughts, wildfires and more. Climate change, with its large negative effects on economic growth, has already increased the cost of debt from public and private creditors across the Vulnerable 20 (V20), a group of countries particularly at risk of climate-related impacts, by $62 billion over the previous decade. And this climate premium is expected to more than double in the next 10 years.

The costs of debt servicing can also increase beyond a government’s capacity to pay — a particularly challenging situation when a large portion of the borrowing is in foreign currency and exchange rates dramatically increase. Developing nations also tend to face much higher interest rates for borrowing than wealthy nations like Germany or the United States, due to real and perceived risks.

For example, the U.S. government — which spent $6.3 trillion in 2022, $1.4 trillion (22%) of which was financed with new borrowing — can issue external debt in its local currency. This eliminates the risk that the money used in the economy (U.S. dollars) depreciates, or becomes less valuable, when exchanged for the currency used to service the debt, also known as “exchange rate risk.” In contrast, Ghana spent $19.8 billion in 2022, much of it on interest payments ($5.5 billion, or 28% of total expenditures). Ghana’s public debt actually decreased by $6.3 billion (11%) from the amount borrowed in 2021, but depreciation of its local currency, the Ghanaian cedi, against the U.S. dollar and rising interest rates meant that the country’s public debt servicing obligations still went up.  

Debt distress is when countries are unable to pay back their loans — a growing problem in developing nations. Between 2011 and 2022, the number of developing countries with high levels of debt (where debt liabilities exceeded 60% of GDP) almost tripled, growing from 22 to 59. And 53% of low-income countries — 23 of which are among the 50 most climate-vulnerable nations globally — are in or at high risk of debt distress.

Where the debt originates from, its composition, and the reasons it has increased vary greatly from one country to the next, as do the set of creditors.

What Do Developing Countries Say About their Fiscal Constraints and Climate Action?

Developing countries are increasingly voicing their concern over debt’s negative impact on their ability to pursue climate action. Statements released by groups like the V20, the Intergovernmental Group of 24 (G24), the UN Economic Commission for Africa (UNECA), Community of Latin American and Caribbean States (CELAC), and the Association of Southeast Asian Nations (ASEAN) — collectively representing more than 100 developing nations — unequivocally point to tighter global financing conditions and rising debt distress as systemic issues that limit a country’s ability to invest in climate resilience and the low-carbon transition.

For instance, the UNECA joint statement emphasizes that tightening global conditions (when it is harder or costlier to borrow) will further limit the fiscal space to build resilience to shocks from pandemics and climate change. The G24 communique recognizes that tighter global financing conditions may further worsen debt distress, and underscores the need to increase resilience, expand global liquidity and reform international financial institutions to contain rising systemic risks like climate change and pandemics.

Other statements and leaders from vulnerable nations offer similar sentiments. Barbados’ finance minister Ryan Staughn said the world needs to find a solution to the debt crisis “that allows countries to be able to continue to respond to the climate crisis without getting ourselves into trouble.” Coye recently stated that “the anachronistic global financial architecture inhibits timely access to affordable development and climate finance.” And Barbados Prime Minister Mia Mottley, who has become a spokesperson for addressing debt and climate through global financial reform with her Bridgetown Initiative, said that “tackling natural disasters and protecting the environment are the single-most significant causes for increases in our debt.”

What Are the Options for Governments Seeking to Meet Investment Needs and Escape the Climate Debt Trap?

As climate action becomes an intrinsic element of sound economic policy, developing country governments are venturing into a mix of debt management and fiscal and trade policy levers to increase their resources through a virtuous cycle of green growth. This requires cooperation with other countries and international actors.

Through statements from groups like the V20 and G24, many nations have already pointed to what they envisage as potential solutions to the climate debt trap. (See examples in table below.)

Source: WRI authors, compiling citations from WRI, based on international statements that reference debt in 2023 from the V20, G24, UNECA, ASEAN, CELAC

Countries have also called to restore debt sustainability in the broader context of reforming the international financial architecture. This point is reinforced by the V20, which calls for “making debt work for climate” in the global financial architecture by accounting for climate-related investment needs in debt treatment, implementing reforms and incentives that enable speedy and predictable debt resolution across creditors, and ensuring that sovereign debt refinancing includes credit enhancements. Leaders voiced similar asks at the 2023 Paris Summit for a New Global Financing Pact and Africa Climate Summit. High indebtedness also provided the backdrop to most of the debates held in early September 2023 at the Finance in Common Summit in Colombia.

There are ways of managing debt in ways that free up space for climate action, from financial instruments that provide partial debt relief, to tools countries can use, to more comprehensive initiatives that require multi-stakeholder or international cooperation:

Using specific instruments can be part of the solution.

Countries have specialized offices to manage their debt according to their specific needs. In addition, international financial institutions like the International Monetary Fund (IMF) and multilateral development banks are particularly crucial to facilitating multi-stakeholder cooperation and providing technical support at the junction of debt, public finance management and climate action. Notably, they can advise countries on the use of specific debt instruments, like debt-for-nature swaps or sustainability bonds. Countries are increasingly adding these instruments to their toolkit to make partial refinancing less costly and create more fiscal space for investing in climate action.

Such deals alone cannot solve the entirety of a country’s debt problems. When undertaken as part of a broader set of solutions, though, specific debt instruments for climate and nature can help countries transcend the climate debt trap. This requires explicit commitment by national authorities to sustainability outcomes and robust policy frameworks for credibility, making them especially suitable for upper-middle income countries that are biodiverse.

For example:

• Colombia issued a sovereign green bond in 2021, the first Latin American country to do so in its local currency, to help it meet its commitment of reducing GHG emissions and becoming carbon neutral by 2050. The bond will support projects on water management, clean transport, biodiversity protection and renewable energy.
• In 2018, Seychelles issued the world’s first sovereign blue bond, which raised $15 million to support sustainable marine and fisheries projects.
• The largest debt conversion so far, a debt-for-nature swap by Ecuador, was established to benefit the Galapagos National Park and Marine Reserves. The country earmarked savings on debt service repayments for conservation. The plan also includes an endowment mechanism to ensure funding in perpetuity. 

How to ensure conservation and climate action gains endure the test of time is a source of uncertainty, since policy commitments and priorities may diverge. When Ecuador faced restructuring of its global bonds in 2020, its sovereign social bond issuance benefited from a guarantee from a multilateral institution. This avoided reducing social protection such as affordable housing at a time when the country was hit with a combination of the pandemic, lower revenues from lower oil prices and deep recession.

Equipping the global financial architecture with new tools

At the international level, governments have emphasized the need for a system that enhances global liquidity for addressing growing systemic risks. A few initiatives and proposals aim to help do so:

The IMF operationalized in October 2022 the Resilience and Sustainability Trust (RST), a loan-based trust that provides modest resources. The trust fulfilled an earlier ask of the Bridgetown Initiative, which put forward proposals for revamping the global financial system and created political momentum to discuss them. In addition to beefing up the RST, the Bridgetown Initiative proposed, among other solutions,  that all lending instruments include a natural disasters and pandemic clause that allows countries to temporarily pause their debt servicing obligations.

More evidence is also needed to assure credit rating agencies (CRAs) that systemically vulnerable countries can reduce their climate risks. When sovereigns are issued a low credit rating by leading agencies, creditors expect a higher return to offset investment risks, and governments need to pay more to service their debt. The V20 has called on financial regulators to incentivize climate action by ensuring leading CRAs account for all climate risks, be they physical (like fires or floods) or transitional (regulatory of technological risks related to the transition to a low-carbon economy).

Another option for raising the resources required for vulnerable countries to escape the climate debt trap is a global deal on carbon financing. This proposal by the V20 would require major polluting economies to pay a fair price for the carbon they emit and use at least part of the revenues generated to meet sustainable investment needs in climate-vulnerable nations.

Initiatives that deal with debt in a comprehensive way

Other international initiatives seek to address the broader issues of long-term debt accumulation becoming unmanageable, including debt restructuring, relief and forgiveness. Countries’ positions on restructuring vary widely, with some of the factors being the time they have or the cost of defaulting  (when the borrower fails to fulfill its debt payments) versus debt servicing. The cost of default for a country may be financial, political, reputational or a combination. As the composition of sovereign debt is country-specific, deciding whether and when to restructure becomes a complex question. 

Yet the current menu of options has often proven ill-suited. For example, timely decisions and speedy resolutions are critical to minimizing the social costs of default. On average, countries that have defaulted since 1960 experienced an increase of 10 percentage points in infant deaths a decade later. This relationship is exacerbated with every year of delay in debt resolution.

Defaults are also costly for creditors, providing impetus to coordinate on a sustainable solution, but negotiations can be lengthy and painful. The G20’s Debt Service Suspension Initiative (DSSI) paused $12.9 billion in service payments for low-income countries between May 2020 and December 2021 in the wake of the COVID-19 pandemic. It was replaced by the G20 Common Framework for Debt Treatment in low-income countries. Only four governments (Zambia, Chad, Ethiopia and Ghana) have requested treatment so far; Zambia and Chad reached an agreement with creditors, but negotiations  took well over a year.

Sustainable Sovereign Debt Is Part and Parcel to Achieving a Sustainable Global Economy

In the aftermath of the compounding climate, economic and health crises, many developing countries are left facing both short-term liquidity and long-term fiscal issues. Attracting more finance for developing countries’ climate needs and diversifying financial instruments is one part of the picture. Reducing the cost of debt, freeing fiscal space to respond to climate change in the short-term, and ensuring long-term debt sustainability are also essential. Nations need to set off a virtuous cycle of green growth to expand their resources and avoid the climate debt trap.

At the same time, it is crucial to strive for consistency between existing flows and global climate targets. For instance, international financial institutions should help countries find economic alternatives that respond to their development needs while contributing to climate action.

Meanwhile, creditors could provide a clear process for delivering timely debt restructuring when it is needed and consider debt relief mechanisms, where applicable. Multi-party discussions bringing together all creditors and partners especially after extreme events, are essential.

When debt threatens the wellbeing of a nation, it inhibits the government’s capacity for other priorities. And when around 41% of people live in countries that spend more on interest payments than on development, it inhibits trust domestically and trust that international cooperation works to everyone’s benefit. Multilateral solutions are essential for achieving sustainable sovereign debt and a prosperous world that benefits everyone.