Climate debt-trap risks pushing vulnerable emerging markets to brink

Rising global borrowing costs are denting the finances of some of the most climate-vulnerable countries right when they most need money to fight the devastating impacts of global warming. 

It’s a convergence of events that risks pushing developing nations into a “debt trap,” according to Prime Minister Shehbaz Sharif of Pakistan, who addressed world leaders at the COP27 climate talks in Egypt last week. Countries that borrowed heavily when interest rates were low are now struggling to fund projects that would make them more resilient to extreme weather, leaving them vulnerable to even higher borrowing costs in the future.

Pakistan, which was pushed to the brink of default by flooding on nearly a third of its territory this summer, is a case in point. The country received a $1 billion loan from the International Monetary Fund to help tide it over, but the flood damage is estimated at around $32 billion and the country has $3 billion of debt to service through June 2023, according to Bloomberg Economics. 

Leaders of nations most vulnerable to climate change have long argued that the countries that contribute the bulk of emissions should foot the bill for mitigation and adaptation, but rich nations have consistently fallen short on their promise to provide $100 billion in annual climate finance to the developing world. While loans from individual countries and development finance organizations have helped plug some of the gap, emerging markets have also had to rely heavily on bond markets.

“If we have to fight and rebuild and repair our infrastructure, which has to be resilient and adaptive, then of course we can only do so through additional funding, not through additional loans and debts,” Sharif said in his speech at the summit in Sharm El-Sheikh. 

Developing-nation governments need to pay back or roll over about $350 billion in dollar- and euro-denominated bonds by the end of 2024, according to data compiled by Bloomberg. Meanwhile, sovereign dollar bonds from a quarter of the countries in Bloomberg’s EM Sovereign Dollar Debt Index are trading with a spread of 1,000 basis points or more over US Treasuries, a generally accepted metric of distress. 

Climate risks aren’t yet widely being reflected in the price of new debt, although investors are starting to ask more questions about how extreme weather events will impact a country’s ability to service its bonds, according to two bankers involved in selling sovereign debt.

“The market as a whole is still a couple of steps behind,” said Christine Phillpotts, portfolio manager at AllianceBernstein LP in New York. “If we continue down the road that we’re heading on, there’s going to be discussion forced upon investors and governments as to not only what is the correct price to be paid for assets in the country, but how do you actually reduce that risk premium.” 

Part of the answer may be more low-cost lending by the world’s development banks, something that Egyptian Finance Minister Mohamed Maait demanded at the climate talks last week. Another potential tool, which was on the official agenda at COP for the first time this year, is a loss-and-damage facility, which would channel funds from rich countries that have contributed more to emissions historically, to those that are on the front lines of climate change. So far only a few wealthy countries have committed contributions.

“From the perspective of the African Group of Negotiators we do need to see immediate support for loss and damage on the continent,” said Barbara Creecy, South Africa’s environment minister on the sidelines of the conference on Sunday. “Of course” we want money right now, she added.

“Anything that allows a poor country to recover” will always help reduce the risk premium baked into their debt, according to Jens Nystedt, a senior portfolio manager at Emso Asset Management in New York. “It makes sense for richer countries that are in a lot of ways responsible” to fund the facility, he added.

The Nature Conservancy, a US nonprofit, has been pushing for debt-for-nature swaps as a potential solution. Such deals typically allow countries to restructure debt at lower interest rates or longer maturities, with the proceeds being allocated to conservation or green projects. Since 2016, the Nature Conservancy has organized debt-for-nature swaps for the Seychelles, Belize and Barbados, which overall helped to convert more than $500 million of debt into $230 million of money for conservation.

The instruments could “offer developing countries with little fiscal space the opportunity to undertake urgently-needed climate investments,” Kristina Kostial, deputy director of the strategy policy and review department at the International Monetary Fund, said during a panel session at COP last week. 

The so-called debt trap was a key topic at the talks this year, partly because it was hosted by Egypt, a developing nation that is already seeing the effects of climate change, and partly because global interest rates are rising. Senegal President Macky Sall said in a speech at the conference that developing nations “aren’t ready to put up with” the current set up where developing nations take on debt to fund climate mitigation. 

“We are funding our own adaptation efforts when we are the victims,” Sall said. “We are being doubly punished.”