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Speaking after the IMF-World Bank Annual Meetings in October 2023, Joseph Stiglitz likened today’s looming debt crisis to that of the 1980s, which was precipitated by a sharp spike in the US Fed rate, known as the Volcker Shock. [1][1] Stiglitz, J. (2023, October 16). Dealing with Debt Crises: Taking stock after Marrakech. Paris, France. Available at: https://findevlab.org/dealing-with-debt-crises-key-takeaways-of-our-conference/ The extreme interest rate hikes caused debt to become unsustainable around the developing world, resulting in a “lost decade” in Latin America, characterized by defaults and subsequent waves of austerity. Indeed, the hikes of the US Fed rate since 2022 have led to heightened financial volatility, exchange rate depreciation and significant capital flight from developing countries, substantially increasing the risk of defaults.

The significant gap in financing for climate and development, combined with the lack of an effective mechanism to address sovereign debt problems, means that developing countries have no meaningful path towards recovery and resilience against future shocks. At a time when they urgently need funding for climate resilience, biodiversity conservation and public services like healthcare and infrastructure, developing countries are forced to funnel scarce resources to creditors. Without a fundamental reform of the international financial architecture, including significant debt relief, countries around the globe may be headed towards another lost decade, or worse.

Larger debt burdens, combined with higher interest rates and difficult global conditions, mean that the cost of servicing debt has substantially increased. Interest payments for low-income countries are particularly high relative to export income, which is the main source of foreign reserves in developing countries. Because external debt is mostly denominated in US dollars and other foreign currencies, high debt payments erode foreign reserves and threaten their balance of payments stability. They also make it difficult for countries to cover the cost of necessary imports, currently exacerbated by higher food and fuel prices around the globe. The continued global economic slowdown further diminishes the prospect of trade and investment in developing countries, keeping recovery out of reach. [3][3] International Monetary Fund. (2024, March 28). The Fiscal and Financial Risks of a High Debt, Slow Growth World. IMF Blogs. Available at: https://www.imf.org/en/Blogs/Articles/2024/03/28/the-fiscal-and-financial-risks-of-a-high-debt-slow-growth-world

Another Turn in the Vicious Cycle

For climate-vulnerable countries, the increased debt burden and difficult global economic conditions take on another dimension in the context of climate change, trapping them in a vicious cycle. An unfair global financial architecture keeps them indebted, while simultaneously blocking progress towards climate & biodiversity action and other Sustainable Development Goals (SDGs).

When increasingly frequent climate disasters strike, low—and middle—income countries lack the resources to cover loss and damage, and thus have little choice but to borrow in order to finance an adequate response. The structure of debt provides an additional challenge, as private creditors now hold the majority of the stocks of developing countries. Private creditors, the majority of which are bondholders, lend at market rates. This too translates into higher interest payments for low- and middle-income countries. Debt from this creditor type also comes with shorter maturities and is difficult to restructure. Middle-income countries are most affected, as they have little to no access to concessional finance. To make matters worse, climate-vulnerable countries face poorer borrowing terms due to the perceived risk of their climate vulnerability, resulting in an even higher debt burden. [4][4] Buhr, B., & Volz, U. (2018). Climate Change and the Cost of Capital in Developing Countries; Assessing the Impact of Climate Risks on Sovereign Borrowing Costs. UN Environment. Available at: https://www.v-20.org/wp-content/uploads/2020/12/Climate_Change_and_the_Cost_of_Capital_in_Developing_Countries.pdf

The Inadequate International Response

Wealthy countries and leaders of international financial institutions have expressed concern over the climate crisis and acknowledged the growing burden of debt in the Global South. At their most recent summit, the G7 recognized that “responding to global challenges, including the climate crisis, and addressing debt vulnerabilities in low and middle-income countries are urgent, interrelated and mutually reinforcing”. [5][5] G7 Hiroshima Leaders’ Communiqué (2023, May 20). The White House. Available at: https://www.whitehouse.gov/briefing-room/statements-releases/2023/05/20/g7-hiroshima-leaders-communique/ The limited response to these intersecting crises in developing countries has nevertheless been inadequate compared to their needs.

The lack of a comprehensive debt resolution mechanism remains one of the key factors that prevent highly indebted countries from accessing sustainable recovery. The G20 launched the Common Framework in 2021, a debt resolution platform for developing countries following the COVID-19 pandemic crisis. Most middle-income countries, however, are ineligible, and the mechanism excludes debt from multilateral creditors. In three years, only four countries have sought restructuring through the Common Framework. It further fails to guarantee equal treatment for different creditor classes, which results in a prolonged and complicated process for debtor countries, without providing sufficient debt relief.

Steps for Long-term and Immediate Relief

A fundamental reform of the international financial architecture, including the creation of a reliable debt resolution framework is necessary to break the vicious cycle. The United Nations (UN) proposes a mechanism open to all countries, which would facilitate debt resolution from all creditor classes in a much timelier manner—preventing “too little, too late” restructurings. [8][8] United Nations Conference on Trade and Development. (2015). Sovereign Debt Workouts: Going Forward. United Nations Conference on Trade and Development. Available at: https://unctad.org/system/files/official-document/gdsddf2015misc1_en.pdf Additionally, significant debt relief would be key to achieving sustainability. It would release fiscal space that countries could use for public spending, climate, biodiversity, and development needs, instead of funneling scarce resources to creditors.

A more comprehensive international response would also include a substantial increase in grant-based and concessional finance to accelerate investment in climate adaptation, mitigation and other SDGs. After decades of pressure from climate-vulnerable nations, wealthy countries committed to the creation of a “Loss and Damage” Fund to provide support against the effects of climate change. At COP28 (the 28th UN Climate Change Conference), the decision to operationalize the fund was adopted, and a few wealthy countries offered initial pledges of about $650 million. [9][9] H. Julia. (2023, December 12). What Countries Have Pledged to the ‘Loss and Damage’ Climate Change Fund. US News & World Report. Available at: https://www.usnews.com/news/best-countries/articles/2023-12-12/country-pledges-to-the-loss-and-damage-climate-change-fund The Loss and Damage Fund must be built through the democratic participation of developing countries, and with more funding to deliver effective support; the US, for example, has only pledged $17.5 million.

In addition, there are immediate measures that could be taken to ease the fiscal burden of these crises on developing countries’ budgets. A new allocation of Special Drawing Rights (SDRs) would provide immediate relief to all developing countries, without creating more debt. In August 2021, the IMF issued $650 billion in SDRs to member states to mitigate the economic downturn caused by the COVID-19 pandemic. The allocation came with no strings attached and at no cost to taxpayers. Low- and middle-income countries received immediate fiscal relief, which decreased exchange rate risk, improved borrowing terms, and helped countries respond to the economic shock of the pandemic. Political actors and civil society organizations from around the world continue to urge the US Treasury Department to authorize a new allocation.

Further, the IMF should permanently eliminate surcharges—extra fees on borrowing countries, which are projected to cost borrowers about $2 billion per year. By increasing interest rates, which have risen up to 8 per cent for some IMF borrowers, surcharges create an additional burden for middle-income countries that are already struggling to respond to climate disasters and meet basic public needs. [10][10] Vasic-Lalovic, I., Galant, M., & Amsler, F. (2024). A Broader Impact Than Ever Before: An Updated Estimate of the IMF’s Surcharges. Washington, DC: Center for Economic and Policy Research. Available at: https://cepr.net/report/a-broader-impact-than-ever-before-an-updated-estimate-of-the-imfs-surcharges/

In closing, without prompt intervention, low- and middle-income nations stand on the brink of a lost decade and irreversible climate change impacts, which will see unpredictable global consequences. Countries facing climate change, biodiversity collapse, significant fiscal constraints and a looming debt crisis need a comprehensive global response, including debt relief from all creditor classes, debt cancellation, and the creation of a reliable debt-resolution mechanism. Significantly more grant-based finance from wealthy countries will be necessary to meet climate, biodiversity and other SDG investment priorities. In the near term, a new $650 billion allocation of Special Drawing Rights will create fiscal space, decrease exchange-rate risk, and aid low- and middle-income countries in addressing immediate public needs.

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