IPD AI Insights

An Updated Bridge Proposal: Towards A Solution to the Current Sovereign Debt Crises and to Restore Growth

07/01/2024
Policy Brief
Finance for Development Lab
Debt and Global Finance

The climate agenda is now on a collision course with the rising debt crisis in developing countries. Although they have largely been treated as separate problems so far, the debt crisis is now becoming a significant obstacle in addressing climate change. Leaders of developing countries are being urged to commit to ambitious long-term climate plans, while their houses are on fire.

Overview

Although good intentions are motivating current efforts to increase liquidity injections for the climate transition through the multilateral system, there is a high risk that these efforts may prove to be inefficient. When debt service is high, the injected liquidity may end up being used to pay off existing creditors, rather than being effectively utilized for climate goals. In the next five years, debt repayments are expected to be high, even though the overall debt levels for most developing countries remain below distress risk levels, provided they can refinance at reasonable rates. For many countries, establishing a sizable liquidity that combines new financing with an extension of the maturity of debt at suitable interest rates would offer the needed financial flexibility for investing in climate initiatives while simultaneously reducing debt.

This note expands on a previous proposal by the Finance for Development Lab 2014 (Diwan et al, 2024). New analysis, supported in part by comments and reactions to Diwan et al. (2024)’s initial proposal and by the discussion held at the workshop “Addressing the Debt Crisis in the Global South” held at the Pontifical Academy of Social Sciences at the Vatican (June 2024), have enriched the analysis and main arguments and allowed us to update the proposal. The first part outlines the primary issue for many countries: leakages from multilateral funding to other existing creditors, and macroeconomic vulnerability to shocks. The second section discusses the two main strategies that have been either promoted or adopted to address these issues: debt relief and refinancing by multilateral institutions. While both strategies are useful under certain circumstances, they also have limitations. Therefore, in the third section, we propose a new approach applicable to countries that would be solvent under sustainable refinancing conditions but are currently illiquid. We also provide details on how this new approach could work.