What if developing countries could get credit for paying back their debt by reducing their emissions?
I was talking to a friend about a year ago about Argentina. She had researched the country’s debt structure in university, and was of the opinion that the nation’s debt posed a substantive barrier to development and reform. Her view was that the cost of debt repayment redirected money from being spent on the infrastructure and social services that would be necessary to grow the economy, meaning the growth the country required to pay back the loan wasn’t possible. She pointed to Argentina’s eight defaults in IMF loans in the last two hundred years as an example, and noted that this was indicative of a financial system that created structural barriers to supporting economic development in the developing world. She then offered an idea as to how to (at least in part) address the issue: the IMF should allow countries to earn credit on debt repayments by reducing their domestic carbon emissions. This would allow states to make investments into their economies, support global decarbonization and help break the vicious cycle of defaults.
At the time, I dismissed the idea as non-workable. IMF loans are issued in periods of crisis, and states typically receive write-downs on issued debt if their finances appear shaky. The IMF has also recently changed their approach to be more outcome-focused – the lender eliminated its structural performance criteria assessments in 2009 and overhauled its fund disbursement mechanisms to make it easier to offer short and medium-term funding. The IMF is also not a development bank – the World Bank is, and it isn’t the IMFs job to support economic development. Other institutions exist for that objective.
But recently, I’ve been thinking about the debt-emissions credit scheme idea in a more favourable light. Institutional characteristics (and obligations) are increasingly being recognized as one of, if not the, primary differentiator between growth rates in the developed and developing world. A nation who has taken out thirty different IMF loans over a sixty year period will inevitably have institutional characteristics that mirror past reform imposed by lenders as requirements to access funding, even though those same reforms might now understood to be barriers to growth and prosperity. The redirected capital flows are also not insignificant: In 2019, the country owed $30B USD to the IMF, equivalent to 6.3% of the country’s GDP. It also made sense from an efficiency perspective; this repayment obligation would have little to no positive spillover effects (i.e. productivity does not increase in the economy because capital exiting the nation means no investments were made), meaning it would redirect capital away from more productive or socially-desirable uses. Finally, Argentina and its debt have recently been in the news: a Presidential election has coincided with a meeting this week with the relatively new head of the IMF, both of whom stress they’d wish to “take on poverty”. The intermediary in negotiations, Nobel Laureate Joseph Stiglitz, has warned Argentinian creditors to expect “a significant haircut”.
The country likely would benefit from finding more productive ways to lower its repayment obligations, both by benefitting concretely from domestic capital spending and from improving its credit rating to borrow in future. The IMF would also likely benefit from the “climate write-down” concept – the institution’s new chief had loudly called for countries to create climate policies of their own, and funding zero-carbon projects would reduce risks of future default and emergency bailouts (two things that a bank created to maintain global economic integrity values highly). The arrangement then might have some merit as a concept. However, merit in itself isn’t enough – the world is full of great ideas that won’t ever happen. So an interesting question might be what policy adjustments, mechanisms or interactions might be necessary to put this into place.
The first barrier would be restructuring funding terms for existing loans. As noted, the IMF’s financing terms have evolved in recent years to be more outcome-focused but this does not cover pre-issued loan agreements. This re-visiting of loan terms would be a first step towards removing some of the financing conditions that have lead to accusations of the IMF being a recession-inducing, special-interest-captured, neo-colonial body (who has also committed the worst of all crimes: being bad at its job). Extending it to incorporate corresponding write-downs on existing debt if investments are made in other areas would mean going further still, but the complexity required to rewrite legal agreements may lead to the idea simply being non-viable
However, creating a mechanism that allowed for nations to opt-in is not outside the realm of possibility; debt cancellation approaches have been proposed in the past by Jeffery Sachs, an economist at Columbia University. Offering this “low-carbon off-ramp” mechanism for states might be useful in some contexts if the burden of payments is stalling development, a feature that the IMF already uses in some circumstances by offering reductions in valuations of initial debts to lower repayment volumes (known as a “haircut”). It could be partially modelled off the World Bank-led “Heavily Indebted Poor Countries” initiative created in the 1990s that offered debt relief in exchange for poverty spending programs. The program would need to tie debt relief to emissions reductions, meaning a fair bit of adaptation would be required, but offering a separate program that countries with existing debts could opt into might be a good way to start without rewriting the conditions of every IMF loan currently given out (which would likely prove a barrier too large to even consider the idea).
The second barrier would be ensuring developing countries actually had the capital to make investments. This seems like an obvious one – simply redirect capital that would have been used to pay back debts toward spending on low-carbon infrastructure (i.e. rely on the fungibility of capital allocation). In some instances it may be that simple, but in others, there would likely be a liquidity challenge associated with spending that heavily on infrastructure. Additionally, unless the IMF (or another lender) were to serve as a lender of last resort in all projects, capitalizing infrastructure spending through bond issuances might not attract as much as investment as needed in developing states. Existing credit scores (and a history of national defaults) will raise eyebrows amongst investors about the risk of long-term investments whose payback periods may be in the decades. Green bonds markets may be flourishing but national credit ratings will still heavily sway forecasted rates of return for a given project. The IMF’s history of supporting capital market liberalization likely would make investments seem less stable as well, especially if infrastructure investments are made in domestic currency whose future value is uncertain. One potential solution is for the IMF to serve as a lender of last resort in cases of project default, but doing so would be complicated and broadly outside their mandate. A better option might be to pair with local development banks to identify and support project funding, creating an agreement for capital spending to decrease IMF debt while the development bank serves as the financier. Cost-share mechanisms offer one approach for this; creating an IMF fund for development banks to tap into could be a part of the off-ramp that mandated cooperation with regional partners.
The third barrier would be the development of criteria noting which indicators/values would be associated with which levels of debt reduction. This is outside the IMF’s areas of expertise. The IMF does not fund projects; they are not a multi-lateral development bank. This means adapting a structure would require two steps. The first is partnering with an MDB, either a regional institution or an arm of the World Bank, to understand what evaluations and project criterion make sense to include in their assessment criteria both globally and for each country. The second step would be to adopt a set of standards that could correlate what level of carbon reductions would equate to corresponding reductions in debt. An easy answer would be to simply say that however much capital is spent on low-carbon projects, the corresponding amount is written down in debt. But this would have policy implications: countries that invest in multi-billion dollar gigawatt-scale hydro projects could receive large write-downs, even if the project ends up being a net emitter when indirect emissions from methane leaked from decomposing vegetation are factored in. This would also structurally bias lending away from projects like renewable energy and mini-grids, two important technologies to support resilience and access in developing countries. There’s also the question of what constitutes low-carbon: natural gas plants and infrastructure might offer a carbon-reduction benefit from a baseline pathway but wouldn’t be desirable in a net-zero environment. None of these are barriers that can’t be overcome – professionals who specialize in project funding and environmental standards are not hard to find. But they do exist today and would need to be overcome were the policy to be put in place.
If this were to happen, it would create a philosophical question about what the IMF is. As noted repeatedly throughout this article, the IMF is not a development bank. It does have a mandate to reduce poverty, but its primary objective is the maintenance of stability of the global financial system. This is where the risks posed by climate change can offer an explanation as to why this program might make sense. Climate change is widely recognized in the finance community as a systemic risk, one who ripple effects would have devastating second and third-order effects on growth. Beyond the scope of direct costs from flooding and storms, consider the idea that Silicon Valley could be evacuated or destroyed by California wildfires. The monetary cost to the global economy would be colossal. Financial markets would collapse as share prices tanked, technological infrastructure and services would disappear (even briefly) and the American dollar’s value (which underpins 54% of developing country debt) would tank and send the entire world economy into a tailspin. There isn’t a comparison for the risks posed by climate change because they have no ceiling. The IMF recognizes this, and might see it as logical to expand the scope of their role into more directly funding low-carbon projects ith local partners.
One potential barrier to these write-downs are the funding mechanisms currently outlined within the Paris Agreement. Article 6 of the agreement, which is currently still being negotiated, allows for rich countries to fund projects in poorer ones through a global carbon offset system. This scheme, wherein rich countries receive “Internationally Transferrable Mitigation Outcome” (ITMO) credits for investment, would increase the risk of double-counting emissions reductions. If a developing country is receiving a debt write-down for making an investment, and that project is funding by someone else, then two countries will claim the same reduction as their own and the market will end up double-counting a single action. This can be avoided by simply reworking the funding terms within projects that qualify for ITMOs: countries are already laying out terms to prevent double-counting, although some developing countries currently oppose them given that others would receive credit for their actions. Creating a flexibility mechanism for debt repayment might be a way to overcome this political deadlock, especially if states receive credit for both debt repayment and their climate obligations by taking action (making it more of a “national debt and emissions credit stacking arrangement” than an emissions arrangement at risk of additionality) – although the issue of getting capital to invest in the first place does not disappear.
The idea isn’t perfect – the IMF’s likelihood of reform in this direction is minimal and this whole approach sounds more like a trendy World Bank Program than a potential future feature of IMF loan terms. It also likely does nothing to overcome the core barriers encountered in development economics. However, it does have some potential. The aforementioned Heavily Indebted Poor Countries Initiative offers an interesting approach for what it might entail in Argentina (although as a middle-income country, the program’s eligibility would need to be expanded): Argentina could make investments in zero-carbon energy, sustainable agriculture and low-carbon mining technology and receive debt relief for doing so. In turn, the investments would spur further economic growth and allow the country to make the investments to support its future growth, creating a positive feedback loop on its future potential to repay debt and making it easier to attract investment. The IMF would reduce the risk of needing to write-down its debt in a country whose investments improve their resilience. And everyone gets to say they’re doing their part to fight climate change. Overall, it’s an idea worthy of consideration – so says both my friend and current Democratic Presidential front-runner Joe Biden, who once co-sponsored a bill supporting a vaguely similar sounding proposal. And if a young socialist and Joe Biden can agree one something, it might be worth a second look.