Sovereign Debt Conversions or Swaps

Developing countries with histories of debt vulnerabilities are often also vulnerable to climate change. Whilst debt-for-nature swaps have been around for decades, they have become more prevalent as a means of addressing three major problems facing less-wealthy nations: high-levels of debt, the impact of climate change and biodiversity loss. They are also attractive to investors keen to purchase assets with an ESG element. But what are "debt-for" transactions, how have they worked to date and how might they evolve in the future?

These so-called "swaps" are not to be confused with financial derivatives contracts whereby there is an exchange of cashflows based on a notional principal amount. Rather, they typically involve existing, hard currency debt obligations (usually in the form of bonds) of a heavily-indebted country being cancelled or reduced in exchange for debtor-country investments in biodiversity protection and critical climate initiatives. The debtor country uses a portion of the proceeds of a new debt issuance to tender its existing debt at the discounted market price. The new debt is often issued by an SPV that is set up specifically for the transaction and often has the benefit of a guarantee or political risk insurance from a credit-worthy entity – often a DFI such as the US International Development Finance Corporation (DFC) or the Inter-American Development Bank (IADB) – thereby reducing its debt service costs going forward.

This usually means that a country's debt needs to be trading at a discount, although the amount of the discount in the buyback of debt securities has varied. For example, Ecuador bought back its debt at between 38 and 52 cents on the dollar whereas for Gabon this was between 85 and 96.75 cents on the dollar. If a country and its creditors agree to a swap, a portion of that nation's debt can be cancelled, with the savings being dedicated  to achieving specific, measurable and traceable outcomes in climate or nature projects.

Debt-for-development and debt-for-impact swaps may be more appropriate for countries which are less impacted by climate change and do not have biodiversity challenges but which have other challenges such as access to clean water.

Belize, Ecuador, Barbados, Gabon and Cabo Verde have all done debt-for-nature swaps in recent years. The IIED report suggests that Ghana, Gambia, Pakistan and Sri Lanka are amongst countries which may benefit from some form of debt swap. The IIED's analysis focuses on the 49 countries most at risk of defaulting on their external debts for which data could be found. According to IMF/World Bank figures for 2022 public external debt stocks – the most recent available – such countries collectively owe $431 billion. Using a methodology derived from previous international debt-reduction schemes, IIED estimates that $103.4 billion of that total could be available for climate / nature related schemes, although this would obviously depend on the market's appetite for a vast increase in the amount of such debt swaps.

Despite the opportunities for more debt swap transactions, there are also challenges to overcome. Some have argued that they can be complex, time-consuming and costly considering that the overall debt reduction is typically low compared to a country's overall debt. Also, for such swaps to have a real impact, "the number and size of transactions must be scaled up significantly", the IMF’s Managing Director Kristalina Georgieva said last year. These are not dissimilar to the challenges initially faced by other sustainable finance instruments and, as is the case with other financial products, complexity, time and cost will reduce the more transactions there are. Indeed, the reasons why debt swaps are becoming more prevalent (primarily debt sustainability and climate vulnerability) do not seem likely to become less urgent anytime soon.

There is currently broad interest in debt swaps from sovereigns, DFIs and investors. Whilst they are not a panacea and may not be appropriate for some countries, we expect the size and volume of such deals to continue to increase throughout the rest of 2024 and beyond.