- There is a renewed push behind debt-for-nature swaps as a tool for managing emerging market (EM) debt distress, with some pushing a programmatic response to a possible EM debt crisis.
- The mechanism may point to a break in Zambia’s debt impasse, argue experts.
- The credit work required to get these off the ground are extremely labour-intensive, putting mainstream investors off.
Capturing nature’s value in economic terms is no easy task, but it may be key to alleviating what some see as an impending debt crisis in the emerging markets.
Earlier this month, Sri Lanka defaulted on its bond payments, adding to a growing list of emerging market sovereigns in or fast approaching debt distress as higher inflation, slower growth and tightening global financial conditions make it harder for poorer countries to pay back their debts.
However, the impending crisis has sparked a renewed focus on debt-for-nature swaps as a tool to alleviate such pressures. Sri Lanka faces unique fiscal and economic challenges, but has rich biodiversity and natural capital resources. These could, if effectively managed, help resolve funding crises for it and other such countries – the likes of Ecuador, El Salvador and Zambia – proponents argue.
Debt-for-nature swaps have been around since the 1980s, gaining more prominence in recent years through deals in the Seychelles and Belize in 2018 and 2021, respectively. Such instruments entail the provision of funding contingent on support for natural assets such as biodiversity. Hence, for instance, the proceeds of bonds issued go into green, social or sustainable projects.
But such swaps are highly bespoke, structurally complex and demand intensive credit work and lengthy multi-stakeholder engagement, raising questions about their effectiveness to address a greater and more urgent challenge.
In April, the IMF’s World Economic Outlook revealed eight countries in the world were in debt distress, with 30 at high risk of default . Emerging market and developing economies have $12.3trn of external debt and debt service payments outstanding, up from $8.9trn in 2014.
“The question is: are we back to the systemic defaults we expected two years ago in the pandemic, because it does seem like all of a sudden default rates are rising again and it’s starting to smell systemic – and that’s an opportunity if you're in the world of policy because you can devise a systemic solution and have a mega impact,” says Bryan Carter, London-based head of emerging market debt at HSBC Asset Management.
Pushing a new framework
Accordingly, experts are advocating for the creation of a programmatic framework for the inclusion of nature in debt relief overseen by international financing institutions like the IMF or World Bank.
Debt-for-nature swaps, either via a country or regional approach, are “neither a panacea nor insignificant” in moving the needle on debt restructuring and climate and conservation challenges, says Slav Gatchev, Virginia-based managing director for sustainable debt at NatureVest, part of non-governmental organisation (NGO) The Nature Conservancy (TNC).
“We are all for programmatic solutions where you don’t have to chip away at one country at a time,” he adds, “and we’ve been advocating with other international NGOs for that to happen.”
However, they are limited by reliance on the political will of institutions such as the G20 and IMF, Gatchev says, and of emerging bilateral creditors like China, India and Turkey. They will have to consider a reduction of official development assistance (ODA) claims against credible climate and biodiversity commitments, he says. The role of TNC is to design the bespoke nature conservation frameworks that enable countries to make, manage and report on these commitments; it structured both the Belize and Seychelles deals.
“We are early in the journey, [but] the big creditors are still not convinced this is the best idea,” he says.
The Emerging Market Investors Alliance (EMIA) is also pushing for ESG conditions to be included in debt restructuring, including debt-for-nature swaps, and is rallying the IMF to commit to include ESG conditionality.
“The IMF is the godfather of conditionality, but it’s always been economic conditionality, so isn’t it time to have ESG and sustainable conditionality as part of that framework?” says Carter, speaking on behalf of the EMIA, where he is an executive fellow overseeing public-sector programmes .
Whether the market takes a programmatic or bespoke approach, or a combination of the two, debt-for-nature swaps look set to become more common. Practitioners – including bankers, lawyers and NGOs – tell Capital Monitor they are looking at a pipeline of six to ten sovereign debt-for-nature swaps, with Ecuador next on the list.
“When there is no market access, this is a way for emerging market countries to reallocate resources away from debt service into capital for key Sustainable Development Goal projects,” says Peter Sullivan, head of public sector for Africa at Citi.
“A lot of emerging market sovereigns are very vulnerable, [that] need to reduce absolute debt levels while mobilising resources into development. Most emerging markets should be taking a very hard look at this.”
Candidates for debt-for-nature swaps
Experts suggest a debt-for-nature swap could break a two-year impasse in Zambia that has left the landlocked country unable to move forward with a $17.3bn restructuring of its external debt. By leveraging its rich biodiversity and natural capital, they say, Zambia could incentivise its creditors to participate in restructuring that has been held up by the inability of its official lenders to form a creditor group.
Zambia’s official creditors could take a haircut on the country’s debt in part exchange for biodiversity or carbon credits, says Carter. In this way, the natural capital in Zambia can be protected in perpetuity, funded by official donors who can claim carbon or biodiversity credits in exchange for debt relief, he adds.
Zambia, alongside Sri Lanka and others, would be an ideal candidate for such a deal, agrees TNC’s Gatchev.
Zambia draws safari enthusiasts from the world over and tourism accounts for 4.5% of its GDP. In 2014, 40% of the country’s wealth was accounted for by natural capital, with 73% of it made up of protected areas, pastureland, cropland and forests, according to analysis by the World Bank.
Sri Lanka is seen as another candidate for a debt-for-nature swap. The United Nations Development Programme has asked the country to execute such a transaction to help manage its debt crisis, the Financial Times reported last week.
But the immediacy of Sri Lanka’s crisis – entailing food shortages and civil unrest – means that it may not be an appropriate candidate for such a lengthy and intensive process.
“It becomes a little trickier with a country in an actual default, as these deals take a while. And in order to benefit from a wrapper, they need to convince the DFI [development finance institution] to write the insurance policy, which might be difficult,” says James Tanner, an associate at law firm Baker & McKenzie in London. “It is a bit like taking out insurance after the house is on fire.”
Debt-for-nature swaps: investment obstacles
That may put off many would-be investors in such deals. That is on top of the other obstacles to attracting capital into such deals. On top of the relatively high risk involved, the structures involved are complex.
The credit work required to understand and price the structure is far beyond that required for a normal debt issuance and means such deals will likely remain the domain of impact or specialist funds, the head of ESG debt capital markets at a large European bank says. Such transactions also require a commitment to ex post reporting, measurement and ensuring the impact data itself is independently verified.
Bankers say future debt-for-nature swaps will be priced off comparable deals such as Belize, and adding a premium or discount based on the level and complexity of DFI support in the new deal.
Belize saved $250m in debt refinancing costs with its scheme by using the proceeds of the new deal to refinance a $533m 4.94% 2034 note at 55 cents on the dollar. It had been trading around 40 cents on the dollar at the time of the deal announcement.
The new Aa2-rated bonds had a coupon of 1.6% of the first year, 2.1% for the second year, 3.6% for the following two years and 4.47% from October to maturity.
Another mechanism that may better align with the commercial incentives of official creditors would be a debt-for-development swap, says Citi’s Sullivan. Under such deals, creditor countries that agree to debt forgiveness could count the value of the debt discounted against their ODA.
As with so much of the huge amount of capital required to fill the emerging market funding gap, it seems DFIs and governments have a lot to do to bridge the divide. If the likes of the UN, IMF and World Bank were to get behind the debt-for-nature initiative, that might help at least a little.
For their part, perhaps governments of countries rich in biodiversity might also consider taking advantage of such valuable assets in this way well before they are in danger of debt distress.