How could sustainable finance help avoid an emerging market sovereign debt crunch?
Against the backdrop of the COVID-19 crisis, a trio of sustainable finance innovations could enable emerging economies to overcome sovereign debt problems and support their delivery of the Sustainable Development Goals, write Alexandra Pinzon, Nick Robins and Mike Hugman
Across the world, there is increasing agreement that economies need to ‘build back better’ from the COVID-19 health and economic crisis. Core to this will be channelling finance so that in the restart phase countries can accelerate their progress towards meeting the Sustainable Development Goals (SDGs). Investors are signalling their desire for governments to put in place sustainable recovery plans. And nowhere is this more urgent than in emerging and developing economies, where fresh thinking is needed that responds to rising sovereign debt stress with financial innovations that underpin long-term sustainability.
A combination of shocks could lead to an emerging market sovereign debt crisis
The COVID-19 crisis has already triggered a wave of debt relief demands from emerging and developing countries. Shocks in commodity prices and the strain of the health crisis led to capital outflows of US$31 billion from emerging markets in March, the second-highest outflow since the financial crisis of 2008. The IMF is forecasting a global growth rate of -3 per cent for 2020, with some emerging and developing economies anticipated to experience growth rates lower than -5 per cent.
While the G20 countries have introduced stimulus measures equivalent to US$7.3 trillion in spending (PDF), many emerging and developing countries lack the requisite fiscal space to introduce similar measures. Financing needs for developing and low-income countries are estimated at US$2.5 trillion at least. The increasing emergency assistance requests to the IMF and the bilateral loan standstill agreed by G20 countries to benefit 76 poorest nations would grant immediate rescue support for these economies. These measures do not, however, ensure future resilience or mitigate debt-paying capacity risks.
This year’s emerging market sovereign debt issuance is anticipated to reach US$300 billion. Many emerging countries face limitations to issue international debt, with devaluation risking the sustainability of their current outstanding debt and further compromising their sovereign health. Traditional debt relief measures will not help, except in cases where countries are truly bankrupt. For the rest, conventional debt relief will result in credit rating downgrades and loss of market access. New approaches are needed which provide emerging economies with the fiscal firepower to respond to the immediate COVID-19 crisis and also to steer their economies on a pathway of poverty reduction and economic development through resource-efficient and low-carbon growth.
Sustainable financing innovations to drive the SDGs in emerging markets
COVID-19 is the first global crisis where sustainable finance and responsible investment tools and mechanisms could make a real difference. Added to this, there is unmet investor demand for financial assets that incorporate Environmental, Social and Governance (ESG) factors. To tackle the threat of sovereign debt crisis in emerging markets, three sustainable finance innovations could be deployed: the fund, the guarantee and the swap.
Option 1 – The SDG-aligned bond fund
Building and expanding on the experience of the Amundi Planet Emerging Green One Fund, which was developed with the International Finance Corporation, this option would involve creating a fund to invest in emerging markets’ SDG-linked debt. A first-loss absorbing junior tranche leveraging the strong balance sheet of a single International Financial Institution (IFI) or group of IFIs could achieve a credit uplift for a country’s sovereign debt from B to BBB rates. With this credit uplift, the fund would attract investments in the senior tranche from existing investors in these markets as well as new investors interested in gaining exposure to the SDG element.
In the early stages, part of the fund would purchase existing non-SDG emerging market debt, supporting the targeted emerging economies during this uncertain period and improving their refinancing opportunities. The participation of SDG-aligned bonds in the fund will increase over time until it reaches 100 per cent.
This long-term instrument would link international investors with SDG verified investments in emerging markets, which could be a mix of green, social or sustainable bonds. In similar fashion to the Amundi-managed fund, this SDG-aligned fund could further stimulate emerging markets’ SDG issuances via a technical assistance vehicle. In terms of financing, a first-loss absorbing tranche of US$750 million in equity from IFIs could help leverage US$5 billion from the private sector. This amount could help to address the needs of countries eligible for International Development Association (IDA) support (i.e. the poorest countries). Furthermore, this idea could be replicated regionally (by creating regionally focused SDG-funds) and leverage regional development banks.
Option 2 – Partially guaranteed SDG bonds
This option would involve new issuances designed to replace existing sovereign bonds issued by targeted emerging countries at no economic loss for investors holding this debt. These new issuances would have a strong SDG component, enabling a partial G20 or official guarantee; and would not have principal or interest payments for the first year. Including these bonds in an emerging market index would significantly attract investor appetite. For example, an existing Ghana 2030 bond has a partial IDA guarantee of 40 per cent of the principal.
Option 3 – Debt for sustainability swaps
There is a long history of debt for nature swaps, where sovereign restructuring is connected to commitments to invest in environmental goals. The Seychelles ‘Blue Bond’ is a recent example. The task now is to scale up this hitherto niche market and broaden its scope to serve the full range of the SDGs.
For those emerging market sovereign bond issuers reaching a debt restructuring process, they could engage with private investors prepared to support their transition to sustainability. A temporary reduction in interest payments agreed with investors would create fiscal space that the emerging economy should commit to invest in its SDGs. We analysed the example of a new set of instruments for Argentina with a uniform 7.5 per cent coupon, for which providing an initial 6 per cent coupon rate on US$200 billion bonds generates US$3 billion a year of additional cashflow for the country. This extra cash flow would then be ringfenced for SDG-verified investments. Emerging and developing countries can build on this idea to create space to achieve their SDGs.
Strong impact reporting needed
Common to all three options will be the need for a strong SDG disclosure framework to measure the impact of the different measures. These innovations could thus help catalyse the creation of a consistent sovereign-level reporting approach, which is currently missing from initiatives such as the Task Force on Climate-related Financial Disclosures (TCFD). In turn, such a framework could also support emerging countries in shaping domestic policies and mobilising private sector investment.
Turning innovation into action
It’s one thing to have good ideas. The test is translating these into real world action that support emerging market development ambitions and harness the market momentum around ESG investing. A system-wide response will be needed involving a number of key actors.
Emerging and developing countries need to be in the driving seat, making sure that these innovations respond to their development priorities and discussing these options within their finance ministries and central banks and reaching out to International Financial Institutions and their creditors. Our view is that there is untapped potential for emerging market governments to deploy investor demand for sustainable finance in the current crisis and leverage creditor support to implement their sustainability plans.
The IFIs have already provided remarkable leadership in this crisis and have often been at the forefront of sustainable finance, effectively starting the green bond market a decade ago. Now we need to go beyond temporary assistance and deft relief, with IFIs working with governments and investors to identify and deploy innovative instruments, such as the ones outlined above. In addition, IFIs are important providers of technical assistance to emerging countries to reshape their policies, aiding in identifying and eliminating perverse incentives, and shifting available public finance in the direction of the chosen SDG-funding mechanisms.
Developed countries will also need to play their part and should enhance their debt restructuring frameworks to incorporate climate, nature and social development objectives. The debt standstill announced by the G20 is a hugely welcome step, but it is critically important not just to postpone sovereign risks but also to ensure that developing countries come out of the COVID-19 crisis ready for a new economy.
A key role for developed countries would be to provide first-loss capital and also to engage proactively with emerging economies to discuss options like the ones we have outlined. Developed countries could also invest in the research required to embed environmental risk and SDGs into fiscal and monetary policy rules globally, sharing that through institutions such as the IMF and the Network for Greening the Financial System (NGFS), a coalition of 66 central banks and supervisors that includes many developing and emerging economies.
Finally, this is a moment where responsible investors with total assets of well over US$80 trillion can play a systemic role in responding to and moving out of the crisis. Investors can provide an important source of demand for options of the nature we have identified. By doing this, they will not only support a proactive plan for the sovereign transition to sustainability, they will also maintain long-term financial returns.
The immense loss at the human and economic level caused by COVID-19 opens up a unique responsibility to reset our economies and financial system. Sustainable development must be central as we emerge from COVID-19, in order to prevent a more permanent crisis caused by climate change and natural capital loss, with all the profound implications this will have for lives and livelihoods across the developing world.
The views in this commentary are those of the authors and do not necessarily represent those of the Grantham Research Institute.