Debt-for-nature conversions: looking ahead

Barbados is the latest country to execute a debt-for-nature conversion, with the help of TNC and IaDB providing technical assistance and financial guarantees. Through the USD 150 million transaction, Barbados expects to save c. USD 50m over the next 15 years in debt service, to be redirected towards marine conservation efforts.

This transaction fosters significant financial innovations – dealing with external and domestic commercial debt instruments at the same time or including hurricane and pandemic clauses – and hence broadens the scope of countries which could turn to similar mechanisms, alleviating debt burdens and freeing up badly needed fiscal space to address the climate and nature crises.

On the flip side, some thoughts ought to be given to the precise design of such transactions and instruments, ensuring they are an efficient use of taxpayers and charity money, and they do not create additional fragilities in countries’ debt stocks down the road.

Takeaways from Barbados and Belize

The most striking aspects of the Barbados conversion are probably that it was executed with commercial creditors – as opposed to Seychelles 2016 with Paris Club creditors – and outside of a distress situation – as opposed to Belize 2021.

When Belize engineered a similar transaction back in 2021, many analysts stressed that it could happen mostly because creditors were “ready to take a hit” with bonds trading deep into distress territories. For instance, Mitu Gulati heard some market chatter that creditors were aiming for 60 cents on the dollar for the buyback and accepted to settle on 55 once the ESG twist was thrown into the mix.

First, it is worth noting that although the distress aspect played a part it is not sure that all creditors did have to take a hit in order to fund the conservation efforts, as discussed earlier on Twitter. For instance, it might be that some investors bought the Belize bond as low as 35 cents on the dollar a few months before the transaction, and hence made more than decent returns when settling at 55 cents on the dollar instead of 60 while also showcasing their ESG commitments. On this topic, Jochen Andritzky and Julian Schumacher have an interesting paper looking at the investors’ perspective in sovereign debt restructurings.

Back to our point, a more defining factor was arguably that Belize retired its whole tradable debt stock through the debt for nature conversion, buying back the whole amount outstanding of its “superbond”. It meant that there would be no second-round effects in the market in terms of pricing, liquidity or market access.

The fact that Barbados was able to successfully execute the conversion by buying only a portion of its outstanding domestic and foreign tradable debt instruments paves the way for many more countries to follow suit, e.g. Kenya as noted by Mark Bohlund.

Killing two birds with one stone?

Since everyone agrees that countries in the Global South face twin climate/nature and debt crises, it appears enticing to have at our disposal a “one size fits all” instrument to deal with both at the same time, killing two birds with one stone as Dennis Essers and colleagues put it. However, it appears as shown in their paper that the conclusion is not that straightforward and that there are many situations in which debt conversions are not necessarily relevant.

Diego Rivetti raised this question specifically for Barbados, and it would be interesting indeed to look at a counterfactual, i.e. how much money could have been mobilized for marine conservation had TNC and IaDB used their firepower directly to fund conservation projects instead of doing it through a complex debt buyback transaction. Lot has been written about the shortfalls of sovereign debt buybacks, and how they can be a particularly inefficient use of donor money as illustrated by the Bolivia example back in 1988.

A new IMF paper does a great job of narrowing down the set of situations in which debt for climate conversions (applies also to nature) make economic sense. Particularly, they note that such swaps are generally less efficient than conditional grants when debt is sustainable because part of the benefits is “lost” on non-participating creditors.

The paper notes however that conversions can make sense in cases where fiscal risks are high and climate adaptation is efficient. For the precise case of Barbados, the IMF coincidently noted in its latest program review that “Barbados’ public debt remains sustainable but subject to high risks”, and that “investment to build more climate resilient infrastructure should be stepped up.” Barbados appears to tick the two boxes, and there are indeed few countries in which climate adaptation is as efficient as in Small-Island States highly exposed to hurricanes and the rise of sea levels.

An uncertain impact on the debt stock?

A topic that is much less discussed about these debt-for-nature conversions however is the longer-term impact on the characteristics and fragilities of beneficiary countries’ debt stocks. In Belize like in Barbados, bonded debt is concretely transformed into non-bonded debt, e.g. bank loans and facilities (a “term loan facility” in the case of Barbados), which can then be further distributed to market participants.

This might come back to bite countries if they need to restructure their debts again down the road. Indeed, non-bonded debt usually does not include majority-voting provisions – equivalent to the collective action clauses commonly found in sovereign bonds – a fact studied in depth in a 2020 IMF paper on the international financial architecture. This means that any amendment to the instrument’s terms, e.g. principal haircut or coupon reduction, often requires unanimous consent. Holders of small shares of syndicated loans for instance can in theory prevent a restructuring process from moving forward.

The G7 private sector working group is making progress on developing templates for majority voting provisions in non-bonded debt with support from market participants, as noted by US Treasury Secretary counsellor Brent Neiman in a speech. However, we’re still a long way from seeing these included routinely in debt contracts, and countries like Belize or Barbados are always a hurricane away from having to go through a sovereign debt restructuring.

Of course, an important innovation in Barbados is that the new debt instruments will feature natural disaster clauses which have been broadened to cover not only hurricanes but also pandemics. It could alleviate the need for a protracted ad hoc restructuring process when disaster hits, but at the same time we should remember that natural disaster clauses in financial instruments are often an art more than a science, as illustrated by the World Bank’s infamous pandemic bonds.

Finally, I am left wondering what impact the scaling up of guarantees by multilateral and official institutions as part of these debt-for-nature conversions could have in terms of seniority in the debt stock of beneficiary countries. Indeed, a defining factor for the successful execution in Belize and Barbados was the guarantees extended respectively by the US Development Finance Corporation, and the Interamerican Development Bank (IaDB).

Such guarantees are usually pretty straightforward, meaning the institution will step up as soon as there is a missed payment without the need for creditors to seek any form of judgement or ruling. Then comes the harder part: the institution turns to the country as part of a “counter-guarantee” or “indemnity” agreement, asking to be paid back for all the funds it had to disburse to the country’s creditors on its behalf.

What this means is that if the guarantee is triggered, the creditor landscape of the country shifts partly from commercial creditors to official institutions, many of which benefit from some form of preferred creditor status. This reduces the share of “restructurable” debt in any subsequent debt workout, forcing the country to inflict more pain on other creditors.

Moreover, failing to make payments when asked to do so could have major consequences. The IaDB states for instance that “a default in repayment of the Counter-Guarantee triggers same treatment as non-performing loans.” Incurring arrears to a multilateral institution is a peculiar occurrence, not least because of the IMF’s non toleration policy for arrears to multilaterals, meaning it can derail IMF program negotiations which form the bedrock of most sovereign debt workouts.

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