Can debt restructuring episodes used to promote climate friendly policies either through the issuance of green bonds or by attaching climate friendly conditions (in terms of mitigation, adaptation, or conservation) to a debt exchange? The key challenge in marrying debt relief and environmental protection is to design a strategy that will enhance the market’s perception of a country with a sustainable post-restructuring debt position while at the same time freeing funds that can be deployed for environment friendly projects. 

In a recent paper, Bolton et al. (2022) propose that in an exchange offer the sovereign debtor could be offered the option to discharge a portion of the foreign currency debt service due on the new bonds it issues in connection with the transaction through the payment of the local currency equivalent of that portion to fund a climate-friendly project, monitored and administered by an independent third party, within its own territory and approved in advance by the lenders.

Bolton et al. (2022) provide the following example: assume that the Republic of Ruritania needs to restructure a stock of sovereign debt that requires $16 million in coupon payments. There is substantial uncertainty as to the level of Ruritanian debt that will restore market access, but sustainability analyses suggest that Ruritania could afford coupon payments ranging between $10 million and $8 million.[1] The bonds issued under the debt restructuring require a $10 million coupon payment (the upper limit of the debt sustainability range) but provide that, at Ruritania’s option, up to $2 million of each of those coupon payments may be used in local currency by funding a creditor-approved climate-friendly project in Ruritania. Failure to fund the project on any coupon payment date under the bonds means that Ruritania must pay the full $10 million — in U.S. dollars — to its bondholders.

Bolton et al. (2020) discuss the benefits of this projects in terms of improved debt sustainability, potential greenium and approbation by the international community. They also point to potential tradeoffs associated with this restructuring technique. In a conventional debt restructuring negotiation the lenders would ask for the full $10 million and take the risk that they were pressing Ruritania too hard. For its part, the sovereign debtor could be expected to insist on a cap of $8 million, arguing that it would be the Ruritanian citizens who will pay the highest price if the lenders’ optimism proves unfounded. And if history is any guide, the result may be many months of stalemated negotiations. The technique described above would allow the parties to bridge the $2 million difference in their assessments of sustainability. Ruritania pays – in hard currency – only the safer $8 million figure. By allowing Ruritania to discharge the additional $2 million through a local currency funding of an approved environmental project, the lenders simultaneously reduce the likelihood of the need for a subsequent debt restructuring and wrap the new restructured bonds in indelible ESG resplendence.

The sustainability of Ruritanian debt and hence the success of its restructuring involves a series of self-fulfilling prophecies and local currency debt tend to be less subject to such self-fulfilling runs. Allowing a portion of Ruritania’s restructured debt service to be discharged in local currency and invested in suitable projects in the country thus acts as a safeguard against the risk that skepticism about the adequacy of the debt relief provided by the restructuring may trigger a self-reinforcing downward spiral. Ruritania’s external debt dynamics are improved albeit at some fiscal cost to the domestic budget.

Naturally, there are limits.  In the presence of fiscal sustainability problems, Ruritania may have to monetize part of the debt (with some consequence in terms of inflation) or use some form of financial repression to convince domestic agents to absorb the debt (with negative consequence on the efficiency of capital allocation). The cost of these actions will depend on their dosage. High levels of inflation and deep financial repressions can have costs that may even surpass those of a new external debt restructuring. If this is the risk, the technique suggested by Bolton et al. (2022) may not be desirable.

Guest contribution by SL4SF