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November 9, 2022

Why the financial odds are stacked against developing countries

To reach global climate goals, and give developing countries access to affordable finance, an overhaul of the financial system is needed.

By Isabeau van Halm

In the run-up to COP27, leaders of developing countries called for an overhaul of the global financial system. Barbados Prime Minister Mia Mottley in September urged world leaders to add disaster clauses to developing nations’ debt and remove barriers for them to access financial assistance from multilateral development banks (MDBs).

In an October meeting of the International Monetary Fund (IMF), finance ministers of the countries most vulnerable to climate change called for “an immediate reform of the sovereign debt restructuring architecture”, with some countries considering ceasing debt repayments in order to push for debt relief. 

COP27: climate finance
COP27 participants visit a pavilion that features the topic of climate reparations on 8 November 2022 in Sharm El Sheikh, Egypt. (Photo by Sean Gallup/Getty Images)

At COP15 in 2009, developed countries pledged to provide $100bn a year by 2020 to help developing nations adapt to climate change. However, rich countries have failed to meet this target. In addition, most of the money that has been provided is in the form of loans – making its true value much lower than reported.

According to an analysis published on 7 November by Carbon Brief, which compares nations’ contributions to the $100bn target with their share of historical emissions, the countries most in “surplus” against their “fair” share – Germany, France and Japan – have given far more climate finance in loans than grants. Carbon Brief argues their “apparent generosity” is therefore “clouded”. More grants instead of loans is a key ask from developing countries at COP27.

A new report prepared by the Independent High-Level Expert Group on Climate Finance and presented at COP27 on 8 November estimated that developing countries, excluding China, will together need more than $2trn each year by 2030 to cut emissions and cope with the impacts of climate change. Rich countries’ failed pledges highlight the need for developing countries to have access to low-cost finance, both to boost domestic public investments and attract investments from the private sector.

“Unlocking substantial climate finance is the key to solving today’s development challenges,” said Vera Songwe, one of the report’s authors, in a press release. “This means countries must have access to affordable, sustainable low-cost financing from the multilateral development banks to help crowd-in investments from the private sector and philanthropy to support the energy transformation, build resilience and protect natural capital. Financing alone is not enough and must be coupled with the right instruments and good policies to accelerate and scale up impact.”

The financing divide between developed and developing nations

However, many developing countries face barriers to accessing affordable financing. They experience significantly higher borrowing costs than developed countries, with the divide only increasing over time, shows data from the UN's Financing for Sustainable Development Report 2022. In 2000, developed countries had an average interest rate of almost 3.5% on outstanding government debt, while that of the least-developed countries was around 1.5%. In 2021, however, average interest rates for developed and least-developed countries were around 1% and 2.5%, respectively.

According to the UN report, a range of factors explain the financing divide, including investor perception and uncertainty over repayment capacity. The report notes that the divide was only exacerbated during the Covid-19 pandemic as many developing countries cut capital spending, while the war in Ukraine is expected to create further volatility by disrupting supply chains and pushing up the rate of inflation.

Sovereign credit ratings set by credit rating agencies (CRAs) are used by investors to assess the level of investment risk in a country. The three most prominent credit agencies – Standard & Poor’s (S&P), Moody’s and Fitch Ratings – assign scaled categories that mean that countries are either deemed investment grade or non-investment grade (also called ‘speculative grade’). Each of the big CRAs uses its own unique methodology to set sovereign ratings, but generally, factors considered include income, growth, inflation, debt, governance quality and economic development. 

Although government debt is a factor in the ratings, there seems to be little correlation between the two. An analysis of ratings from S&P, Moody’s and Fitch shows that Japan, which has a debt-to-gross domestic product (GDP) ratio of 221%, received a high investment grade rating. By contrast, Paraguay has a debt-to-GDP ratio of 22% and has a track record of long-term economic growth but still has a speculative grade rating. Negative warnings by CRAs have been linked to increases in the cost of borrowing, especially for developing countries, which can in turn exacerbate the financing barriers these countries already face.

A 2018 report assessing the relationship between climate vulnerability, sovereign credit profiles and the cost of capital in developing countries found that climate vulnerability had already raised the average cost of debt in the 40 countries most vulnerable to climate change – causing $40bn in additional interest payments on government debt alone between 2007 and 2016. According to the charity Debt Justice, which calls on creditors like the IMF and the World Bank to suspend debt payments, lower-income countries spend five times more on debt payments than dealing with climate change.

“The worsening of both public and private financing costs will hold back crucial investments and the development prospects of societies that are already punished by climate change,” said the V20 presidency, which represents the world's most vulnerable countries to climate change, in October 2021. “Perversely, countries that have not contributed to climate change effectively end up paying twice, as a floor: for the physical damage their economies face and through higher costs of capital, which spreads even more thinly the already resource-challenged coffers of vulnerable countries.”

Accounting for climate change

Ratings agencies are still recovering from the reputational damage they suffered after failing to predict the financial crisis of 2008, and many have voiced concerns they do not have adequate climate science data to model, for example, climate change impacts on sovereign ratings.

A UN policy briefing from March 2022, which explores the challenges faced by developing countries over credit rating downgrades, proposes a series of reforms to the existing models used by the major CRAs. The goal is to break the vicious cycle between developing countries’ climate vulnerability and their struggle to access cheap debt. 

One proposal involves harnessing "technological innovation" to incorporate scenario analysis into ratings models. Simulating changing debt dynamics under evolving economic conditions impacted by climate change could facilitate the establishment of longer-term sovereign ratings. Models could also start to incorporate the positive effects of sustainable investment, the report suggests. 

Pointing to "opaque" methodologies used by many of the larger ratings agencies when it comes to assessing sovereign debt, the UN briefing argues that greater transparency, as well as more qualitative assessments of countries to complement the modelling, could address potential biases against developing countries.

Climate finance at COP27: de-risking climate investments

While there are strong arguments for policy interventions such as debt relief or reforms to the ratings landscape, governments and private investors have already been exploring a number of innovative financing structures that aim to unlock climate capital in emerging economies. However, these have had varying degrees of success as investors complain they are high-risk and complex to navigate.

As noted in a recent IMF blog post, the combination of the perceived high-risk environments of emerging markets combined with the high upfront cost of investing in green projects does little to incentivise private investors to direct their capital there. 

Blended finance, which matches official aid such as that from MDBs with other private or public capital to support sustainable development in emerging countries, has been touted as a means of de-risking climate investments in these countries.

However, investors have recently complained that these transactions are extremely difficult to construct, especially when MDBs, which have multiple stakeholders, are involved.

Other mechanisms include debt-for-nature swaps, where wealthy countries purchase foreign debt from cash-poor countries rich in natural capital. After converting the debt into the local currency, investors use the proceeds to fund conservation activities in that country. 

In September this year, for example, Barbados struck a deal to turn a portion of its sovereign debt into lower-interest loans in a debt-for-nature swap worth $150m, where the $50m it expects to recuperate in the next 15 years will go towards marine conservation. Arranged by Credit Suisse and CIBC FirstCaribbean and guaranteed by the Nature Conservancy and Inter-American Development bank, Prime Minister Mia Motley called the arrangement a “game changer”.

However, as with blended finance, investors have complained that such deals are complex and high risk, particularly when the country involved is already in an actual default. 

Nevertheless, innovative finance models will be key to financing adaptation in vulnerable countries, argues an article from the World Economic Forum, when increased borrowing from climate-vulnerable countries is ‘unlikely to be a sustainable option’.

With world leaders expected to announce at COP27 how they will ensure climate finance reaches those countries that need it, all eyes will be on Egypt to see what solutions are proposed and which commitments are followed through on. 

A note on the data analysis for this article:

The average credit ratings by country are based on an analysis of the sovereign credit ratings of the three big CRAs: S&P, Moody’s and Fitch. The ratings were linear transformed and assigned a number on a scale of 1–21, 21 for the highest ratings and 1 for the lowest, then averaged.

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