Room to Grow: Integrating Climate Change in Debt Sustainability Analyses for Low-Income Countries

Developing countries need to invest heavily to transform their economies to achieve sustainable development and address climate change, but they are falling behind in the shift to clean energy, enhancing adaptation and resilience, addressing loss and damage, and restoring nature. 

To meet these policy goals, debt sustainability analyses (DSAs) conducted by the International Monetary Fund (IMF) will be critical, given the increasing frequency and severity of climate-related shocks, the macro-critical nature of climate change, and the structural transformation required to pursue climate resilient growth paths.

The DSA serves two major functions. First, the DSA provides an assessment of the debt sustainability risks faced by the country. It quantifies the available “fiscal space” for additional borrowing conditional on a sustainable debt burden. Second, the DSA helps to inform debt restructuring needs when countries undertake debt treatment. 

A new policy brief from the Task Force on Climate, Development and the IMF provides actionable insights to improve the IMF/World Bank Debt Sustainability Framework for Low-Income Countries (LIC DSF) to guide climate-related investment decision-making in LICs, with a view to support growth and mobilize investments in a fiscally sound and financially stable manner. These evidence-based insights support the integration of climate risk into the DSA’s modeling framework that is consistent with the state-of-the-art in climate economics and finance. The findings from this policy brief are informed by discussions at a January 2024 workshop on the LIC DSF hosted by the Task Force. 

Key policy recommendations:

• The IMF and World Bank should integrate climate risks in the LIC DSF by enhancing its methodology in four areas.
  • Data. The granularity of the data collected for climate risks, including geolocation and production activity (for physical climate risks) and data complementary to greenhouse gas emissions such as energy technologies (for transition risks), needs to be improved. The data challenge is acute in the area of climate finance flows in low-income countries, which limits the reliability of any analysis and resulting evidence that attempts to highlight the macro-critical aspect of these flows.
  • Scenarios. The LIC DSF methodology should utilize the latest generation of climate risk scenarios, identify packages of grants and concessional finance needed for climate investments, introduce realism regarding private finance mobilization by considering fiscal and financial risks, and the IMF and World Bank should actively contribute to scenario development by tailoring them to country characteristics. Scenarios should also consider the compounding losses from climate risks, including transition risks and cross-boundary spillover risks, and other shocks and the benefits of early action. How climate damages impact the creditworthiness of countries and interest rates is also a crucial consideration.
  • Macro-financial model. The IMF and World Bank should complement existing macroeconomic models with models that depict analytically important characteristics of climate risks such as non-linearity, deep uncertainty and endogeneity, the persistent impact of shocks on variables including fiscal outlays, and feedback effects that amplify shocks.
  • A risk management approach. Such an approach should be adopted in assessing the fiscal and financial impacts of climate risks. 

• The IMF and World Bank should revise the LIC DSF to reflect the importance of an investment-led growth path for low-income countries. 

• The IMF and World Bank should collaborate to build capacity and partnerships. 

DSAs are powerful tools to inform pathways to development and stability for low-income countries, which in accordance with the Paris Agreement, should be characterized by investments in climate mitigation and adaptation. Strengthening the methodological approach of the LIC DSF will lead to greater realism of growth projections and demonstrate the investment imperatives of building climate resilience and sustainable development.