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ABSTRACT
We study the availability of fiscal space in climate-vulnerable developing countries. These countries require urgent climate adaptation and transition investments. However, their governments describe being bypassed for international financial support due to ‘limited fiscal space.’ We suspect that many governments are not close to a point of long-term insolvency but are unable to maneuver fiscally because of what has been called a ‘financial death trap.’ We apply a measure of fiscal space based on an endogenous debt limit reflective of a country’s record of fiscal adjustment consistent with long-term solvency. We find that for many countries, the distance between the endogenous debt limit and forecast public debt ratios – i.e. fiscal space – is fairly ample. Our findings imply that climate-vulnerable countries should be afforded a second look by international financial institutions using a long-term lens, of which this measure of fiscal space is an example. By illuminating the difference between long-term insolvency and short-term liquidity crises, the endogenous debt limit measure could be part of a multi-pronged strategy to unlock greater flows of adaptation finance. It could lower the cost of capital or be useful in the efficient allocation of adaptation financing among countries given current shortfalls. Actions to obviate the financial death trap are also warranted. Climate ambitions will be derailed if otherwise solvent and able governments are unable to access finance for urgent climate adaptation investments.
Key Policy Insights
Fiscal space, the distance from projected debt ratios to country-specific debt limits beyond which long-term solvency fails, is estimated to be fairly ample in many climate-vulnerable developing countries.
A clear understanding of fiscal space in climate-vulnerable developing countries could help unlock greater flows of adaptation finance.
Debt thresholds in IMF debt sustainability frameworks should not be confused with limits to fiscal space per se. Doing so could cause otherwise solvent and able governments to be caught in a financial death trap.
Delayed or foregone climate adaptation and transition investments, and delay of their mitigation co-benefits, due to a financial death trap warrant action to overhaul the global financial system.
Acknowledgements
The authors thank Justin Muyot for outstanding research support and three anonymous reviewers for their valuable insights. The authors also thank Marilou Uy and Kevin Gallagher of the Task Force on Climate, Development and the IMF for helpful comments on an earlier version, which was a working paper of the Task Force. The authors claim all errors in data or analysis as well as all views expressed, which do not necessarily represent the views of the institutions they are affiliated with.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 At most 40% of grants went to least developed countries (p. 27).
2 The Paris Agreement (Art. 9.4) recognizes the need for public grant-based finance.
3 As shown in Part 3, at least 32 of 48 V20 countries have had negative IRGDs since 2009, which are expected to persist till at least 2025, based on IMF projections of interest expense, general government debt and GDP growth per government found in staff reports containing Debt Sustainability Analysis. Escolano et al. (Citation2011) explore why IRGDs have been persistently negative.
4 About 33% of public climate finance grants in 2016-2020 went to mitigation (inferred from p. 25, paragraph 1, of OECD Citation2022). The potential for crowding-in private investment for mitigation is greater than for adaptation because financial sustainability and returns are more easily attained in the former.
5 ‘Loss and damage’ is assumed to have separate funding.
6 For instance, the green spending multipliers in Battini et al. (Citation2021).
7 In effect, ‘the interest rate becomes infinite as the government loses market access and is unable to roll over its debt’ (Debrun et al., Citation2019). ‘Default here occurs because of an inability to pay and not for strategic reasons.’
8 It could also be important to distinguish the circumstances if a default does occur despite evidently ample estimated fiscal space. On the one hand, poor investment or profligate spending could make such an outcome inevitable (e.g. Sri Lanka, https://www.bbc.com/news/business-61505842). On the other hand, the country may have been caught in a financial death trap, because of market perceptions of outsized liquidity risks, among other factors (e.g. Ghana (Sachs, Citation2021) or Ethiopia (https://www.fitchratings.com/research/sovereigns/common-framework-conflict-still-weigh-on-ethiopias-rating-22-07-2021)).
9 The new IMF framework abstracts ‘from any considerations other than financing availability and fiscal sustainability.’ Financing is ‘the extent to which the government can expect to have access to market funding at reasonable rates.’ Sustainability is ‘the extent to which public debt and annual financing needs … remain sustainable’ (IMF, Citation2018a, pp. 9-10).
10 Such as output gap (to control for the effect of business cycles); government expenditure gap (to control for temporary fluctuations in government outlays); (logarithm) of CPI inflation (to control for any effects of inflation); a two-year moving average of revenue-to-GDP (to proxy the capacity of fiscal institutions); trade-openness; a dummy variable for the year 2008 and onwards, and a dummy variable indicating an IMF-supported program in a given year (to proxy for international influence on fiscal behavior). Other institutional variables (political stability, fiscal rules) were not useful.
11 IRGDs using estimated sovereign interest rates, computed by adding a country default spread to the 10-year US Treasury bond rate for the years 2009 to 2019, were also applied to MACs. Results are available upon request.
12 Escolano et al. Citation2011 (earlier mentioned) explore why IRGDs have been persistently negative.
13 As of 2021, thresholds for MACs are being reconsidered (IMF, Citation2021). For LICs, thresholds for the present value of public debt (% of GDP) depend on a country’s ‘debt carrying capacity’: 35% (if weak), 55% (medium), 70% (strong). If breached, the probability of fiscal stress is deemed to be ‘too high’ (IMF, Citation2018b).