Swapping Debt for Nature: Does Ecuador Show the Way?

In the fringes of the opaque world of “innovative finance,” there is much excitement over recent efforts to swap the distressed foreign debt of less developed governments in return for a promise to protect biodiversity or “green the economy.” The excitement stems not the least from the fact that though debt-for-nature swaps had been experimented with as far back as the 1980s, only to lose momentum, there has been a sudden spate in such deals in recent times Belize concluded a deal in 2021 (involving bonds valued originally at $553 billion); Barbados struck a deal to buy back a fraction, valued at $150 million, of its outstanding bond debt due to mature in 2029 and 2043; Ecuador completed in May 2023 what is, thus far, the biggest debt-for-nature swap (involving bonds with a face value of $1.6 billion); and Gabon, most recently, clinched a deal in August 2023 buying back $500 million worth of bond debt.

Though still a small share of total external debt, the magnitudes involved in Belize, Ecuador, and Gabon are much higher than the deals struck in the past, and large enough to attract interest as a joint solution to debt stress and past and future environmental damage. Moreover, while the earlier deals involved, besides the debtor sovereign, official bilateral creditors and philanthropic institutions and non-governmental organisations (NGOs), the recent deals are led by private players, who both structure the deal as well as finance it. Historically, given the fact that less developed countries were hard put to service hard currency debt and much of the debt up for restructuring was in or on the verge of default, private players had no interest. In those circumstances, the effort was aimed at getting creditor governments to write off some of the debt or get NGOs backed by philanthropies to buy up distressed debt at a discount and write it off, and to get the debtor to spend all or much of the “savings” garnered through these means on conservation projects in local currency. The debtor was offered some debt relief but, more importantly, relieved of the burden of finding or diverting scarce foreign exchange to service the debt.

In the new wave of debt-for-nature swaps, private players have a dominant role to play. Debtor governments are helped by financial majors and influential “non-governmental” players (such as the Nature Conservancy) to borrow sums at much better terms than existing foreign debt to buy back a part of their more expensive debt at a discount. Interest rates on the new loans are much lower and maturity dates are postponed, giving the debtor relief and breathing space. Though the market here is the restructuring medium, government-sponsored and multilateral financial institutions from or backed by the developed countries step in to offer insurance or partial guarantees that substantially improve the ratings of the new bonds issued by the debt-stressed sovereign. With the risk associated with the instruments being taken over by these entities, the bonds are acceptable to investors at terms far better for the debtor than applicable on the debt being replaced or on past debt outstanding.

This ability of private facilitators to deliver debt relief, however limited, is attributed to the willingness of the debtor country to commit to use a part of the “savings” garnered from the discounted buyback of old debt and the low interest rate on the new debt on conservation or greening projects. As a result, the bonds issued to mobilise the new loan are designated as “blue” (marine conservation) or green bonds, even though not all of the resources mobilised are spent on blue or green projects. That designation helps find investors in the bonds, including insurance companies and pension funds, looking to enhance or widen their environment, social and governance (ESG) investment portfolio. Combine the blue bond designation with the reduced risk deriving from guarantees and insurance coverage and the extremely favorable terms at which the bonds can be placed is easily explained. But what advocates of these deals emphasise are the large savings for the distressed debtor and the green benefits for the international community, making it a “win-win” proposition.

A case in point is the biggest of these, recently announced by Ecuador in May 2023 and orchestrated by Credit Suisse, which, before its merger with UBS, had come to dominate the field. The deal has been headlined as one in which, in the process of restructuring distressed sovereign debt, resources have been freed up to support the newly established Hermandad Marine Reserve and the Galápagos Marine Reserve, as well as to fund an endowment for marine conservation. Overall, the Ecuadorian government has committed to allocate around $18 million a year for 20 years for conservation in the environmentally prized Galápagos Islands through a non-profit foreign endowment fund, the Galápagos Life Fund.

The deal as “structured” has components very similar to other deals arranged in recent times, including in Belize.1 It begins with leveraging bondholder fears resulting from the economic situation in Ecuador and the recent political uncertainty in which the opposition in the National Assembly was attempting to impeach the incumbent president, Guillermo Lasso, accusing him of embezzlement. That allowed arriving at a deal in which a combination of three sets of bonds of different maturity dates with a face value of $1.63 billion could be bought for just $656 million or at a discount of 60%.

To finance this buyback, the Ecuadorian government received an equivalent loan on much better terms (interest rate of around 7% as opposed to 16% on existing Ecuadorian debt and a grace period of seven years for capital repayments), from a special purpose vehicle (SPV) named GPS Blue Financing. GPS Blue, in turn, raised the requisite funds by issuing (in collaboration with Credit Suisse) “blue” “Galápagos bonds” that were insured in full by the US government-backed International Development Finance Corporation (IDFC) and partly reinsured by private reinsurers as well as a partial guarantee of $85 million from the Inter-American
Development Bank. This implied that not only were investors protected, but the bond issuer was covered as well, with risk being transferred to these state backed agencies, who justify their action as being aimed at de-risking environmentally positive instruments to attract private capital. A consequence of the de-risking support is that Moody’s could hand out an investment grade Aa2 rating for the bond, which was the agency’s third highest rating and 16 levels above the Caa3 junk rating that Ecuadorian sovereign debt was subject to. Not surprisingly, though the new bond offered a yield of just 5.6%, it attracted much interest, including from the likes of UK asset management major Legal and General, which snapped up $250 million of the issue and sent out a signal that bonds emanating from these kinds of complex deals are a good bet.

This, and deals in other countries like Belize, have been declared a “win-win” for countries facing sovereign debt distress, for private investors and for the international community concerned about biodiversity loss and climate change. But not so soon, argue the critiques.2 The question arises as to what drives the holders of bonds to sell them back to the government at a discount, or accept an “haircut,” which go as high as 60%. Second, what is in it for the private players such as Credit Suisse or Bank of America that makes them invest time and “expertise” to design and help complete these swap arrangements? Third, how come a debt-distressed country is able to issue new debt in the form of blue or green bonds that are placed at very favourable rates and terms? Fourth, how much is the debtor implicitly or explicitly paying out to utilise this swap? And, finally, how much of a conservation dividend does the operation provide?

The easiest of these questions to answer is the fi rst. The debt involved is a small fraction of the stock that was built when access to extremely cheap excess liquidity in the international system led to a supply-side push of capital into sovereign debt in the less developed countries, including the risky, so-called frontier markets.3 It soon became clear that much of this foreign debt to be serviced with hard currency was unsustainable even in normal times, let alone in a period marked by a pandemic, followed by rising interest rates and inflation led by speculation precipitated by the war in Ukraine. In the event, countries were hard put to service external debt, and the distressed debt was trading at a huge discount in markets. All it took to persuade the bondholders to sell that debt back to the debtor governments was to offer them a modest “premium” above these discounted prices. In fact, even after part of the debt was bought back, reducing supply in the market, the price of these bonds in secondary markets did not rise to equal the buyback price. Given the economic situation in the debtor countries, holding on to the bonds would have meant facing default and restructuring in due course. Accepting a haircut was much smarter.

For debtor governments, the buyback at what was a signifi cant discount, was a way of winning some relief from stress. However, the challenge they faced was one of finding the resources to finance the buyback given their fiscal and foreign exchange positions. It is here that the private agents like Credit Suisse (in Belize, Barbados, and Ecuador), and (after the Credit Suisse merger with UBS) Bank of America in Gabon, came in with their restructuring packages. They channelled to the debtor a loan needed to cover the discounted total cost of debt being bought back, at interest rates that were extremely favourable compared with that being paid on outstanding debt of the debt-stressed borrower, with grace periods and extended maturities that eased the servicing burden on the new debt.

Which brings up the second question being raised above: What prompted the likes of Credit Suisse that were offering their services to structure the deal to also advance a loan that was so favourable for an already stressed debtor? The answer lies in how the operation is structured. In both Belize and Ecuador, the blue bonds were insured by the US government-backed IDFC. This explained the favourable terms of the loans, benefits of which were partially passed on to the government.

In fact, the yield on bonds sold to investors were lower than that charged in the bond sale, the proceeds of which went to the government and the cost of which had to be borne by it. The loan to Ecuador carried a rate of 7%, while the blue bond was issued at 5.4%. That difference, even after accounting for premiums for insurance paid to IDFC and reinsurers and costs such as audit, accounting and rating agency charges, leaves a fat fee to be shared between the likes of Credit Suisse and the host of other private financial players and consultants involved. In Belize, Daniel Munevar estimates that a similar difference in interest rates delivers up to $84 million over the lifetime of the deal, which was close to 45% of the $190 million the country is estimated to have gained from the debt relief implicit in the discounted buyback of debt as well as the lower interest outflows on the new loan that financed that buyback.

Finally, while the blue bonds carry an implicit ESG tag, the justification for this on grounds of protection of nature are not warranted as just a little of the money conjured out of the exercise is allocated to that cause, and there is no identified means of verifying whether the promised conservation benef ts would actually be delivered. On the other hand, multiple layers of non-transparent transactions make the deal a winner for finance with some crumbs for the distressed debtor.

At fi rst sight, it appears that everyone has benef ted: governments from the discounted debt buyback financed with a loan on attractive terms; investors who get a reasonable return on an almost risk less, ostensibly ESG-compatible instrument, because of backing from IDFC and others; Credit Suisse from the spread and fee it receives by structuring the deal and other intermediaries from fees; and the rest of the world from the externalities associated with conservation of biodiversity. But what stands out in all of this is that the risks associated with loans sitting with a distressed debtor have not gone away they have just been taken over by the US government through the IDFC. Leveraging that contribution of the US government, private investors in the blue bonds have got themselves a good deal, and Credit Suisse and private “non profi ts” have fattened their bottom lines. However, the debt relief gains are limited and the conservation gains uncertain and unverifiable.

NOTES

  1. For a detailed analysis of the Ecuadorian debt-for-nature swap, refer to Daniel Ortega- Pacheco et al (2023).
  2. The bonds bought back by Ecuador amounted to around 2.5% of the government’s sovereign debt stock and 5.5% of external commercial debt stock.

REFERENCE

(This article was originally published in the Economic and Political Weekly on September 16, 2023)

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