30 May 2023, Oshani Perera

Thank you for your comprehensive story on the Galapagos Debt Swap on 24 May 2023 entitled UK fund giant L&G bets on Ecuador’s Galápagos debt experiment.  It is good to see debt swaps enjoying a moment in the sun.  Even better, we greatly welcome the confidence of Legal & General which was, with doubt spurred on by Moody’s provisional investment grade credit rating of the debt swap that was well above that of Ecuador.  

If we may unpack this story further: 

• The Galapagos is no ordinary marine reserve.  It is protected by a so-called Special Law, governed by an inter-institutional authority, has special provisions limiting fishing and tourism, is a UNESCO World Heritage site, is intrinsic to the legacy of Charles Darwin and one of the last biodiversity hotspots we have left. Nothing can be more important than conserving its integrity.  We can even argue that it is the fiduciary duty of institutional investors to conserve such ecosystems, as without them, future pensions and savings are at stake. 

• While Ecuador has its share of political woes, the commitment by successive Ecuadorian governments to protect and ensure the sustainable use of the Galapagos ecosystems has been constant.  The country has built robust capabilities in science and conservation practices, collaborates closely with international conservation organisations and boasts of a strong track record in balancing conservation with ‘sustainable use’.  The latter is particularly noteworthy; the Galapagos territory tries to maintain a no-growth policy on tourism and artisanal fishing.  Before the pandemic, tourism revenues accounted for 80% of the Galapagos economy which made it Ecuador’s largest service export and fourth-largest non-petroleum export. 

• The debt buy-back described was greatly sweetened by the US$ 85 million credit guarantee provided by the Inter-American Development Bank and US$ 656 million of political risk insurance from the US International Development Finance Corporation.    

These features collectively inspire confidence. Creditors that took a haircut and those others that invested in the swap may have certainly banked on the fact that Ecuador has a proven track record in protecting the islands. They may also have confidence that Ecuador will continue to strengthen its institutional frameworks and build in-country expertise to meet the ambitious conservation and sustainable use obligations embedded in the swap.  This brings me to a very important point:  if debt for nature swaps are to work, markets need to be assured that the debtor country has the institutional maturity and proven tracked on science, conservation and sustainable use to live up to the obligations of a swap.   

With the balance sheets of the IMF and World Bank being extremely strained with the debt of developing nations, expectations around debt swaps are rising. Your article suggests several countries are in talks with intermediaries and donors. This is good news.  The more money that can be directed at shoring up biodiversity loss and reversing climate change, the better.  And when sovereign debt is trading at a deep discount, the opportunity to swap for more favourable terms and invest the proceeds in nature and sustainable development should not be missed.   

But we remain worried that in the rush for swaps, market participants might overlook the fundamentals on the debtor nation’s ability to prevent continued defaults and deliver on the obligations of the swap.   

In 1993, the Food and Agriculture Organisation reported on seven sovereign debts swaps that were arranged in the 1980s.  One of the countries discussed, Ecuador, obtained its first debt for nature swap in the early 1990s.  Have previous debt swaps have resulted in better debt management as well as sustainable use?   And why are countries that have benefited from swaps over a decade ago, now coming back to the debt stress negotiating table?  If debt for nature swaps continue to be arranged without the necessary safeguards, the entire climate and nature finance landscape may face a serious reputational risk. 

We write from experience in undertaking due diligence on debt for nature swaps with the proceeds targeted at sustainable agriculture.  We focused particularly on farming, based on the principles of agroecology. We foresaw large gains in ecosystem services and soil restoration that would help crops, animals and people withstand climate change.  We banked on farmers being able to diversify their revenues across several crops while also tapping into carbon credits, biodiversity credits and on-site value addition through food processing. 

Our business case included reduced costs from lowered use of imported synthetic chemicals and reduced water use. We looked at potential savings in public health as agrarian communities may no longer suffer from illness stemming from the long-term exposure to synthetic chemicals. We argued that sustainable agriculture makes a particularly good case for a swap as it would increase food security and improve the livelihoods of small farmers and small businesses are the mainstay of developing economies.  The countries we are advising have agrarian sectors that account for more than 35% of total employment. Hence the time, trouble, and transaction costs of working on a swap appear most worthwhile.  

But we continue to stand on the fence on these projects as the institutions in these debtor countries are simply not capable of administering the proceeds from the swap and carry out its obligations on nature and agriculture.  We also remain wary given the weak domestic expertise on both conservation and sustainable agriculture.  While pockets of impressive knowledge and demonstration projects prevail, the overall knowledge economy on sustainable agriculture and food systems remains poor and polarised. All this does not make for the best conditions for a successful swap that will deliver on the expectations of creditors, donors and citizens.   

Hence, a word of caution to the many policy makers that may have read your article and are already seeing the dollar signs from potential debt swaps in their own countries:  Debt swaps are not a free lunch. It is a deep commitment to long term sustainable development and the more careful management of sovereign debt. Obligations to donors and creditors remain and reputation risks are high. Legal & General and Moody’s and the entire institutional investor community will not look kindly at your country if the proceeds of the swap are mismanaged.   

Given that sovereign debt will remain a challenge for a long while, it is timely for leadership from the Global Environment Facility and the likes of the G20 Sustainable Finance Working Group to put together a framework for sovereign debt swaps.  While no two swaps are the same, the framework could provide insight into the underlying prerequisites and also the social, climate, and biodiversity related outcomes that could be sought through the use of its proceeds. Perhaps this could be accompanied by supplements on different types of sustainable use, for example, sustainable tourism, agriculture, aquaculture and artisanal fisheries, soil remediation, reversing desertification etc?   

This will help markets better appreciate the terms and conditions under which swaps are feasible and reduce the heavy transaction costs that swaps currently entrail.  This may also win over many development NGOs that mistake swaps for a deeply unfair debt structuring or equal it to land grabbing or even see it as a territorial concession when a sovereign state renounces its control over a territory within its state.   

Nothing can be further from the truth.  Debt for nature swaps can offer some indebted nations the opportunity to restructure their debt under a commitment to investment in nature and the sustainable development goals.  While each swap is highly bespoke to the conditions of the indebted nation, a common framework from the Global Environment Facility and the G20 will go a long way in reducing information asymmetry and encouraging better debt sustainability in the longer term.   

The Shamba Centre for Food & Climate is ready to support such a process.  As you aptly suggest in your article, large pools of capital are becoming interest in inclusive capitalism and the currency of biodiversity.   

Carpe Diem.