Transforming Debt into Climate Action: Driving Sri Lanka’s Economic Recovery

Sri Lanka was forced to default on its external debt and seek a USD 3 billion bailout from the International Monetary Fund (IMF) in March 2023. Its total debt stock stood at USD 92 billion, with 40% being external debt in 2023. Sri Lanka’s debt portfolio is complex and its outstanding debt to the People’s Republic of China (PRC) and India accounted for 18% of total external debt (59% of bilateral loans) in September 2022 (Figure 1). Amidst the conclusion of debt restructuring, Sri Lanka might benefit from opening up to alternative financial instruments.

Figure 1: Composition of Central Government External Debt by Selected Creditors

Sources: Ministry of Finance. Quarterly Debt Bulletin 2023; *IMF. Article IV Consultation 2021; **Central Bank of Sri Lanka. Annual Report 2022.

Debt-for-climate-and-nature swaps are a sovereign debt restructuring tool that facilitates the (partial) restructuring of external debt in exchange for domestic investment in climate action. Well-designed debt-for-climate-and-nature swaps provide debtor countries with the fiscal space to invest in climate adaptation and biodiversity sustainability.

With unsustainable debt and climate change identified as pressing issues for developing countries, Sri Lanka emerges as a priority country for debt-for-climate-and-nature swaps. In the past, debt-for-climate-and-nature swaps followed a "piecemeal approach"—implementing smaller, uncoordinated projects and managing funds through extrabudgetary channels. In contrast, recent swaps follow a "systematic approach"—focusing on broader programs instead of individual projects and providing budget support by channeling funds directly into debtor countries’ national budgets. This approach makes debt-for-climate-and-nature swaps more effective by mobilizing larger amounts of funds, increasing debtor governments’ accountability, linking payments to performance, and aligning Nationally Determined Contributions (NDCs) and National Biodiversity Strategies and Action Plans (NBSAPs) in target setting.

Debt-for-climate-and-nature swaps were first introduced in 1984 in response to the deteriorating tropical rainforests and mounting debt obligations in Latin America. Since then, many countries have adopted this to address both financial and environmental challenges.

In 2002, the United States engaged in a bilateral swap with Peru, subsidized by NGOs such as The Nature Conservancy, to protect over 1 million hectares of wilderness areas. The US has also engaged in similar swaps with Guatemala and Indonesia to protect tropical forests.

In 2015, Seychelles, pioneered a Blue Economy debt-for-nature swaps, converting USD 21.6 million of sovereign debt with Paris Club creditors to fund marine conservation. This is considered the world’s first debt swap for ocean conservation and climate adaptation.

In 2023, Ecuador entered into the world’s largest debt-for-climate-and-nature swap, facilitated by Credit Suisse, buying back USD 1.6 billion of sovereign debt for USD 656 million in new sovereign debt. In return, Ecuador agreed to allocate USD 450 million in long-term marine conservation in the Galápagos Islands. The success of this deal was driven by several key factors: participation of academia, collaboration and consensus among multiple stakeholders including civil society and local governments, an innovative financing model, and government leadership.

The effectiveness of swaps depends on the ability to address several key challenges: political and macroeconomic stability to ensure long-term success, stable institutional structures to support planning and implementation, strong regulatory frameworks to cover both financial and environmental obligations, and knowledge and skills related to swaps at all levels of the public service. Accordingly, the success of debt-for-climate-and-nature swaps depends on the leadership role of debtor governments and a systematic approach to the design and implementation of swaps.

Debt swaps are determined collectively by the respective parties involved; hence, it is difficult to predict their magnitudes. However, following the three criteria proposed by Boland (the magnitude of debt, the type of lending—whether it involves commercial or concessional loans, and the interest of creditors—considering the country’s track record), Sri Lanka may consider the following four creditors for a possible debt-for-climate-and-nature swap in the future (Table 1).

Table 1: Potential Creditors for Sri Lanka

Sources: Ministry of Finance. Quarterly Debt Bulletin: September 2022 and March 2023.

In addressing the triple challenges of high indebtedness, climate change, and loss of nature, debt-for-climate-and-nature swaps can serve as an effective alternative fiscal instrument for Sri Lanka.

Systematic planning, stringent government commitment, and the involvement of all relevant key stakeholders are crucial for success.

Addressing knowledge and skill gaps on debt swaps is also essential. With sufficient political and macroeconomic stability, Sri Lanka could be ready to implement this strategy, potentially accelerating its economic recovery.