Authors: Shakira Mustapha, Theodore Talbot and Jon Gascoigne

Government officials in Barbados study districts affected by a tropical wave in June 2021. Two weeks later, the wave strengthened to category one Hurricane Elsa. Photo: C. Pitt/Barbados Government Information Service

Our new Insight Paper examines an innovation in sovereign debt contracts that may be groundbreaking in its potential impact on public finances and lives of citizens in disaster- and climate vulnerable countries – a debt pause clause.

A political window of opportunity

On the eve of the World Bank Group's annual Spring Meetings in Washington, DC, political buzz and momentum are gathering around a contractual innovation in sovereign debt that may prove groundbreaking in its potential impact on public finances and lives of citizens in crisis- and climate vulnerable countries.

The international community is at the crossroads of the potential widespread adoption of debt pauses clauses (also known as Climate Resilient Debt Clauses or related terms).

These pause clauses transform a plain vanilla instrument (bond or loan) into a state-contingent debt instrument. The clause sets out the kinds of pre-defined events or triggers, for example, a violent earthquake, that would enable the borrower to temporarily (usually one or two years) defer repayments (of interest, principal or both).

The logic is simple. When a disaster strikes, it makes smart economic sense for countries to use scarce revenue to respond in time and in full. Temporarily pausing debt repayments to external creditors (money that would typically go out the door to creditors like bondholders or banks) creates a predictable and ready source of liquidity when it's needed most.

The uptake of these clauses is currently limited to three small island states (Grenada, Barbados and The Bahamas) and two creditors (Inter-American Development Bank and UK Export Finance).

However, the potential for pause clauses to be taken up at scale is rising, with increasing attention on the need for lower-income and climate-vulnerable countries to work to disaster-proof public finances amidst high and rising debt, accelerating climate risk and brittle balance sheets.

The Bridgetown Initiative, launched in 2022 by The Honourable Mia Mottley, Prime Minister of Barbados, calls for debt pause clauses to be normalised in all debt instruments (as has largely been done in Barbados). Important policy fora are also exploring pause clauses such as the upcoming Paris Summit for a New Global Financial Pact, to be convened in June 2023 by French President Emmanuel Macron, in close partnership with the India G20 Presidency and with support of the Prime Minister of Barbados. While not new instruments, these clauses are currently in the spotlight.

Despite this political momentum, widespread adoption of these clauses will require coordination and a nuanced understanding of what they can and can’t achieve.

Firstly, pause clauses aren’t a silver bullet. But they’re a useful tool in the toolkit.

For countries with high but sustainable debt burdens, public finances will likely become strained following a disaster, aggravating liquidity problems that can lead to a disorderly default.

A temporary deferral created by pausable debt, complemented by scaled-up financing from development partners, may help avoid this by giving the sovereign borrower’s economy time to recover before resuming debt service. But the extent to which these clauses are useful largely depends on the proportion of the debt stock with these clauses.

Debt pause clauses can be a swift and pre-agreed response to liquidity crunches that arise after a disaster. But they are not designed to address solvency problems— structural debt issues or protracted financing problems. Those may ultimately require a country to go through a debt restructuring process with its official and private creditors.

Secondly, they’re unlikely to be free. But they could be made to be free where it matters.

The UK-chaired Private Sector Working Group sub-group on Climate Resilient Debt Clauses concluded that these clauses would likely have no or minimal pricing impact (with respect to international sovereign bonds). The underlying logic is two-fold: first, the instrument is Net Present Value (NPV)-neutral, and second, investors would have already priced in the relevant climate risks at the outset of purchasing the bond.

We need more evidence to support this. And structural factors matter. If repayments can be paused, lenders may need to cover the cost of missed inflows when causes are triggered. That is a layer of cost on top of the credit risk lenders' price into the cost of borrowing. A combination of market frictions (liquidity and novelty premia) and transaction costs (like setting up and monitoring triggers) are also likely to drive up borrowing costs, at least in the short run. Notably, the Inter-American Development Bank currently charges a fee for its Principal Payment Option, in part to differentiate a contractual deferral from a debt restructuring.

Liquidity concerns are less of an issue as loans from multilateral or official bilateral lenders are typically held to maturity. Given their development mandate, these creditors could explore options for offering pausable loans to climate- or crisis-vulnerable countries without charging an additional fee.

Thirdly, credit ratings matter. But adopting or triggering debt pause clauses need not send a negative signal.

Countries are concerned that adopting debt pause clauses into their debt portfolio signals their vulnerability to disaster risks, raising doubts about their ability to repay and undermining their creditworthiness.

These concerns are rational given that there is currently insufficient evidence to assess the reaction of the market and credit agencies to these clauses, with only one primary market issuance to date (Barbados’ 2029 foreign currency external bond).

In rating the Barbados bond, Fitch equalised the bond rating to the sovereign Issuer Default Rating and noted that it “would not treat payment deferrals, if in line with the bond terms, as a default event”. The rating reflects several specific features of the clause. Thus, while this was the rating action taken in this case, this does not guarantee that similar transactions will be automatically rated the same way. Ultimately, instrument and country-specific details will matter.

Climate-vulnerable countries could use debt pause clauses as part of a larger risk layering approach (including other solutions) that show their commitment to building fiscal resilience. Creating a credible link to fiscal resilience may help to offset the impact disaster risks have on a country’s borrowing costs.

Fourthly, most multilateral development banks don’t offer pausable loans. But they could.

The key risk for these institutions, like the World Bank or the African Development Bank, is any impact on their preferred creditor treatment (PCT). PCT is an unwritten rule under which multilateral development banks are repaid first if a client country is under fiscal stress.

This privilege is a pillar of the multilateral development banks’ financial model because it supports their strong credit ratings that, in turn, unlock very cheap funding. As a result, these institutions tend to be sceptical of any innovation that might undermine or weaken PCT.

But IDB’s move to offer these clauses through its Principal Payment Option - allowing for the deferral of principal debt payments for two years after occurrence of an eligible natural hazard- suggests that PCT and debt pauses clauses can co-exist if appropriate steps (as described in our new Insight Paper) are taken to signal clearly that pre-agreed deferrals aren’t the same as defaults.

Finally – ‘Hard’ triggers aren’t available everywhere and for everything. But that need not be a limitation.

Triggers are at the heart of pause clauses. They determine when countries can – and can't – opt to stop repayments temporarily. Triggers can range from hard quantitative assessment of an event and loss (like windspeed above a specific) to soft subjective judgement (like declaring a state of emergency).

Despite the private sector’s taste for hard triggers, the robustness and availability of hard triggers vary by hazard and geography. Recent Caribbean pause clauses piggyback on existing triggers from the regional risk pool (Caribbean Catastrophe Risk Insurance Facility Segregated Portfolio Company - CCRIF SPC), but these are not comprehensively available.

More importantly, soft trigger approaches are often feasible and can be combined with hard triggers, as shown by World Bank’s ’Catastrophe Deferred Drawdown Option’, Barbados’ pandemic debt pause clause and IDB’s one-time Principal Payment Option (discussed above).

A key concern with soft triggers is moral hazard, the possibility that being able to invoke what is effectively a type of insurance will lead to riskier behaviour. This concern is reasonable but probably exaggerated. Governments are acutely conscious of their reputations with markets and rating agencies and the potential political cost of declaring a national crisis. And the ‘payoff’ from debt pause clauses is capped – liquidity gets repaid.

Scaling up pause clauses to more countries and types of risk will ultimately require more comfort with – and attention to – softer triggers.

The way forward

Likely any innovation in a sector that relies on predictability and standardisation, disrupting sovereign lending and getting pause clauses to scale is not trivial – but is likely to be worth it.

Success will require concerted policy effort from borrowing countries and intergovernmental and multilateral leadership. Official creditors – multilateral development banks and bilaterals – can lead the way.

Technical details matter. Both sovereign borrowers and creditors need clarity and guidance on the potential pricing and rating implications of these clauses. And even if these clauses come with a price tag for borrowers, they may still prove worth it, especially when early action can limit the impact of disasters on those most vulnerable and at risk. Getting triggers right is another crucial yet tricky precondition. This will require impartial expertise on what they should be. They will likely vary substantially by country and region.

Finally, embedding scrutiny and learning is key. Given the novelty and lack of practical experience with these clauses on both the sovereign borrower and creditor side, all actors must be open to learning and be transparent and accountable regarding needs and expectations to offer pausable debt by default.

Success should not be defined in terms of how many countries adopt these clauses. Instead, it should be measured by how effective they are in quickly and predictably liberating fiscal space to stop disasters devastating lives and livelihoods and setting back hard-won development gains.

Growing interest: Taking debt pause clauses to scale for resilience and recovery