Are Debt-for-Nature Swaps a Viable Alternative? The Credit Rating Agency Issue
El Salvador recently concluded a $1bn Debt-for-Nature swap (DFN) which, according to White & Case who facilitated the swap, is ‘both the world’s largest conservation-focused operation of this kind to date and the world’s largest DFN conversion for river conservation’. As a result, the team at White & Case have suggested that such swaps ‘offer a promising alternative to traditional financing sources’. At the same time, Ecuador has also just completed a large DFN. The question is whether this is really the case?
The concept of a project-based ‘swap’ is increasingly becoming common parlance. The concept is a simple one, as explained by the African Legal Support Facility (ALSF): ‘Debt-for-Nature swaps are financial transactions whereby a portion of the foreign debt owed by a developing nation is eliminated, decreased, or erased in return for locally supported conservation initiatives being funded by (at least in part) the reduced debt burden the nation will face after the swap’. This ASLF report provides a really good review of the concept and its history, including criticisms relating to DFNs not focusing on the underlying issue of unsustainable debt. For this post though, the issue is in the detail of the description above. As the IGSD mention in relation to Debt-for-Climate swaps, ‘much of the world is awash in unsustainable public and private debt… efforts to relieve the debt crisis provide opportunities to advance the climate protection, health, and economic goals together, specifically through Debt-for-Nature swaps’. From a credit rating perspective, it is accepted that ‘Official’ debt – that from bilateral or multilateral sources – is not of concern, but ‘Private’ debt certainly is. In the description above from the ASLF, everything points to altering the original contract-based agreement between Issuer and Creditor. For a Credit Rating Agency (CRA) examining the relationship between Issuer and Private Creditor, this is a potential problem.
How CRAs judge DFNs varies and for good reason. For example, when Belize issued a DFN swap in 2021 totalling $364 million, complete with credit enhancement from the US Development Finance Corporation, the DFN rating was higher than Belize’s sovereign rating from Moody’s and, subsequently, S&P Global upgraded Belize’s sovereign credit rating to B-. The precise details of the Belize swap are available here and reveal that the reason for the credit rating was based almost solely on the fact that the swap constituted ‘US risk with a little sprinkle of Belize’. This is just one example that has led onlookers to conclude that ‘as a country’s external debt decreases thanks to DFC swaps, it can lead to better credit ratings, which can, in turn, lead to favourable borrowing conditions in international markets…’ It is worth noting an inconsistency in the field’s literature at this point. Many point to a seeming fact that ‘in the recent debt-for-nature swaps, the debt buy-back was assessed by Moody’s as “distressed exchange” for Ecuador and Belize, but not for Gabon and Barbados’. The problem is that this view contradicts the common view that Belize were actually positively-rated by Moody’s (at least, their swap was, and S&P upgraded the Sovereign Rating) and these views seem to all stem from the very same source – an article by Thorsten Nestmann, a Group Credit Officer for Sovereign and Supranational Issuers at Moody’s – in which he says: ‘by contrast, Belize had already missed debt payments a few months before the swap, indicating extreme credit stress at its Caa3 rating. Similarly-rated Ecuador appeared to lack market access as it was going through a period of severe political turmoil around the time of the transaction. Bond yields for both Ecuador and Belize were also at highly distressed levels, trading north of 20%. This was reflected in the deep discount that the bonds were bought back at, at 45% for Belize and over 60% for Ecuador’. At the time of writing, I have been unable to verify this understanding with even one other source, not even the Moody’s website itself – Moody’s, on its website, actually said that the superbond buyback was credit positive, but that future default risk remains high.
If there is potential confusion over Belize, there was none over Ecuador. The South-American Country had attempted the largest swap on record, organising for nearly $1.6 billion with funds to be directed to conserving the Galapagos Islands. However, Moody’s took a dim view of this, stating in a report that ‘the operation retired 10.5% of the total $15.6 million value of the three bonds but did so by repurchasing them at deeply distressed prices, constituting a loss to investors compared to the original promise of the bond contracts and generating a substantial reduction on principal for the sovereign’. As a result, Ecuador was deemed to have undertaken a ‘distressed exchange’ and was placed into default by Moody’s as a result.
The aforementioned Thorsten Nestmann explained why there is a difference. He said that: ‘with regard to bond buyback offers, Moody’s analyses factors including the size of the buyback relative to total debt and/or market debt with the likelihood that larger transactions, affecting around 5% or more of outstanding debt, are more likely to help avoid an eventual default. Furthermore, the loss severity, measured as the discount to par, often signals the likelihood of the issuer being unable to meet its debt obligations and impacts the magnitude of debt reduction. Moody’s takes into account sources of cash used to buy back the debt. If new cash is being raised externally in the debt markets, this can signal that the issuer has access to the debt markets and is not in distress’. S&P, in a report earlier this year, confirmed that they view each swap on its own merits and that debt restructurings qualify as distressed if they meet two conditions: (i) the investors receive less than the original promise, and (ii) should the debt restructuring not take place, there is a realistic possibility of a conventional default on the instrument over the medium term. S&P later confirms that both conditions must be met. Furthermore, S&P reveal that they generally view an Issuer’s sovereign credit rating as an indicator i.e. ‘if the issuer credit rating is “B-” or lower, the debt restructuring “would ordinarily be viewed as distressed”’. Fitch, in relation to Ecuador’s exchange this month, essentially confirmed that they deploy the same two-stage conditionality test to determine whether a swap is a distressed exchange.
It does appear that it is Moody’s leading the way in constraining the development of DFNs, as they are the only CRA seemingly to penalise a given DFN with a downgrade for the country involved. Nevertheless, the understanding from the CRAs above really brings into question the mainstream insistence that DFNs can be an ‘alternative’ form of finance for the developing world. First, the DFNs already contain issues in relation to their transparency and how to verify that the resources have been used for the stated purposes. But, from a credit rating perspective, the use of proceeds is not of concern. The call for more countries to utilise DFNs is somewhat blind to this reality. As a researcher at the International Institute for Environment and Development said, ‘these transactions (DFNs) are not necessarily suitable for countries in severe debt distress, as by that point they would need extensive debt restructuring and relief… debt swaps are more suitable for countries with high but not prohibitive debt burdens who want to manage their to improve their economic situation’. If we believe this to be true, then the takeaway message is a simple one: debt-for-nature swaps are a good option for particular countries, but certainly not all. Therefore, promoting them as a ‘viable alternative’ during a debt crisis is potentially irresponsible and feeds into the major criticism of those who are advocating for the systemic adoption of such products – that energy takes away the necessary energy for resolving an underlying debt crisis that has no modern debt treatment system. More focus on developing a debt treatment infrastructure fit for modern purpose is a better way forward. There is a lesson to be learned from the DFN experience for all involved – ignore the credit rating infrastructure at your peril. The involvement of Private Creditors means that the credit rating infrastructure must now become front and centre and for all aspects – be it relating to DFNs, debt-for-climate, ‘pause clauses’, debt jubilees, or alterations to the International Financial Architecture. Not doing so will inevitably result in failure, on many levels.