Prime time for the pause clause? Making climate resilient debt work

by Theo Talbot, Chief Economist & Associate Director – Sustainable Finance

Photo: Fayaz Aziz / Alamy Stock Photo

Pakistan is in trouble. Heavy monsoon rains have flooded an area the size of the UK. The country’s National Disaster Management Agency estimates that 33 million people are affected. The country’s breadbasket is soaking wet. Nearly half the arable land in Sindh, South Punjab, and Baluchistan has been damaged. And with agriculture accounting for $2.3 in every $10 of the country’s GDP, the knock-on effects are terrible, particularly for poor people. The floods will cost both lives and livelihoods.

One way or another, the people who pay for disasters are mostly the people directly affected by them. Our research shows that most of the funding for recovery and response comes from affected country governments – and that over half of this is in the form of loans, making the ability to borrow critical.

But Pakistan is one of dozens of low- and lower-middle income countries struggling to meet their current repayments. It can’t easily use the valve of borrowing to smooth the shock of flooding.

The problem isn’t (yet) solvency. It is about finding the money to respond. The IMF’s most recent update on the country’s macroeconomic and fiscal health finds that the government paid nearly $72 billion in debt service in 2020/2021, about a fourth of GDP. The bulk of payments go to domestic lenders like local banks but about a sixth goes to international lenders, multilateral institutions like the World Bank or bilateral creditors like Japan and France.

Defaulting on debt would free up money but isn’t a free lunch. There’s no insolvency regime like Chapter 11 for countries so negotiating with creditors (called restructuring) is messy, expensive, and drawn out. Success is double-edged. Defaulters are frozen out of international markets and pay more to borrow when they are let back in.

The accelerating climate crisis, the weight of debt service, and the absence of an easy path through restructuring all mean countries are looking elsewhere for financial breathing room when disasters strike.

Enter the pause clause

What if Pakistan had the option to redirect debt service to disaster relief and repay it a bit later?

A pause clause is shorthand for a Climate Resilient Debt Instrument (CDRI) that allows borrowing countries to do exactly that. It’s an innovative new approach being road tested in the Caribbean  that could create critical liquidity for vulnerable countries when disasters happen. The growing excitement about pause clauses can be tracked back to creative restructuring agreements hammered out by Barbados and Grenada, countries beset by disaster risk and debt risk.

If Pakistan’s debt had a pause clause, the current floods might trigger a grace period (say, a year) on repaying principal and interest before resuming as normal. It would help. The same IMF report shows debt service to external lenders worked out to $11.5 billion last fiscal year. That’s in the ballpark of the country’s estimated recovery costs of $10 billion.

Freed debt payments could be diverted to cash transfers to poor households, putting emergency funds in the hands of those best-placed to use them, or to subsidizing reconstruction to create jobs and goose local economies. Pakistan’s lenders would have to paper over the missing cash flows until the grace period ended. But, the argument goes, they may be better off overall if the grace period staved off a messy default.

People are paying attention. The G7 is exploring whether pause clauses should be included widely or even automatically in loans to poorer countries. A Climate and Development Ministerial meeting in September reported ‘clear calls’ for CDRIs to be expanded. And the New York Times recently put out a long read about Barbados’ long journey to adding pause clauses to its stock of borrowing.

Enthusiasm for pause clauses is well-founded. But to scale these innovations from the Caribbean up and across we need to confront two challenges – whether new pause clause agreements can offer good value (and for whom) and the basis on which pauses are triggered.

Pause clauses aren’t free

Pause clauses would delay repayments but not cancel them. In the case of Barbados and Grenada, missed payments are added to a loan’s outstanding balance. That means pauses can be neutral in present value terms. The pause clause is like a warm knife pushing butter across toast. The amount stays the same but how much you get with each bite changes.

That doesn’t mean the feature is free. Lenders don’t only care about the present value of a loan, they also care about when that value arrives— that is, the timing of repayments. A loan that pushes payments further out in time—as would happen if a clause were triggered—will generally cost more.

While pause clauses raise one type of cost, they might lower another. The risk that countries don’t repay what they borrow—credit risk—is priced into the interest rate. But if loans with payment flexibility give countries breathing room to get their economies on track, they could reduce the chance of default. Like a hurricane that leaves only the trees that can bend with the wind standing, the logic is that countries may default on loans with inflexible payment terms but leave those with pause clause loans intact.

Will borrowers have to pay more to borrow flexibly? For loans priced by markets, markets will net out which effect dominates and, if the costs dominate, how those are shared between lenders and borrowers. For loans from institutions that set policy rates, like the IMF or Asian Development Bank, policymakers set the price that countries pay.

But the logic can’t be overturned: pause clauses won’t be free if they’re valuable (because their value arises from the possibility of pushing repayments out in time, raising their cost). But they might also reduce the risk of default, creating value that pushes in the opposite direction.

Pause clauses require choices about what to protect

For these innovations to work, lenders and borrowers must agree when the pauses are activated. Grenada, for example, can pause repayments on its post-restructuring debt for a year if the country is hit by violent weather.

Violent weather is doing a lot of work in that sentence.

What counts? Grenada buys insurance from CCRIF SPC, a regionally-owned development insurer that offers governments policies that pay out in response to hazards like heavy rainfall or tropical cyclones. The country’s pause clause piggybacks on the arrangement. An insurance payout doubles as the condition—in the jargon, the trigger—that activates a pause clause.

There’s the key point: pause clauses are actually insurance policies that live in loans. Not because they can be activated by insurance payouts (the trigger could be any condition the lender and borrower agree on), but because they should free up money when it is needed.  

That means that effective pause clauses require choices about when governments need the money. That could be when some existing sovereign insurance policy pays out. But it may instead be after a more severe event than the country’s covered against, or in response to a different type of risk entirely. It might be broader, like any event that would push a share of the population below the poverty line. Or narrower, like protecting against a highly specific peril.

Getting this wrong would be bad. The African Risk Capacity (ARC) Group is another innovative regional development insurer covering a growing number of African governments against drought. Many African governments are also at risk of debt distress. Would debt pauses triggered as a result of ARC payouts be good? If a country’s fiscal health were tied to its harvest, triggering debt holidays on drought might make sense. But if a country’s need for fiscal space was correlated with, say, flooding but not drought, then pauses triggered on ARC payouts would be woefully mistimed, leaving governments stranded in the situation that Pakistan now finds itself.  

Answering these policy questions—the appropriateness of existing triggers, the coverage countries need, how much they would pay for pausable lending—requires governments to make choices. Most importantly, they need to decide what they want coverage for.

Pressing play on pause clauses

Humanitarian aid is stretched and political will in richer countries is unlikely to extend to cover all losses from climate change. Countries in the crosshairs of climate risk and debt distress are looking elsewhere to manage response and recovery. Channelling money away from lenders and towards recovery can be a critical resource.

To get there, we must start with realism. The experiences of Caribbean countries are promising but distinct. Lenders came to the table during default negotiations, not simply countries borrowing from markets as a matter of course.

Pause clauses are unlikely to be free. And they are unlikely to be easy to design, because triggers must match the risks countries want to use pause clauses to insure against.

As Pakistan’s experience shows, though, pause clauses may be worth the effort. And we can all put our shoulders to the wheel to help. Donors and the multilateral system can subsidise pause clauses directly or through the balance sheets of development banks that offer them as new products. They can also pay for advice and climate models that countries may want (to decide what should trigger their clauses and what to pay for their flexibility).

There are high returns to realism. Properly designed, pause clauses create a rapid and novel source of financing. That could help to liberate governments from the hard choice between protecting their most vulnerable citizens and protecting their balance sheets when disasters strike.