Many countries burdened by high debt levels are struggling to invest in key areas like education, healthcare, and climate action. Debt-for-development swaps (debt swaps) offer a way to improve countries’ debt profile while creating some fiscal space to fund these essential areas. But how do debt swaps work? Are they the right fit for every country facing economic challenges?
The Basics: What is a Debt Swap?
In simple terms, a debt swap is an agreement to redirect money from debt payments to a development objective, such as protecting forests, improving schools, or strengthening healthcare. In some swaps, the creditor itself agrees to swap debt payments owed to them for spending on development. In other swaps, the borrower exchanges expensive debt for cheaper debt, which reduces debt payments. The country then commits to use some of the savings for development.
The Appeal—and the Limits
Debt swaps help countries manage their debt while supporting long-term development. However, they are not a universal solution. Past swaps have faced challenges around transparency and cost efficiency, raising questions about whether they always achieve the intended results.
To better understand these challenges, a recent World Bank-IMF note highlights how debt swaps must be carefully evaluated for each country's financial situation to ensure they are both financially sound and aligned with the country’s strategic priorities.
The note stresses that swaps should only be used where they are viable and beneficial for the country from a financial perspective. Debt swaps tend to work best for countries with moderate or high risk of debt distress, particularly those facing short-term liquidity challenges. In these situations, they offer a way to relieve financial strain while channeling resources into key development areas. Countries with unsustainable debt levels—where major restructuring is required—may need instead broader solutions before a debt swap is appropriate.
So, What Makes Debt Swaps Work?
- Financial support must be efficiently used. Debt swaps typically require some form of credit enhancement to reduce the cost of the new debt. Therefore, a thorough analysis of costs and benefits is crucial to ensure that the deal justifies the opportunity cost of the subsidy provided, considering also the transaction cost of the operation.
- Careful planning and oversight are key. Funded projects must align with national priorities, and transparency is critical to ensure they are properly managed. Robust debt and public financial management systems are critical to track financial flows and monitor project progress.
- Swaps need to be anchored in the country’s Debt Sustainability Analysis and broader debt management strategy. The country’s initial debt position and the swap’s effects on debt sustainability must be evaluated before moving forward with a swap. The swap should be integrated into a comprehensive debt management plan to ease financial pressure while advancing key development goals
In the right context, swaps can allow countries to invest in vital development while improving the cost and risk profile of their debt portfolio. But for true, lasting impact, debt for development swaps must focus on three key criteria: efficient use of resources to maximize impact, robust transparency and governance to ensure savings are properly managed, and consistency with national plans and priorities to guarantee that projects contribute to sustainable growth and development.