Un-trapped potential: Risk ratings can catalyse or constrain sustainable development

Despite a growing recognition that a global economic transition is inevitable, driven by a warming planet, urgent sustainability targets, tech innovation, and demographic changes, the methodologies we use to evaluate sovereign risk have scarcely evolved. This is particularly true for low- and middle-income countries, which face the paradox of paying a high premium to borrow capital in order to improve the very macroeconomic fundamentals used to assess their creditworthiness.

Sovereign credit ratings and OECD country risk classifications exert a heavy influence on these countries’ ability to access capital, influencing borrowing costs and investor appetites. To a great extent, they determine whether productivity-improving investments in education, healthcare, infrastructure, and major sustainability initiatives can happen at all. Yet these ratings are produced under a stagnant paradigm which emphasises legacy debt burdens and short-term macro indicators over other increasingly salient factors.

We are still penalising countries for their past, failing to assess the degree to which their borrowing will improve economic productivity and ignoring strong indicators of future potential: favourable demographics, renewable energy capacity, improving governance, and concrete public commitments to sustainability. These models also fail to price in the transnational costs of climate inaction, as well as social unrest and geopolitical instability arising from governments’ inability to address poverty and environmental degradation.

It is worth asking whether present ratings methodologies are fit for purpose in a world where climate change, infrastructure gaps, and inadequate public services are fraying the social contract in many countries and creating unpredictable negative externalities for everyone. The answer staring us in the face is that the entire framework needs to be dramatically reimagined.

Adjusting the scales towards sustainable planning

If the financial industry is serious about environmental, social, and governance (ESG) principles, ESG thinking must extend to country risk. That does not mean layering ideology on top of analysis, but rather a new type of financial pragmatism. Strong institutions and sustainable industries are not peripheral concerns, but the core of countries’ growth and credit profile over the coming generations.

Reimagining existing frameworks means integrating sustainability factors such as transition readiness, institutional quality, and exposure to physical climate risk into our models. Multilateral institutions like the International Monetary Fund (IMF) could support low- and middle-income countries in developing rigorous, long-term sustainability plans, differentiating between what can be financed through domestic revenue and what requires external borrowing. Countries would set out clear metrics and projections demonstrating how lower-cost capital could drive gains in productivity and accelerate progress towards targets like the UN Sustainable Development Goals (SDGs). A revised framework would acknowledge that governance improvements or climate investments today may matter a good deal more than weighing a country’s debt-to-GDP ratio without context.

In support of such planning, sovereigns can also draw more on financial innovations like sustainability-linked bonds, debt-for-climate swaps, and local-currency green securitisations to crowd in private capital for sustainable public goods. These tools require credible strategies and coordinated support from ratings agencies and institutions like the IMF and OECD.

The role ECAs might play in breaking the trap

Export Credit Agencies (ECAs) can lead in building better models. Their core function of reducing the cost of capital for cross-border investment is vital to solving the cyclical problem of unaffordable finance in low- and middle-income countries. ECAs should be much more forceful in this arena. They should be well-capitalised and equipped with large, ambitious mandates, much like the China Development Bank and related institutions that drove large-scale infrastructure financing during China’s economic rise.

Following the Second World War, ECAs were instrumental in rebuilding national economies. They can and do serve a similar function for emerging and developing markets now, particularly if their underwriting frameworks prioritise ESG-aligned investments. They can throw their weight behind favouring long-term public goods like clean energy, mass transit, and social infrastructure, going beyond conventional project assessment tools.

ECAs do not operate in isolation. Their pricing and underwriting strategies are shaped by sovereign and country risk ratings produced by ratings agencies and the OECD. If those methodologies fail to distinguish productive investment from mere consumption, ECAs’ impact is constrained.

ECAs can also be major catalysts for sustainable development via blended finance structures, working with development finance institutions and multilaterals to de-risk private investment. ECAs can shift market incentives and catalyse participation from commercial lenders who would otherwise not become involved. Ambitious blended finance projects must become the norm as sustainability finance moves from the periphery to the centre.

The case for disaggregation

We need to disaggregate. Not all debt is equal, nor is all private capital. The development community must do a better job of differentiating between government borrowing for long-term development and for short-term political gain. The same is true of investment flows. Foreign direct investment that builds factories and infrastructure is not the same as portfolio capital. In the absence of a precise shared vocabulary, risk models too often fail to make important distinctions.

A fundamental truth is that private investors make decisions based on risk-adjusted returns. If perceived risk is inflated due to dated models, capital is priced out of the places where it is most needed. There is a dearth of credible analysis showing how borrowing at interest rates closer to high-income countries would affect developing economies’ growth trajectories and ability to meet debt obligations. Why has this area, which has profound implications for how we understand sovereign risk, been so neglected?

The IMF has begun to acknowledge this. Over the past several years, it has worked to align its debt sustainability analysis with the SDGs. The framework, however, is still too mechanical, overly reliant on static macroeconomic figures and slow to appreciate qualitative shifts in countries’ governance and outlook.

ESG considerations must extend beyond private investment strategy into our understanding of the public sector. Updating country risk methodologies, empowering ECAs, and aligning the cost of capital with urgent development goals are key to achieving this. The upside is tremendous: much smarter capital allocation and improving quality of life for billions of people. If we delay, we risk a further compounding of errors made in the last century. We know that the financial world can move quickly under the proper incentive structure. It is our duty now to get it right.