The World Bank/IMF Debt Sustainability

Framework for Low-Income Countries

Kuala Lumpur, Malaysia

November 3, 2009

Presentation given at the

Asian Regional Public Debt Management Summit

Frederico Gil Sander

overview
The IMF/World Bank Debt Sustainability Framework

► Background
− Why assess debt sustainability in LICs?
− What makes LICs different to other countries?
− Nexus between debt distress and the quality of policies and
institutions

► The DSF
− What is it, what are its objectives and what is it used for?
− The three pillars of the DSF
− Challenges
− Treatment of public debt
− Recent changes

► Concrete Example

2
background
Why assess debt sustainability in LICs?

► There is a history of frustrated attempts at ramping up external

borrowing to finance public investment
− Hope that investment would yield sufficient income to service the
additional debt did not materialize
− Debt crises have emerged on several occasions

Ratio of NPV of debt to GDP

(percentage)
160

140 Developing Countries

Low income countries
120
HIPCs
100

80

60

40

20

3
background
Why assess debt sustainability in LICs?

► Debt relief has helped, but is not sufficient to ensure debt

sustainability going forward

4
background
Why assess debt sustainability in LICs?

► Some financing patterns are changing

− Increasingly important role of non-traditional bilateral creditors and
commercial creditors
− These creditors are not represented in existing donor-coordination
organizations

►LICs face significant challenges that are difficult to reconcile:

− Meet development objectives, including the MDGs
− Maintain debt at sustainable levels

►Those challenges may be exacerbated for the LICs that have

experienced a relief of their debt burdens:
− Significant debt reduction - ↑Ease of borrowing
− Economic circumstances remain unchanged

5
background
What makes LICs different to other countries?

► High vulnerability to exogenous shocks

− Narrow production and export structures
− Structures concentrated on primary commodities with volatile prices
− Response capacity to shocks is weak

Export Structure

2005 MIC

Manufacturing
Non Manufacturing

2005 LIC

0% 20% 40% 60% 80% 100%

Source: WDI, World Bank.

6
background
What makes LICs different to other countries?

► Greater reliance on official external creditors

− Debt is more concessional
− Larger proportion of grant financing

►Governments account for the largest share of LIC’s external debt

100%
Exte rnal
De bt
80%
Composition
(2000-06)
60%
Non
Concessional
40%

Concessional
20%

0%
LICs MICs
Source: GDF, World Bank.

7
background
What makes LICs different to other countries?

► Weaker policies and institutions tend

to increase the risk of debt problem in
two ways: 0.0

− Directly, as weaker institutions -0.1

shorten the horizon of governments, -0.2

reflect decreased public financial LICs
-0.3
management capacity and MIC
accountability, and complicate the -0.4 s
implementation of sustainable -0.5
macroeconomic policies Kaufman Inde x
-0.6
− Indirectly, as weaker institutions lead on Gove rnance
(avg 2000-06)
to slower growth, which leads to debt -0.7
problems Political Stability* Aggregated index*
*Inde x ta ke va lue s be twe e n -2.5 a nd 2.5. Highe r num be r
indic a te s be tte r pe rfo rm a nc e
Source: World bank.

►Empirical link between quality of

policies and institutions and risk of
debt distress

8
background
The empirical nexus between debt distress and the quality of policies and
institutions

► Empirical foundations: Kraay and Nehru – 2004

► What factors explain the episodes of debt distress?

► Debt distress defined as:

− accumulation of arrears
− resort to Paris Club relief
− resort to IMF non-concessional support (SBA/EFF)

► Three sets of predictors:

− debt levels
− quality of policies and institutions
− shocks

9
background
The empirical nexus between debt distress and the quality of policies and
institutions

► Econometric Results

10
background
The empirical nexus between debt distress and the quality of policies and
institutions

► Econometric Results

Basic Results

(1) (2) (3)

Sample All LIC(a) MIC(a)

PV Debt / Exports 0.644 0.143 0.262

(0.152)*** (0.074)* (0.060)***
CPIA -0.557 -0.311 -0.020
(0.142)*** (0.091)*** (0.051)
Real GDP Growth -4.620 -0.930 -2.080
(2.085)** (1.199) (0.749)***
Constant 0.821 1.911 -1.375
(0.512) (0.789)** (0.925)

Observations 200 83 117

Out-of-Sample Predictive Power

(Fraction of events correctly predicted)
All Events 0.71 0.75 0.78
Distress Events 0.74 0.56 0.70
Normal Times Events 0.70 0.83 0.80
Standard errors in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%
(a) Marginal effects rather than slope coefficients are reported for first three variables in
order to facilitate comparison of magnitude of estimated effects between these two columns.
.

11
background
The empirical nexus between debt distress and the quality of policies and
institutions – Interpretation of the results:

►The likelihood of debt distress is substantially explained by three

factors:
− debt burden,
− quality of policies and institutions, and
− susceptibility to shocks

►The quality of policies and institutions is as important as the debt

burden in predicting debt distress episodes

►To assess the probability of debt distress, country-specific debt

thresholds are more appropriate than a uniform threshold

12
background
The Country Policy and Institutional Assessment (CPIA)

► In the Kraay-Nehru study and the Debt Sustainability Framework,

the CPIA is used as a measure of policies and institutions

► Index calculated by the World Bank that evaluates the quality of a

country’s present policy and institutional framework (late 1990s)

► Calculated annually for all countries

►Comprises16 criteria grouped in 4 clusters:

− Macroeconomic management
− Structural policies
− Policies for social inclusion and equity
− Public sector management and institutions

13
background
The Country Policy and Institutional Assessment (CPIA)

► Countries are noted under each criterion (1 to 6)

► The overall note is the simple average of the rates for all the
criteria

► Since 2001 several improvements have been introduced to

strengthen comparability across countries:
− Detailed guidelines
− 2-phase approach (benchmarking and rest of the countries)

► Since 2005 CPIA overall rates for IDA-only countries are publicly
available

14
the DSF
What is the Debt Sustainability Framework?

► A framework—called the LIC DSF—was developed jointly by the

World Bank and the IMF (adopted in 2005) to:
− Bring a greater consistency, discipline, and transparency to
sustainability analyses
− Allowing for better informed policy advice

►Based on the:
− Importance of debt sustainability
− Need to take into account LIC’s specificities:
− Empirical foundations on the link between quality of policies and
institutions and debt distress

15
the DSF
Objectives of the DSF

►Support the efforts of LICs to meet their development goals without

creating future debt problems by:

► Guiding LICs’ borrowing decisions in a way that match the financing needs with
their current and prospective ability to repay

► Allowing creditors to tailor their financing terms in anticipation of future risks.

►Improve World Bank and IMF assessments and policy advice

►Help detect potential crises early so that preventive action can be

taken

16
the DSF
Practical Uses of the DSF

►The effectiveness of the DSF ultimately depends on its broader use

by borrowers and creditors

►The DSF is a tool for raising awareness of debt sustainability,

improving communication and coordination between creditors and
borrower, and among creditors (reducing the free-riding issue)

►Outreach and training is key to achieving this goal

► It can take the form of seminars, technical workshops, hands on training,

technical assistance, etc.

17
the DSF
Practical Uses of the DSF

►DSF is used to determine IDA’s grant eligibility among it’s

borrowers
►Grant allocation is based on external debt distress risks
ratings determined under the DSF. Risk ratings are
translated into a traffic light system for each country:
– Green Low Risk of Debt Distress
• 100% standard IDA credit highly concessional terms
– Yellow Medium Risk of Debt Distress
• mix of grants and loans 50%-50%
– Red High Risk/on Debt Distress
• 100% grants

18
the DSF
Practical Uses of the DSF

►Both the Bank and the Fund have actively undertaken outreach
efforts on the DSF with nearly all major multilateral and bilateral
creditors. Outreach opportunities to commercial creditors have been
pursued as well.
►An increasing number of creditors are incorporating elements of the
DSF into their financing terms.
►Multilateral creditors:
► As of now, the AfDB, the IaDB, the AsDB, and IFAD incorporate elements of the
DSF into their own financing terms.
►Bilateral creditors:
► Most OECD donors explicitly use the DSF to guide their lending terms
► OECD export credit agencies have adopted, in January 2008, a set of lending
guidelines that adhere to IDA and IMF concessionality requirements for LICs.
► PC- The Evian Approach

19
the DSF
The Three Pillars of the DSF

1. A standardized forward-looking analysis of debt and

debt-service dynamics
2. An assessment of external debt sustainability in relation
to indicative country-specific debt burden thresholds
that depend on the quality of policies and institutions
3. A risk of external debt distress classification that takes
into consideration this threshold assessment, as well as
other country specific factors

20
the DSF
The Three Pillars of the DSF

1. A standardized forward-looking analysis of debt and debt-

service dynamics
• Takes into consideration LICs’ specificities:
• long horizon (20 years) to reflect long grace period and maturity
• present value not face value to capture the concessionality
• The analysis comprises projections under:
• a baseline scenario (most likely outcome),
• alternative scenarios (that discipline the projections under the
baseline),
• standardized stress test based on a country’s historical
vulnerability to shocks
• country-specific stress tests if the vulnerabilities are not duly
captured by the standard tests

Standardization allows comparison across countries but flexibility is

needed to address country-specific circumstances

21
the DSF
The Three Pillars of the DSF

2. An assessment of external debt sustainability in relation

to indicative country-specific debt burden thresholds that
depend on the quality of policies and institutions
• Thresholds are indicative, not ―borrowing limits‖
• Country circumstances (e.g., low risk in large enclave infrastructure
investments) should be considered

Quality of policies and institutions

Weak Medium Strong
CPIA<3.25 3.25<CPIA<3.75 CPIA>3.75

NPV of debt-to-GDP 30 40 50
NPV of debt-to-exports 100 150 200
NPV of debt-to-revenue 200 250 300
Debt service-to-exports 15 20 25
Debt service-to-revenue 25 30 35

22
the DSF
The Three Pillars of the DSF

3. A risk of external debt distress classification that takes

into consideration this threshold assessment, as well as
other country specific factors
Low risk
– Debt indicators are well below debt-burden thresholds
– Stress tests do not lead to significant breaches of thresholds
Moderate risk
– Baseline scenario does not indicate a breach of thresholds
– Stress tests show a significant rise in debt service ratios or a breach of
debt thresholds
High risk
– Baseline indicates a breach of debt or debt service thresholds
In debt distress
– Current debt and debt service ratios are in significant or sustained
breach of thresholds

! Classification should not be done mechanistically

23
the DSF
Challenges with DSAs

– DSAs need to be based on realistic macroeconomic

scenarios

– The “battle” against unrealistic assumptions

• Active use of the historical scenario
• Scrutiny of past projections against outcomes to improve the
quality of future projections
• High projected growth dividends associated with large upfront
borrowing (5 percent of GDP or more in PV terms) trigger the
inclusion of an alternative « high-investment, low-growth
scenario
• Explicit justification is required when a significant
improvement in the terms of financing is assumed

24
the DSF
Challenges with DSAs

– The standard analysis may need to be adapted for LICs

that have:

• Significant external private financing

• The associated vulnerabilities may not be captured (such as abrupt
reversals in market sentiment leading to sudden capital outflows)
• The DSA needs to be complemented with a more extensive
vulnerability analysis (such as the share of short-term debt and
reserve coverage ratios)
• Accumulated large financial assets
• The DSF focuses on a country’s liabilities, not its assets
• For countries with large assets (such as oil-exporting countries), the
public DSA can be conducted on a net debt rather than a gross
debt basis

! Debt distress ratings are derived based on gross external debt

25
the DSF
Treatment of Domestic Debt

• Integrating domestic and external debt in the DSF poses conceptual and
practical challenges:
– Non-comparibility across countries
– Often poor data quality
– Different financial terms, implying a different set of risks
– Domestic debt has other functions besides budget financing
– How to incorporate into a framework that aims to provide a signal to
donors regarding the appropriate level of concessionality of external debt.

! Not straightforward to incorporate DD into existing thresholds

26
the DSF
Recent Changes – Additional Flexibility (2009)1

• The debt of SOEs be excluded from indebtedness indicators when the SOEs can
borrow without a public guarantee and their operations pose limited fiscal risks for
the government.
• Bank and IMF staff undertake more in depth analysis to better assess the impact
of public investment on growth
• Undertake country specific analyses to ensure that DSAs do not lead to excessively
conservative borrowing policies during recessions or growth slowdowns
• The role of remittances be better recognized in DSAs, especially where they are
large, including in the determination of debt-related risk ratings.
• Minimize ―threshold effect‖ increase inertia
• Conducting full-blown DSAs every 3 years, in the interim updates
• Discount rate reduced to 4 percent from 5 percent, no relaxation of the ―rule‖
application

1 See http://go.worldbank.org/VW1LCJFDJ0 for the relevant policy paper.

27
the debt sustainability analysis: a concrete example

Let me
introduce the
IMF/World
Bank DSA

28
the debt sustainability analysis: a concrete example

Analysis of macroeconomic forecast:

analysis of macroeconomic and financial forecast

• Growth prospects are improving driven by higher private investments and high export growth

• Inflation is projected to subside to single-digit levels

• Projected import growth is also large in the medium term

o This is consistent with increases in FDI (capital good imports)

• Remittances are large and finance a great portion of the trade deficits
o Private transfers are expected to increase from 16 percent of GDP in 2005 to nearly 25 percent in 2007
• Private external debt is growing substantially over the medium term
o The assumptions on growth in FDI and private debt may be grounded on reforms/ measures taken by the
authorities to improve the business climate

• Preponderance of concessional loans

o Most borrowing in the near term is forecast to be on concessional terms
o Over the long-term, as the economy develops borrowing, will become less concessional.
the CPIA and debt burden thresholds

• The country is rated as a medium performer:

o the CPIA is 3.64
o a rating between 3.25 and 3.75 reflects medium performance

• Policy based external debt burden indicators:

analysis of debt trajectories under the baseline scenario

• Solvency considerations:

All the debt stock

ratios are well below
their respective
thresholds
analysis of debt trajectories under the baseline scenario

• Liquidity considerations:

All the debt service ratios are also well

below their respective thresholds
 debt trajectories under alternative scenarios and stress tests

• Solvency considerations:

External debt ratios remains below

the threshold under the historical
scenario: no evidence that the
projections can be over-optimistic

The most extreme stress shock is

The B5: combination of lower GDP
growth and lower net non-debt
creating flows. Only one indicator is
breached: PV of debt-to-GDP.
Breach over 5 years with an average
deviation of 7 percentage points.

But staff judged that scenario to be

less likely in practice.
debt trajectories under alternative scenarios and stress tests

• Liquidity considerations:

External debt service ratios remains below the

threshold under the historical scenario and even
under the most extreme stress shock.
 debt trajectories under alternative scenarios and stress tests

 Most extreme scenario is B5 and staff judged the probability of occurrence to be low
 Second worrisome scenario for which the possibility of occurrence is deemed greater is the B4
scenario = modeling of a fall in non-debt creating flows. In 2008-09, these flows were mostly
comprise of transfers.
o The breach occurs during 1 year only
o Remittances tend to be much less volatile than other types of inflows.
debt distress rating

Despite the temporary breach, country case 1 received

a low debt distress rating:

The authorities have a good track record of macroeconomic

stability
conclusion

• A DSA is only as good as its underlying baseline scenario.

• It is important not to evaluate the risk of debt distress in a

mechanistical manner

• A good DSA must clearly discuss the logic of the

classification and the main sources of uncertainty

• The DSF is not the only response to the question of the

risk of excessive debt in LICs. However, it is the only
detailed and standardized analysis that is available to the
public

38
for further information

• Information on the DSF and country DSAs can be found:

 http://www.imf.org/dsa
 http://www.worldbank.org/debt

• Interested parties can direct questions DSAs and concessionality

policy-related questions through a dedicated mailbox:

 LendingToLICs@IMF.ORG

 LendingToLICs@WORLDBANK.ORG

THANK YOU
Thank you!