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
120

Developing Countries Low income countries HIPCs

100 80 60
40

20 0

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% Source: WDI, World Bank.

80%

100%

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% 80% 60% 40% 20% 0% LICs Source: GDF, World Bank.
7

Exte rnal De bt Composition (2000-06) Non Concessional

Concessional

MICs

background
What makes LICs different to other countries?

► Weaker policies and institutions tend

to increase the risk of debt problem in two ways:
− Directly, as weaker institutions

0.0 -0.1 -0.2 LICs -0.3 -0.4 -0.5 -0.6 -0.7 Kaufman Inde x on Gove rnance (avg 2000-06) 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

shorten the horizon of governments, reflect decreased public financial management capacity and accountability, and complicate the implementation of sustainable macroeconomic policies − Indirectly, as weaker institutions lead to slower growth, which leads to debt problems ►Empirical link between quality of

MIC s

Source: World bank.

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 Sample PV Debt / Exports CPIA Real GDP Growth Constant Observations (1) All 0.644 (0.152)*** -0.557 (0.142)*** -4.620 (2.085)** 0.821 (0.512) 200 (2) LIC(a) 0.143 (0.074)* -0.311 (0.091)*** -0.930 (1.199) 1.911 (0.789)** 83 (3) MIC(a) 0.262 (0.060)*** -0.020 (0.051) -2.080 (0.749)*** -1.375 (0.925) 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 facil itate comparison of magnitude of estimated effects between these two columns. .

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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

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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

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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

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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

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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.

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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

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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

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the DSF
The Three Pillars of the DSF

1.
2.

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

3.

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the DSF
The Three Pillars of the DSF

1.

A standardized forward-looking analysis of debt and debtservice 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 CPIA<3.25 Medium 3.25<CPIA<3.75 Strong CPIA>3.75

NPV of debt-to-GDP NPV of debt-to-exports NPV of debt-to-revenue Debt service-to-exports Debt service-to-revenue

30 100 200 15 25
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40 150 250 20 30

50 200 300 25 35

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
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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

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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

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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

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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.
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the debt sustainability analysis: a concrete example

Let me introduce the IMF/World Bank DSA

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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 o Private transfers are expected to increase from 16 percent of GDP in 2005 to nearly 25 percent in 2007 The assumptions on growth in FDI and private debt may be grounded on reforms/ measures taken by the authorities to improve the business climate

• Private external debt is growing substantially over the medium term

• Preponderance of concessional loans
o o Most borrowing in the near term is forecast to be on concessional terms 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 o The breach occurs during 1 year only 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

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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

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