WORLD BANK AND IMF

DEBT SUSTAINABILITY
FRAMEWORK

FATIMA MUBARAK
IBEF1707
M.SC. INTERNATIONAL BUSINESS
ECONOMICS AND FINANCE (2017-19)
INTRODUCTION
The World Bank Group and the International Monetary Fund help low-income
countries (LICs) strengthen their ability to manage debt effectively, an increasingly
important part of development. Effective public debt management can reduce
financial vulnerabilities, contribute to macroeconomic stability, preserve debt
sustainability, and protect a government's reputation among investors. These
institutions offer services and products, provide global expertise, and support
countries in strengthening their debt management capacity and institutions.

The World Bank and the IMF work together to support the efforts of LICs to achieve
their development goals without creating future debt problems. This work is
structured through the Debt Sustainability Framework (DSF), and experts use a tool
called Debt Sustainability Analysis (DSA) to assess individual countries.

The Debt Sustainability Framework (DSF), developed in 2005, is designed to guide the
borrowing decisions of low-income countries in a way that matches their financing
needs with their current and prospective ability to repay debt. It also allows creditors
to tailor their financing terms in anticipation of future risks.

The Debt Sustainability Analysis (DSA) is a tool that is used as part of a framework
developed by the World Bank and the IMF to help guide countries and donors in
mobilizing critical financing for low-income countries, while reducing the chances of
an excessive build-up of debt. DSA is a structured examination of a country's debt
that debt experts from the IMF and World Bank conduct regularly in low-income and
middle-income countries. Some of the focal points of these analyses are:

 an analysis of a country’s projected debt burden over the next 20 years and its
vulnerability to external and policy shocks;

 an assessment of the risk of external debt distress in that time, based on

indicative debt burden thresholds that depend on the quality of the country’s
policies and institutions; and

 Recommendations for a borrowing (and lending) strategy that limits the risk of
debt distress.

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THE DEBT SUSTAINABILITY FRAMEWORK
The DSF is a joint World Bank-IMF framework that helps low-income countries to
achieve their development goals without creating future debt problems. It also helps
keep countries that have received debt relief under the HIPC Initiative and the MDRI
on a sustainable track. The framework allows creditors to tailor their financing terms
in anticipation of future risks, and helps clients balance the need for funds with the
ability to repay their debts.

In addition, the framework serves as the basis for financing decisions through the
International Development Association, the fund for the world's poorest countries.
The framework helps determine the grant-loan mix of assistance -- the decision is
linked directly to the rating of the country’s risk of debt distress under the DSF
assessment. While the debt sustainability in low-income countries is based on CPIA
related, indicative thresholds applied under the DSF, debt levels in middle-income
countries (MICs) are assessed with the help of other tools.

The DSF analyzes both external and public sector debt. The framework focuses on the
present value of debt obligations for comparability, as terms extended to LICs vary
considerably and still carry concessionality. A 5 percent discount rate is used to
calculate the present value of external debt.

To assess debt sustainability, debt burden indicators are compared to indicative

thresholds over a projection period. There are four ratings for the risk of external
public debt distress:

 low risk, generally when all the debt burden indicators are below the
thresholds in both baseline and stress tests;

 moderate risk, generally when debt burden indicators are below the
thresholds in the baseline scenario, but stress tests indicate that thresholds
could be breached if there are external shocks or abrupt changes in
macroeconomic policies;

 high risk, generally when one or more thresholds are breached under the
baseline scenario, but the country does not currently face any repayment
difficulties; or

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  in debt distress, when the country is already experiencing difficulties in
servicing its debt, as evidenced, for example, by the existence of arrears,
ongoing or impending debt restructuring, or indications of a high probability of
a future debt distress event (e.g., debt and debt service indicators show large
near-term breaches or significant or sustained breach of thresholds).

To flag countries with significant public domestic debt, the framework provides a
signal for the overall risk of public debt distress, which is based on the joint
information from the four external debt burden indicators, plus the indicator for the
present value of public debt-to-GDP ratio.

Countries with different policy and institutional strengths, macroeconomic

performance, and buffers to absorb shocks, have different abilities to handle debt.
The DSF, therefore, classifies countries into one of three debt-carrying capacity
categories (strong, medium, and weak), using a composite indicator, which draws on
the country’s historical performance and outlook for real growth, reserves coverage,
remittance inflows, and the state of the global environment in addition to the World
Bank's Country Policy and Institutional Assessment (CPIA) index. Different indicative
thresholds for debt burdens are used depending on the country’s debt-carrying
capacity.

Thresholds corresponding to strong performers are highest, indicating that countries

with good macroeconomic performance and policies, can generally handle greater
debt accumulation.

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The DSF has enabled the IMF and the World Bank to integrate debt issues more
effectively in their analysis and policy advice. It has also allowed comparability across
countries.

The DSF is important for the IMF’s assessment of macroeconomic stability, the long-
term sustainability of fiscal policy, and overall debt sustainability. Furthermore, debt
sustainability assessments are taken into account to determine access to IMF
financing, as well as for the design of debt limits in Fund-supported programs, while
the World Bank uses it to determine the share of grants and loans in its assistance to
each LIC and to design non-concessional borrowing limits.

The effectiveness of the DSF in preventing excessive debt accumulation hinges on its
broad use by borrowers and creditors. LICs are encouraged to use the DSF or a similar
framework as a first step toward developing medium-term debt strategies. Creditors
are encouraged to incorporate debt sustainability assessments into their lending
decisions. In this way, the framework should help LICs raise the finance they need to
meet the Sustainable Development Goals (SDGs), including through grants when the
ability to service debt is limited.

Key reforms that took effect in July 2018 include:

 Moving away from relying exclusively on the CPIA to classify countries’

debt-carrying capacity, and instead using a composite measure based on a
set of economic variables

 Introducing realism tools to scrutinize baseline projections;

 Recalibrating standardized stress tests while adding tailored scenario stress

tests on contingent liabilities, natural disasters, commodity prices shock,
and market-financing shock

 Providing a richer characterization of debt vulnerabilities (including those

from domestic debt and market financing) and better discrimination across
countries within the moderate risk category.

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DEBT SUSTAINABILITY ANALYSIS
The Debt Sustainability Analysis is a tool that is used as part of a framework
developed by the World Bank and the International Monetary Fund to help guide
countries and donors in mobilizing critical financing for low-income countries, while
reducing the chances of an excessive build-up of debt.

The objective of the framework is threefold:

 Assess the current debt situation, its maturity structure, whether it has fixed or
floating rates, whether it is indexed, and by whom it is held;

 Identify vulnerabilities in the debt structure or the policy framework far

enough in advance so that policy corrections can be introduced before
payment difficulties arise;

 In cases where such difficulties have emerged, or are about to emerge,

examine the impact of alternative debt-stabilizing policy paths.

The framework consists of two complementary components: the analysis of the

sustainability of total public debt and that of total external debt. Each component
includes a baseline scenario, based on a set of macroeconomic projections that
articulate the government's intended policies, with the main assumptions and
parameters clearly laid out; and a series of sensitivity tests applied to the baseline
scenario, providing a probabilistic upper bound for the debt dynamics under various
assumptions regarding policy variables, macroeconomic developments, and financing
costs. The paths of debt indicators under the baseline scenario and the stress tests
allow assessing the vulnerability of the country to a payments crisis.

DSAs should however not be interpreted in a mechanistic or rigid fashion. Their

results must be assessed against relevant country-specific circumstances, including
the particular features of a given country's debt as well as its policy track record and
its policy space. Thus, two types of frameworks have been designed: those
for market-access countries and those tailored for low-income countries. In both
cases, the frameworks have been regularly refined with a view to—among other
elements—bringing a greater discipline to the analysis and responding to the
changing economic and financial environment.

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SUB NATIONAL DEBT SUSTAINABILITY
Sub national governments’ role in delivering public goods and services is becoming
increasingly important. States and provinces are taking on more responsibilities in
areas of public investment and the provision of goods and services.

While the dynamics of central government fiscal management (e.g., with respect to
sources of revenue and expenditure modalities) and related institutions are
standardized and well comprehended across countries, those for sub national
governments are much less clearly understood. Cross and within country differences
in policy flexibility, and in fiscal aspects such as revenue sources and expenditure
obligations, together with the country-specific nature of intergovernmental
financing, suggest that no single standard sub national fiscal and debt framework
may be sufficiently robust to accommodate to all sub national fiscal structures.

Benchmarks or indicators of sustainability at the sub national level should be

developed on a case-by-case basis, reflecting some ex-ante guidelines that are
relevant to the government in question. Moreover, a standard set of data and robust
forecasts for key sub national macroeconomic and fiscal variables (e.g., sub national
output, revenue and expenditure growth, etc.) are not always available, making it
necessary to customize the sub national fiscal and debt framework to the
information at hand, which certainly does not preclude endeavours to identify or
develop own data and robust economic projections.

Sub national fiscal and debt sustainability assessments have been undertaken by the
World Bank Group in several contexts, including:

 Development Policy Loans to sub national governments: These generally

require an assessment of the potential impact of any proposed World Bank
lending operations on fiscal and debt sustainability. Such assessments are
usually included in the DPL proposal and its underlying analysis.

 Analytical Work produced by the Bank for sub national clients: Insights from
sub national fiscal and debt sustainability analyses contribute to improving
public financial management, service delivery, and broader macroeconomic
policy coordination in the context of broader analytical work produced by the
Bank.

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A CRITICAL ANALYSIS OF THE DSF

As an exercise in inter-temporal accounting, assessing debt sustainability is no doubt

a daunting task. The economic environment that affects the evolution of debt ratios
is highly variable and uncertain; no government can make a credible commitment for
the foreseeable future to adhere to a particular policy stance. A constant and even a
falling debt ratio may be unsustainable over the longer-term if the domestic and
external environment evolves unfavourably and the government is unable to respond
to changed circumstances by squeezing out the surplus needed.

The level of debt that should be considered as sustainable also varies considerably
across countries as there is no single “safe” debt ratio that could apply to all. First,
the amounts of primary budget and/or current account surplus needed to stabilize
debt can be different in different countries with similar degrees of indebtedness
depending on the terms and conditions of their debt stocks and potential growth
rates. Second, countries differ in their ability to generate budget and/or trade
surpluses needed, depending not only economic factors such as their tax and export
bases, but also socio-economic characteristics.

The standard framework can only tell us how much surplus is needed to stabilize the
debt ratio for given values of its determinants, but not whether a particular debt
profile can be sustained over time. It says nothing about dynamic interactions among
the key variables that determine the evolution of debt ratios, and treats fiscal and
external sustainability independently without specifying the interactions between the
two.
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The standard framework is used for assessing the sustainability of emerging market
economies’ public and external debt without addressing its shortcomings. By doing
so, it focuses primarily on fiscal sustainability and fails to take proper account in its
policy recommendations of financial market instability and the implications of boom-
bust cycles in capital flows for fiscal sustainability and balance-of-payments stability.
Its projections for public and external debt and capital inflows are highly optimistic,
reflecting in large part the confidence it places in orthodox fiscal and financial policies
and the efficiency of markets in assessing and handling risks. More importantly, its
policy advice gives primacy to meeting debt service obligations over poverty and
development objectives.

Correction of these shortcomings calls for a clear recognition of the inherent

instability of international capital flows, the threat that corporate balance-sheet
vulnerability can pose for balance-of-payments and fiscal sustainability, and the role
of capital account measures in regulating capital inflows and preventing a build-up of
external financial fragility. It also calls for including growth and poverty objectives as
explicit constraints in debt sustainability assessments, treating debt servicing, rather
than public social and infrastructure spending, as residual.

A comprehensive debt sustainability analysis requires a fully-fledged government

budget constraint, which includes not only the external position, but also public
domestic debt and the feedback effects of the choices on deficit financing.
Considering uncertainty and the risk of default, there is a need to carefully evaluate
the resource required to finance poverty reduction policies, and to develop a legal
framework to deal with private creditors. As a result, debt relief should be tailored on
specific country needs and it should be part of a more comprehensive development
policy, aimed at reducing poverty, built on the fully-fledged government budget
constraint and designed for providing a permanent exit from debt dependence and
an incentive to strengthen institutions and policies.

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ILLUSTRATION: THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIA

Ethiopia’s location gives it strategic dominance as a jumping off point in the Horn of
Africa, close to the Middle East and its markets. Bordering Eritrea, Somalia, Kenya,
South Sudan, and Sudan, Ethiopia is landlocked, and has been using neighbouring
Djibouti's main port for the last two decades. However, with the recent peace with
Eritrea, Ethiopia is set to resume accessing the Eritrean ports of Assab and Massawa
for its international trade. With about 102 million people (2016), Ethiopia is the
second most populous nation in Africa after Nigeria, and the fastest growing
economy in the region. However, it is also one of the poorest, with a per capita
income of $783. Ethiopia aims to reach lower-middle-income status by 2025.

In January 2018, Ethiopia was downgraded to high risk of debt distress based on the
LIC DSF. The very next month, Moody’s affirmed its B1 (B+ equivalent) rating with a
stable outlook. The proximate reason for Ethiopia’s downgrade by the IMF and WB is
that the ratio of PPG external debt service to exports (DSE) went above its threshold
in the most recent baseline projection scenario contained in IMF Country Report
released in January 2018. The reason for the DSE breach is on account of maturing
principal on non-concessional loans, with the maturity reduction of one particular
bilateral deposit at the central bank from 8 to 6 years being pivotal. In addition,
foreign exchange reserves fell and there were "widespread foreign exchange
shortages", in other words, international liquidity is an issue.

In 2016/17, the trade deficit was 16.1% of GDP of which 13.1 pp or over 80% was on
account of the public sector deficit while only 3.1 pp were on account of the private

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sector. Moreover, net private transfers were 6.9% of GDP while official transfers
were just 1.8%, meaning that the "public" component of the current account balance
was -11.3% of GDP partially offset by the private component of +3.8% of GDP,
resulting in an overall balance of - 8.1% of GDP (that is, a CAD of 8.1% of GDP,
including a deficit of 0.6% of GDP on net income from abroad, see Table 5b). Thus,
the public sector deficit, itself driven by large infrastructure investments, drives the
CAD and external debt. Therefore, if Ethiopia is at high risk of external debt distress,
the fundamental cause must lie in the public finances. This means that public debt
and its dynamics need to be given a central position in any assessment of debt
distress.

But the DSA in IMF has nothing to say about public debt except that it stays below its
threshold and does not "flag additional risks". Indeed, two crucial questions for
Ethiopia, but unlikely to be addressed are the following:

1. What would public debt dynamics look like in the absence of financial repression
(issuing domestic debt at negative real interest rates combined with capital controls)
and real exchange rate overvaluation? Both these could mask unsustainable public
debt dynamics by keeping interest rates artificially low and understating the burden
of foreign currency debt.

2. Will the big public investments pay off by will boosting future growth and taxes
and thereby ensuring solvency via adequate future primary fiscal surpluses?

Both questions are vital but unlikely to be picked up without a new framework for
DSA.

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