A. General Considerations

20. Analyses of debt sustainability are inherently forward-looking and probabilistic. Whether a country—and specifically its government—will be able to service its debt depends on its existing debt burden as well as the prospective path of its deficits, the financing mix between loans and grants, and the evolution of its repayment capacity—namely (the foreign currency value of) GDP, exports, and government revenues. Projections of the debt dynamics provide a link between debt sustainability and macro-economic policies. At the same time, such projections are only as good as their underlying assumptions, and these assumptions have a particularly slender basis for the long time horizon implied by the average maturity of concessional loans. The scope for error is large—both on the upside and the downside—with past experience suggesting a systematic tendency toward excessive optimism.¹⁰ Indeed, while the specifics differed across countries, a common theme behind the historical rise in low-income countries’ debt ratios was that borrowing decisions were predicated on growth projections that never materialized. This experience points to the need for well-disciplined projections, including by laying bare the assumptions on which they are predicated and by subjecting them to rigorous stress tests that explicitly incorporate the impact of exogenous shocks.¹¹

21. Debt sustainability can be assessed on the basis of indicators of the debt stock or debt service relative to various measures of repayment capacity (typically GDP, exports, or government revenues).¹² Each of these indicators has its merits and its limitations, suggesting that they should be used in combination.¹³

• ➢ Debt service is the most obvious measure of the immediate burden that debt imposes on a country by crowding out other important uses of scarce resources by the borrower. Debt-service ratios provide the best indication of this claim on resources and the associated risk of payment difficulties and distress. In the same vein, low and stable debt-service ratios are the clearest indication that debt is likely to be sustainable. However, in light of the back-loaded repayment profiles typical of concessional debt, current debt-service ratios may understate the burden inherent in the existing debt stock. In principle, this problem can be avoided by examining the projections of debt-service ratios, but these projections are subject to very large uncertainties associated with making forecasts over periods as long as 40 years.

• ➢ Debt stocks provide a useful shorthand measure of the future debt service burden inherent in existing debt. This burden is best measured by the present value of debt, which—in contrast to its face value—captures the concessionality of outstanding obligations. Reliance on existing NPV-based indicators avoids the need for projections, but is not without problem, as such indicators compare future debt-service obligations with existing repayment capacity without taking account of countries’ ability to grow. This is particularly relevant when maturity periods are long. Similarly, while the NPV-based indicators may signal debt-servicing difficulties some time in the future, they do not provide information on when these problems may become pressing. Moreover, NPVs are sensitive to the level of the discount rate and can be difficult to interpret when discount rates change with market conditions (see Box 2). The appropriate discount rate should ideally capture the long-term return on risk-free assets, suggesting an approach that filters out temporary fluctuations. For this reason, it is proposed that the discount rate for future NPV calculations outside the HIPC Initiative be set initially at 5 percent—the (rounded) current level of the U.S. dollar CIRR—and be adjusted by a full 100 basis points whenever market rates (measured by the 6-month average of the U.S. dollar CIRR) deviate from it by at least this amount for a consecutive period of six months. This proposal strikes a balance between the desire to keep the discount rate stable without de-linking it entirely from market conditions.

• ➢ Finally, the choice of the most relevant denominator depends on the constraints that are most binding in an individual country, with GDP capturing overall resource constraints, exports those on foreign exchange, and revenues those on the government’s ability to generate fiscal resources. In general, it is useful to monitor external debt in relation to GDP and export earnings and public debt in relation to GDP and fiscal revenues. Similarly, external and public debt service are usefully expressed relative to exports and revenues, respectively.

For these reasons, it is best to base debt sustainability analyses on a variety of indicators, acknowledging that each is important in signaling current or prospective constraints that a country may face in meeting its debt-service obligations. At the same time, some structure to assessing these indicators is desirable in an operational context. Accordingly, it is proposed that the framework will, in the first instance, focus on the debt stock in present value terms, as a summary indicator of the future obligations a country has already taken on, while the time path of debt-service indicators would be tracked to assess the likelihood and timing of liquidity problems. For illustration, Figure 2 shows the estimates of NPV debt stocks, relative to exports, for a selected group of low-income countries.

NPV of Debt-to-Exports Ratios in Selected Low-Income Countries, 2001 ^1/

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: World Bank, Global Development Finance 2003; and official HIPC documents.^1/ NPV estimates incorporate the delivery of committed debt relief for those countries that had reached the decision point under the HIPC Initiative by end2001 (see ^{footnote 3}). Exports reflect average exports of goods and services for 1999-2001.2/ Liberia, Burundi and Sudan's NPV of debt-to-exports ratios were 1100, 1700, and 680 percent respectively; they have been truncated for scaling purposes.^3/ Denotes all HIPCs that reached the decision points by end-2001.

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NPV of Debt-to-Exports Ratios in Selected Low-Income Countries, 2001 ^1/

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: World Bank, Global Development Finance 2003; and official HIPC documents.^1/ NPV estimates incorporate the delivery of committed debt relief for those countries that had reached the decision point under the HIPC Initiative by end2001 (see ^{footnote 3}). Exports reflect average exports of goods and services for 1999-2001.2/ Liberia, Burundi and Sudan's NPV of debt-to-exports ratios were 1100, 1700, and 680 percent respectively; they have been truncated for scaling purposes.^3/ Denotes all HIPCs that reached the decision points by end-2001.

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NPV of Debt-to-Exports Ratios in Selected Low-Income Countries, 2001 ^1/

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: World Bank, Global Development Finance 2003; and official HIPC documents.^1/ NPV estimates incorporate the delivery of committed debt relief for those countries that had reached the decision point under the HIPC Initiative by end2001 (see ^{footnote 3}). Exports reflect average exports of goods and services for 1999-2001.2/ Liberia, Burundi and Sudan's NPV of debt-to-exports ratios were 1100, 1700, and 680 percent respectively; they have been truncated for scaling purposes.^3/ Denotes all HIPCs that reached the decision points by end-2001.

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22. Perhaps the most difficult judgment lies in choosing the appropriate threshold for assessing whether a country’s current or projected debt burden is sustainable. Clearly, this judgment needs to be informed by the experience of countries encountering debt-servicing problems at alternative levels of debt and with varying frequency. A growing body of empirical literature has examined episodes of “debt distress” in low-income countries (defined in terms of debt-servicing difficulties—arrears or Paris Club reschedulings—or the impact of debt burdens on growth), tracing these episodes to debt or debt-service indicators associated with a high probability of debt distress or adverse growth implications, sometimes contingent on other macroeconomic and institutional factors.¹⁴ The specific results must of course be interpreted carefully, as the occurrence of debt distress, as measured, depends not only on an indebted country’s difficulties in servicing debt but also on the response of creditors and donors—e.g., on whether to reschedule debt service or provide “new” financing. More generally, as the wider literature on early-warning systems has shown, there are inherent limits to the ability of such models to discriminate between cases in which countries will or will not run into difficulties. Countries experience debt-servicing problems for a variety of reasons specific to their circumstances, and only some of these can be captured in cross-country regressions. These caveats do not deny an important role for empirical thresholds in judging the sustainability of a country’s debt dynamics, but warrant caution in using them too rigidly as binding constraints on new borrowing.

23. In light of these considerations, the proposed methodology for assessing debt sustainability consists of two building blocks: (i) the choice of appropriate threshold ranges for debt-burden indicators based on empirical findings and an explicit consideration of country-specific circumstances; and (ii) projection and interpretation of the debt-burden indicators under the policy baseline and under probable “stress scenarios” which incorporate a country’s vulnerability to exogenous shocks. Both steps will require a significant element of judgment to create a balanced financing strategy for an individual country.

B. Empirical Thresholds

24. As a first step, it is useful to explore the debt ratios at which low-income countries have run into—or managed to avoid—debt-servicing difficulties in the past.¹⁵ The upper panel of Figure 3 illustrates the frequency distribution for the NPV of debt-to-GDP ratios that were associated with debt-servicing difficulties, defined by significant arrears accumulation on official debt (equivalent to at least 5 percent of the total debt stock), while the lower panel shows the corresponding distribution for “non-distress” events (at least three consecutive years without significant arrears). A comparison of the two distributions, and of the median levels for the respective debt ratios, shows that “distress” episodes tended to be associated with a noticeably higher debt ratio. To derive debt sustainability thresholds from this analysis, it is useful to focus on the median debt ratio in the year prior to running into debt-servicing difficulties, which can be interpreted as a cutoff for distinguishing distress from non-distress events. This ratio, which is marked by the dotted line, is 43 percent of GDP, and is very similar to the thresholds derived under different methodologies in the empirical literature.¹⁶ Accordingly, it appears to be a reasonable threshold at which an “average” country may be expected to run into problems. While useful as a first cut, such average threshold is nevertheless rather crude, since it disregards other factors that may have an impact on a country’s debt-servicing ability, and thus does not discriminate well between distress and non-distress events. Indeed, the proportion of incidents in which countries either avoided debt-servicing problems at ratios above the threshold or, conversely, experienced difficulties at lower ratios—i.e., the magnitude of “type I” and “type II” errors—is large at about 36 percent each. The threshold analysis therefore needs to be refined by taking account of country-specific circumstances.

Frequency Distribution of the Present Value of Debt to GDP for Distress and Non-Distress Events

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff estimates.1/ For the definition of distress and non-distress events, see Appendix I. The threshold is defined as the median PV of debt-to-GDP ratio in the year prior to distress.

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Frequency Distribution of the Present Value of Debt to GDP for Distress and Non-Distress Events

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff estimates.1/ For the definition of distress and non-distress events, see Appendix I. The threshold is defined as the median PV of debt-to-GDP ratio in the year prior to distress.

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Frequency Distribution of the Present Value of Debt to GDP for Distress and Non-Distress Events

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff estimates.1/ For the definition of distress and non-distress events, see Appendix I. The threshold is defined as the median PV of debt-to-GDP ratio in the year prior to distress.

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25. Among the factors that influence the debt levels countries can sustain, the quality of policies and institutions turns out to be a key determinant. Countries operating in a weaker institutional and policy environment are likely to experience debt distress at significantly lower debt ratios, as such countries tend to be more prone to misuse and mismanagement of funds and less capable of using their resources productively. This result, which is one of the key findings of Kraay and Nehru (2004), is corroborated by the Fund staff’s empirical analysis in Appendix I, showing a very similar, and indeed large, impact of policies on the likelihood of distress. With the quality of policies measured by the Bank’s Country Policy and Institutional Assessment (CPIA) index,¹⁷ both studies come to the conclusion that countries operating in a weak policy environment (25^th percentile of the CPIA) have the same risk of distress as countries with strong policies (75^th percentile) at debt ratios that are lower by about 30 percent of GDP, 200 percent of exports, and 100 percent of revenues (including grants).

26. As with any “early-warning” system, a crucial decision is which probability of debt distress one is willing to tolerate. A higher probability allows for more debt, though obviously at the greater risk of subsequent distress. One possibility, adopted by Kraay and Nehru, is to benchmark the probability on the average, or unconditional, likelihood of debt distress (which is 25 percent in their sample).¹⁸ They therefore derive debt thresholds, contingent on the quality of a country’s policies and institutions, such that the probability of debt distress at that debt level is 25 percent.¹⁹ An alternative approach is to benchmark on the average (or unconditional) debt threshold at which countries have first run into debt-servicing difficulties. This is the approach followed by Fund staff in the analysis presented in Appendix I. By using the average threshold of 43 percent of GDP derived above, the probability of debt distress for a country with an average quality of policies and institutions turns out to be 20 percent.²⁰ Table 1 spells out the implied debt threshold ranges corresponding to the 25^th and 75^th percentiles of the CPIA index. While the results are very similar, it bears emphasizing that the implicit choice of distress probabilities remains a policy decision. The above ranges are guided by historical experience of debt distress, but higher or lower thresholds—and correspondingly higher or lower risk of debt distress—may be regarded appropriate in a forward-looking framework that attempts to balance the risk of debt distress with the need for new financing.

Table 1.

Emprical Debt Sustainability Ranges (in percent) ^1/

Sources: Kraay and Nehru (2004); and Fund staff estimates (see Appendix I).

^1/Ranges correspond to CPIA policy ratings at the 25 and 75 percentile, respectively.

^2/Corresponds to a 25 percent distress probability.

^3/Corresponds to a 20 percent distress probability, consistent with an NPV of debt-to-GDP threshold for “average policies” of 43 percent (in line with the median in the year prior to distress).

Table 1.

Emprical Debt Sustainability Ranges (in percent) ^1/

	Bank staff analysis 2/	Fund staff analysis 3/
NPV of debt-to-GDP	21-49	26-58
NPV of debt-to-exports	79-300	83-276
NPV of debt-to-revenue	142-235	138-264

Sources: Kraay and Nehru (2004); and Fund staff estimates (see Appendix I).

^1/Ranges correspond to CPIA policy ratings at the 25 and 75 percentile, respectively.

^2/Corresponds to a 25 percent distress probability.

^3/Corresponds to a 20 percent distress probability, consistent with an NPV of debt-to-GDP threshold for “average policies” of 43 percent (in line with the median in the year prior to distress).

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Table 1.

Emprical Debt Sustainability Ranges (in percent) ^1/

	Bank staff analysis 2/	Fund staff analysis 3/
NPV of debt-to-GDP	21-49	26-58
NPV of debt-to-exports	79-300	83-276
NPV of debt-to-revenue	142-235	138-264

Sources: Kraay and Nehru (2004); and Fund staff estimates (see Appendix I).

^1/Ranges correspond to CPIA policy ratings at the 25 and 75 percentile, respectively.

^2/Corresponds to a 25 percent distress probability.

^3/Corresponds to a 20 percent distress probability, consistent with an NPV of debt-to-GDP threshold for “average policies” of 43 percent (in line with the median in the year prior to distress).

27. Irrespective of what probability of debt distress is considered tolerable, the empirical evidence suggests that debt thresholds should be established in light of the quality of a country’s policies and institutions. Table 2 presents a translation of this notion into an operational matrix, by defining indicative policy-dependent debt limits, based on the (rounded) results of Bank and Fund staff’s empirical analyses. As stressed above, while the differences in debt thresholds between poor and strong policy performers are independent of the chosen probability, the absolute levels of these limits are a function of the probability for distress one is willing to tolerate. If the approach of centering the debt thresholds around the unconditional benchmark of about 45 percent of GDP is acceptable, these limits provide a useful basis to guide future borrowing (and lending) decisions—perhaps with a conservative bias, given that the underlying NPV data in the empirical analyses are derived on the basis of historical discount rates (either fixed average rates or variable CIRRs) that are higher than current rates.²¹ Finally, Table 2 also presents indicative thresholds for debt-service ratios based on the findings of Kraay and Nehru, and derived on the same basis as the debt-stock thresholds.²² This would suggest that countries with strong policies and institutions may be able to sustain debt service of up to 35 percent of exports and 40 percent of revenues, while poor performers should limit these ratios to about half the size.

Table 2.

Indicative Policy-Dependent Debt and Debt-Service Thresholds (in percent)

Source: Staff calculations.

Table 2.

Indicative Policy-Dependent Debt and Debt-Service Thresholds (in percent)

	Assessment of Institutional Strength and Quality of Policies
	Poor	Medium	Strong
NPV of debt-to-GDP	30	45	60
NPV of debt-to-exports	100	200	300
NPV of debt-to-revenue	150	200	250
Debt service-to-exports	15	25	35
Debt service-to-revenue	20	30	40

Source: Staff calculations.

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Table 2.

Indicative Policy-Dependent Debt and Debt-Service Thresholds (in percent)

	Assessment of Institutional Strength and Quality of Policies
	Poor	Medium	Strong
NPV of debt-to-GDP	30	45	60
NPV of debt-to-exports	100	200	300
NPV of debt-to-revenue	150	200	250
Debt service-to-exports	15	25	35
Debt service-to-revenue	20	30	40

Source: Staff calculations.

28. The suggested approach implies that debt sustainability assessments incorporate an explicit evaluation of a country’s institutions and policies. While a number of historical indicators are available to help inform this assessment, it inevitably requires judgment. Besides the Bank’s comprehensive CPIA index, which is published in quintiles and encompasses both objective macroeconomic criteria as well as subjective assessments by its staff, other historical indicators are available to complement the assessment. These include a governance index compiled by Bank staff along six dimensions,²³ other indices of transparency (such as Transparency International’s country ratings) and of political risk and bureaucratic quality (such as the International Country Risk Guide), assessments of compliance with standards and codes undertaken in the context of FSAPs, and measures of the track record of policies under Bank- and Fund-supported programs. In addition, Fund staff has begun to explore ways in which to assess the quality of policies more systematically across member countries in the context of the forthcoming Global Monitoring Report. Beyond these historical indicators, the prospective quality of policies—which is the relevant concept—may also be influenced by new developments, such as emergence from conflict, changes in government, or recent reforms that are expected to have a significant bearing on future policy performance. Caution will need to be exercised, however, to prevent policy optimism from feeding into excessive levels of new borrowing before evidence of improvements becomes apparent.

29. Besides the quality of policies and institutions, a country’s susceptibility to shocks has been found to have a significant bearing on the debt levels it can sustain. Adverse movements in key macroeconomic variables can undermine a country’s debt- servicing capacity and move debt ratios onto an explosive path. The variables that determine the vulnerability of a country’s debt outlook include the volatility of its export earnings, output growth, and exchange rate path, as well as fluctuations in non-debt financing, including both grants and foreign direct investment. In a forward-looking framework, these factors are best captured through stress tests, calibrated to a country’s historical volatility. It is proposed that the stress test results be interpreted in a manner such that a country’s debt outlook should be robust (i.e., remain below its respective thresholds) not only in the baseline but also in the face of probable shocks.²⁴ While the specifics of this proposal—including the time horizon to which it applies—are elaborated in the following section, it should be stressed that this interpretation introduces a conservative bias to the framework; baseline ratios would have to be below the respective thresholds by a margin that corresponds to the impact of country-specific shocks. This conservative bias serves to counteract the empirical bias toward over-optimism in baseline projections of debt ratios.

30. Finally, while other factors undoubtedly play a role in affecting an individual country’s ability to carry debt, there are limits on the extent to which they can be captured systematically in the framework without making it too complex. Such factors may include complementary indicators of a country’s absorptive capacity and of a government’s ability to devote its resources to servicing debt. In many instances, a useful proxy for this ability may be a country’s per capita income level under the plausible assumption that poorer countries have more limited absorptive capacity and smaller cushions against shocks, while facing generally tighter constraints in diverting resources from low-priority areas toward debt service.²⁵ In addition, concerns about the denominators (GDP, exports, and fiscal revenues)—such as, measurement or coverage issues—may warrant caution in interpreting the debt-burden indicators. While the framework needs to have the flexibility to take account of such considerations, it is important that this does not undermine its overall purpose, which is to strike an appropriate balance between countries’ short-term financing and longer-term sustainability concerns. It is therefore proposed that such factors that are considered important for an individual country’s debt-servicing ability—and that are not captured already in the assessment of policies and macroeconomic volatility—be taken into account in the interpretation of the results of the debt sustainability analysis, discussed in the next section.

31. To summarize, cross-country empirical studies provide useful insights for assessing the sustainability of countries’ current and projected indebtedness. An important empirical finding is that there is significant dispersion in the debt ratios that countries can sustain, and that the quality of a country’s macroeconomic policies and institutions has a crucial bearing on the levels associated with distress. The proposed framework builds on this finding, by making the quality of policies and institutions an explicit factor in setting indicative country-specific thresholds. Importantly, this approach implies that the established thresholds are inherently dynamic, as countries that advance and improve their policies and institutions will be able to sustain higher levels of debt. In contrast to the policy dimension, a country’s susceptibility to shocks—while also of major importance for debt sustainability—will not be captured in the country-specific threshold but rather through stress-tests, by defining a prudent borrowing path that keeps debt ratios at sustainable levels also in the event of plausible shocks. Finally, a careful case-by-case judgment will be required to incorporate other considerations that are deemed to have a significant bearing on the debt and debt-service ratios countries can sustain.

C. Analysis of Current and Projected Debt Indicators

32. Once indicative thresholds have been established, the second step consists of assessing and interpreting a country’s current and prospective debt-burden indicators under the baseline and in the event of probable shocks. The purpose of this second step is to examine the implications of current policies and possible shocks which may take debt to risky levels in the future. The proposed analysis consists of two elements: (i) projections and stress testing of the five relevant debt-burden indicators in a standardized format; and (ii) analysis and interpretation of the main debt-sustainability concerns.

Long-Term Projections and Stress Testing

Projections and stress-test results would be presented in standardized templates for public and external debt dynamics that lay bare the assumptions on which they are predicated. The proposed approach is an adaptation of the debt sustainability framework that has been applied in the Fund to countries with significant access to financial markets, including industrial and emerging market economies.²⁶ The suggested low-income country templates for external and public sector debt—to be used for debt-sustainability analyses outside the context of the HIPC Initiative which is governed by its own specific rules—are discussed in more detail in Appendix II, on the basis of two hypothetical country cases, and their interpretation is summarized in Box 3. The templates derive the path of the five main indicators—both under the policy baseline and under stress—and make explicit the key underlying assumptions and how they compare with a country’s own history. The fiscal template derives the NPV of public external and domestic debt (the latter approximated by its face value) in percent of GDP and revenues, together with the public debt service-to-revenue ratio. The external template determines the NPV of public and private external debt (the latter, again, approximated by its face value), as a share of GDP and exports, as well as the external debt service-to-exports ratio. Both templates also provide explicit projections of the NPV of public and publicly guaranteed external debt, relative to the relevant denominators, to allow a comparison with the indicative thresholds. In light of the generally long maturity and grace periods, the projection horizon covers 20 years, which still implies that a sizeable part of the back-loaded debt-service obligations on new loans contracted on IDA, or other highly concessional, terms, will not be captured in the debt-service projections—though they are captured in the NPV of debt.

Box 3.

Debt Sustainability Analysis—Illustration of the Proposed Approach

This box summarizes the key features of the proposed approach for external and public debt-sustainability assessments which is illustrated, in more detail, in Appendix II, on the basis of two hypothetical country cases. In general, the sustainability of both external and public sector debt should be assessed separately, unless domestic debt of the public sector (external debt of the private sector) is negligible, in which case a single analysis of external (public) debt would be deemed sufficient. Moreover, in those low-income countries that have access to private international capital markets and hold relatively small amounts of concessional debt, the Fund’s existing template for countries with “significant market access” may be a more suitable analytical tool to assess debt sustainability.

The results of the external debt sustainability analysis are summarized in the left-hand panels of Figure 4 for the hypothetical country A. Based on an assessment of Country A’s policies and institutions, debt-burden thresholds of 40 percent of GDP and 180 percent of exports are deemed appropriate upper benchmarks for the NPV of its public and publicly guaranteed (PPG) debt, with a corresponding PPG debt-service threshold of about 20 percent of exports. A comparison of the projected debt-burden ratios with these thresholds suggests that Country A’s debt situation, while projected to improve in the long run, is tight over the medium term, with little room for borrowing beyond what is projected in the baseline.

Simulations of Debt-Burden Indicators Under Alternative Scenarios, 2003-2023

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff simulations.1/ Revenues are defined inclusive of grants.

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Simulations of Debt-Burden Indicators Under Alternative Scenarios, 2003-2023

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff simulations.1/ Revenues are defined inclusive of grants.

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Simulations of Debt-Burden Indicators Under Alternative Scenarios, 2003-2023

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: Staff simulations.1/ Revenues are defined inclusive of grants.

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Stress tests confirm this preliminary conclusion. The analyzed stress tests include a “historical scenario” where key variables are assumed to be at their historical averages, an “adverse financing scenario”, simulated as a consistently higher interest rate on new borrowing, and so-called “bound tests” that model the implication of temporary adverse deviations in key parameters from the baseline projections—with the size of the deviations informed by Country A’s historical experience, measured by averages and volatility. The interpretation of the bound tests is linked to projections 10 years ahead, at which point they correspond roughly to an average probability of 25 percent. Country A’s historical scenario produces a considerable deterioration in the debt-burden indicators over time. The reason for the deviation from the baseline is the gap between current account deficits and FDI inflows, which is projected to shrink over time. Thus, a convincing case for the favorable outlook for FDI flows and the current account would have to made, in this specific case, to justify the baseline projections. Moreover, four of the six bound tests result in NPV of debt-to-GDP ratios that exceed the indicative threshold by 4-7 percentage points after 10 years. The analysis therefore suggests that country A should try to seek higher concessionality in its new financing or keep its borrowing levels below those envisaged under the baseline to create more room for maneuver in the event of adverse shocks. A revision of borrowing plans would seem warranted, in particular, if FDI inflows over the coming years fall short of expectations.

The analysis of public debt sustainability in Country B is summarized in the right-hand panels of Figure 4. Country B’s government has considerable domestic obligations of 20 percent of GDP, which are included in the NPV simulations at their face value. However, due to HIPC assistance, the external component of Country B’s public sector debt is below its assumed indicative thresholds of 45 percent of GDP and 200 percent of revenues, including grants, in present value terms. Both overall and external public debt are projected to improve considerably over time, on account of strong GDP growth (relative to Country B’s history) and front-loaded fiscal adjustment. Total debt service, which absorbs more than 30 percent of revenues in the near term, is projected to fall rapidly, as expensive domestic debt is being reduced.

The stress tests, which are applied to total public debt, suggest that Country B’s debt dynamics are particularly vulnerable to a weaker growth outlook. While the “historical scenario”, as well as a “no-reform scenario” (akin to an unchanged primary balance) would imply a favorable debt outlook—though less optimistic than under the baseline—slower long-term growth would keep debt ratios high. Vulnerability to weaker growth is also confirmed by the “bound tests”. Reflecting country B’s poor and volatile historical growth record, the standard two-period shock to growth would be sufficient to keep the NPV of overall public debt high after ten years, at about 55 percent of GDP and 245 percent of revenues. With projected domestic debt of less than 7 percent of GDP and 30 percent of revenues, the implied ratios for PPG external debt would be slightly above their respective thresholds. Although total debt service would remain below 20 percent of revenues, Country B’s borrowing strategy would have to be revisited, if the optimistic growth assumptions fail to materialize in the coming years. More generally, an adjustment strategy focused more strongly on raising revenues rather than relying on spending cuts, would appear more viable to protect priority expenditure in the event of adverse macroeconomic developments.

33. The design of stress tests is adapted from the template applied in the Fund for countries with significant market access, to reflect the circumstances of low-income countries and the specific features of the proposed framework. The role of the stress-testing exercise is twofold:

• ➢ As in the case of “market-access countries,” the stress tests help discipline macroeconomic projections, including by comparing the underlying assumptions to the country’s historical record. This is captured in the “historical scenario” that derives the debt indicators under the assumption that the key variables are at their historical 10-year averages. To the extent that debt dynamics in the program baseline scenario appear significantly more benign than would be implied by the country’s previous record, careful justification for the more optimistic outlook would be required. In addition, the analysis also includes scenarios that depict the debt indicators in the event of less favorable terms on new financing (external debt template) or in the absence of fiscal-policy reform (public debt template).

• ➢ A second function of the stress tests—captured in the “bound tests”—is to examine the implications of shocks for the projected debt and debt-service path, based on a country’s historical volatility. The link to a country’s historical volatility implies that the deterioration in the debt-burden indicators relative to the baseline will be greater in those countries that have been more susceptible to shocks. Under the presumption that a country’s projected borrowing path should be robust to “likely” shocks, the results of the stress-testing exercise would feed directly into the overall design of an appropriate financing strategy. In other words, even if the debt indicators under the baseline are below the thresholds deemed prudent for the country, the financing strategy should be reconsidered if they exceed the thresholds under the shock scenarios, specified at an appropriate point in time.²⁷ To avoid an unduly conservative approach to new borrowing, the stress tests are designed to mimic relatively plausible shocks—corresponding to an average 25 percent probability over a 10-year horizon.²⁸ The trade-off is that this ex ante approach to volatility cannot deal with large exogenous shocks with a probability below 25 percent. Thus, low-income countries would still require contingency instruments to mitigate the impact of such shocks ex post (see Section IV. B).

Analysis of the Main Debt Sustainability Concerns

34. The first step of the analysis consists of a comparison of the projected debt-burden indicators with the indicative country-specific thresholds established before. The general presumption would be that the debt-burden indicators should remain below the thresholds in both the baseline and the stress scenarios. But even if this is the case, rapid changes in debt-burden indicators from low levels should be monitored closely, as they may signal an unsustainable policy path. When debt-burden indicators are above the thresholds, a careful interpretation is required to draw balanced conclusions about the sustainability of the debt outlook. Here, four principal situations can be distinguished: (i) most indicators are above the relevant empirical benchmarks; (ii) only one of the debt ratios is above its benchmark; (iii) the results of the public and external debt sustainability analyses differ significantly; and (iv) debt-stock and debt-flow ratios paint a different picture.

35. In cases in which most indicators are above the relevant empirical benchmarks (either under the stress tests or already in the baseline), a country’s debt situation would be considered a matter of concern. The appropriate policy response will depend on the specific country circumstances but would generally involve some combination of policy adjustment to reduce the overall level of borrowing, and—where possible—a higher share of grant financing or increased concessionality on planned borrowing.²⁹ In practice, for countries with Fund- and Bank-supported programs such an outcome would generally trigger an iterative process, at the end of which the agreed policies and the amount and terms of new financing would result in debt dynamics that are deemed sustainable. For countries that already start off with debt ratios in excess of the indicative thresholds—perhaps as a result of a severe shock or weak policies in the past—debt ratios would be expected gradually to approach their indicative threshold levels, as some new borrowing may be required to avoid an unduly harsh policy adjustment should sufficient grants not be forthcoming.

36. A careful interpretation is required when only one of the debt ratios exceeds its respective benchmark. In this case, debt sustainability concerns may arise mainly from weaknesses in the specific variables used to measure debt-servicing capacity. Here, judgment will be needed to determine whether there is in fact a debt problem or some other kind of issue—for instance, statistical biases in measuring GDP, or particular weaknesses in revenue collection. A diagnosis of the latter may call for a different policy response—respectively, measures to improve the quality of data, or to strengthen revenue administration and widen the tax base—although in many cases these measures would need to be accompanied by cautious borrowing policies until they bear fruit. A careful interpretation of the results would also need to take account of other factors that influence a country’s effective repayment capacity, such as high workers’ remittances or significant re-exports (with a large import component) which would tend to ease or tighten a country’s foreign-exchange constraint, respectively. Interpreting weaknesses in any of the denominators and identifying the appropriate response is a difficult but crucial part of the analysis.

37. Careful judgment is also needed in cases in which the assessment of public and external debt differ significantly. A large deviation between public and external debt ratios reflects either high public domestic or high private external debt.³⁰ The latter is unlikely to be an issue in most low-income countries and is also potentially less troublesome—unless the private sector is over-borrowing, which raises issues of contingent liabilities. The assessment of whether private sector debt is excessive and poses a significant risk for public debt sustainability must be made in the context of country-specific analysis, and dealing with such a problem would require a tailored policy response that addresses its specific origins.³¹ Thus, while the external debt-sustainability template projects the total external debt ratio (including private obligations) as one important indicator, its central focus (including for the stress tests) is on public and publicly-guaranteed external debt—consistent with the empirical threshold analysis.

38. High domestic debt of the public sector, on the other hand, has become a serious issue in a number of low-income countries and needs to be factored into the analysis. While there are no empirical thresholds available to assess the appropriateness of total public debt in low-income countries, the inclusion of domestic obligations in the public debt-sustainability analysis is, nonetheless important. Domestic debt service—just like its external counterpart—presents a drain on public resources that raises the risk of debt distress. Issuance of domestic debt instruments occurs for different reasons, making domestic debt measures more difficult to interpret (Box 4). For example, in a small number of strongly-performing countries, domestic debt has been accumulated in response to large external aid inflows.³² In these countries, a key issue is the appropriate use and phasing of aid flows to ensure that they do not lead to excessive appreciation pressures on the domestic currency. In many instances, issuance of domestic debt reflects the explicit objective of promoting the development of domestic financial markets, which also serves governments’ long-term goal of eventually issuing debt at reasonable cost in domestic currency. Whatever the reasons, the benefits of domestic debt must be carefully weighed against the potentially heavy burden it imposes on the budget, as for most low-income countries, it is currently a costlier form of financing compared with highly concessional external funds—even after exchange-rate risks are taken into account.³³ This implies, however, that the appropriate policy response would be to combine prudent external borrowing policies, informed by the indicative thresholds, with a strategy that contains domestic debt at “reasonable” levels. What level of domestic debt is reasonable, is a difficult question that does not lend itself easily to empirical analysis, as it depends on a variety of country-specific factors, including its purpose, cost, and coverage.³⁴ In short, while there are no empirical thresholds available to assess the appropriate level of domestic debt, it needs to be monitored and carefully interpreted. This is the reason why domestic debt is included in the proposed public sector debt-sustainability analysis, recognizing that its implications for an appropriate forward-looking financing strategy must be judged on a case-by-case basis.

Box 4.

Domestic Debt in Low-Income Countries

For a long time, in the context of debt sustainability analyses, it was commonly assumed that different degrees of coverage of public debt were applicable to middle-income and low-income countries. Focusing on the external public debt burden was considered adequate for the latter, since their domestic debt levels were low. Domestic financial markets were relatively less developed and were not a significant source of financing.

In reality, however, the perception that domestic debt does not play an important role in low-income countries may have been partly the result of weak data availability. Indeed, although external debt remains the dominant source of public financing, for some low-income countries domestic debt is far from negligible. At end-2000—the latest date for which consistent information is available—6 out of 20 low-income countries with available data had a ratio of domestic debt to GDP greater than 25 percent (see table). Moreover, the table may understate the overall domestic debt burden of the respective governments. Not only is data often unavailable, in most cases the available data covers central government debt only, and excludes debt contracted by local governments and public enterprises¹.

Domestic Debt in Selected Low-Income Countries

Source: IMF Statistical Appendices; Central Banks and staff estimates.Note: Data covers central government debt only, except for India, where the coverage is for the public sector, including the central government, state governments, and major public enterprises.

^a/1999/00;

^b/June 2000;

^c/September 2002;

^d/1999.

Domestic Debt in Selected Low-Income Countries

2000	Domestic Debt as % of GDP	Interest Payments on Domestic Debt as % of GDP	Interest Payments on Domestic Debt as % of Revenues
Benin	5.8	0.1	0.6
Burkina Faso	18.0	0.2	1.6
Burundi	13.3	1.4	7.0
Cameroon a/	18.7	0.4	2.1
Cote d'Ivoire	20.4	0.4	2.3
Ethiopia a/	42.2	1.4	7.6
Gambia, The	31.4	3.5	18.8
Ghana	28.9	5.3	30.1
Guayana b/	36.9	2.1	11.8
India a/	67.5	n/a	n/a
Kenya a/	22.2	2.9	12.4
Liberia c/	57.0	1.0	7.8
Nicaragua	42.2	1.0	4.0
N iger	18.5	0.2	1.8
Nigeria	21.0	2.4	5.4
Pakistan a/	46.4	6.3	54.7
Rwanda	11.7	0.3	1.8
Senegal	6.7	0.2	1.0
Togo	24.2	n/a	n/a
Uganda	4.9	0.3	2.9
Yemen d/	11.1	1.9	4.8
Zambia	19.3	1.4	7.2
Average	25.8	1.6	9.3

Source: IMF Statistical Appendices; Central Banks and staff estimates.Note: Data covers central government debt only, except for India, where the coverage is for the public sector, including the central government, state governments, and major public enterprises.

^a/1999/00;

^b/June 2000;

^c/September 2002;

^d/1999.

View Table

Domestic Debt in Selected Low-Income Countries

2000	Domestic Debt as % of GDP	Interest Payments on Domestic Debt as % of GDP	Interest Payments on Domestic Debt as % of Revenues
Benin	5.8	0.1	0.6
Burkina Faso	18.0	0.2	1.6
Burundi	13.3	1.4	7.0
Cameroon a/	18.7	0.4	2.1
Cote d'Ivoire	20.4	0.4	2.3
Ethiopia a/	42.2	1.4	7.6
Gambia, The	31.4	3.5	18.8
Ghana	28.9	5.3	30.1
Guayana b/	36.9	2.1	11.8
India a/	67.5	n/a	n/a
Kenya a/	22.2	2.9	12.4
Liberia c/	57.0	1.0	7.8
Nicaragua	42.2	1.0	4.0
N iger	18.5	0.2	1.8
Nigeria	21.0	2.4	5.4
Pakistan a/	46.4	6.3	54.7
Rwanda	11.7	0.3	1.8
Senegal	6.7	0.2	1.0
Togo	24.2	n/a	n/a
Uganda	4.9	0.3	2.9
Yemen d/	11.1	1.9	4.8
Zambia	19.3	1.4	7.2
Average	25.8	1.6	9.3

Source: IMF Statistical Appendices; Central Banks and staff estimates.Note: Data covers central government debt only, except for India, where the coverage is for the public sector, including the central government, state governments, and major public enterprises.

^a/1999/00;

^b/June 2000;

^c/September 2002;

^d/1999.

Domestic financing often fulfils a buffer role, which may result in sudden increases in domestic debt stocks:

1. Domestic debt may surge because the government has to sterilize significant foreign inflows.

2. The government may also issue domestic debt to mop up liquidity that has been created by supporting public sector banks in financial difficulties or to recapitalize insolvent private banks, as recently done in Nicaragua.

3. Domestic debt may also rise as governments intentionally attempt to foster the development of the country’s domestic financial market.

Domestic debt complicates the assessment of debt sustainability:

1. Domestic debt tends to be issued at shorter maturities and is therefore more vulnerable to roll-over risks.

2. In the domestic market, unlike in the market for external debt, the government may be able to influence the cost of borrowing through its implementation of interest and monetary policies.

3. Unlike external debt, domestic debt is usually issued at market interest rates and is therefore much more vulnerable to changes in the macroeconomic environment, and generally more costly in low-income countries.

¹ For example, in Ghana the central government’s domestic debt stood at about 27 percent of GDP in 2001, but the ratio including local governments’ and SOEs’ was twice as high. (IMF, Ghana: Selected Issues, May 2003).

39. Finally, the analysis needs to distinguish between stock and flow problems, which tend to have different implications for an appropriate financing strategy. A high debt-service ratio in the near term combined with a relatively low debt stock is indicative of liquidity needs that could be alleviated by additional (appropriately concessional) financing or conventional Paris Club flow reschedulings (if a significant amount of debt service is due to bilateral creditors). A high debt-stock with low current debt-service ratios is indicative of debt-servicing difficulties in the future. While long grace and maturity periods provide room for a gradual response to the debt-stock problem—acknowledging the opportunities for countries to grow out of excessive indebtedness before its implications, in terms of debt service, are felt—many of these countries’ own history is a sobering reminder of the significant downside risks. Thus, a high debt stock generally calls for primary reliance on grant financing and only limited new borrowing on highly concessional terms—which is also more feasible as the low debt service contains overall gross financing needs. A combined debt-service and stock problem calls for more urgent measures, as the country will need financing to ease its liquidity constraints, without further undermining debt sustainability. In this situation, policies to alleviate the debt problem, including a prioritized and well-specified expenditure program and the mobilization of grant resources will need to be a major focus of any program.

40. In sum, debt sustainability analyses for low-income countries should consist of two elements: (i) indicative country-specific debt-burden thresholds that depend on the quality of individual country’s policies and institutional environment; and (ii) an analysis and careful interpretation of actual and projected debt-burden indicators under the baseline and in the face of plausible shocks. These two pillars, in combination with other relevant country-specific considerations, provide an informed basis for the design of an appropriate country-specific borrowing strategy under which policies and the amount and terms of new financing would generate a debt and debt-service outlook that is deemed consistent with a country’s prospective repayment capacity and supportive of its eventual graduation from official aid flows. In a number of cases, the application of this framework will likely generate the need for a significant increase in grant financing over the coming years to enable these countries to achieve their development objectives on a durable basis—i.e., without creating debt-service problems in the future. The policy implications for the global community are discussed next.

A. Incorporating Debt Sustainability Considerations Into External Financing Policies

42. To reduce the likelihood of future debt crises in low-income countries, it is important that creditors and donors provide new financing at levels and on terms that limit a country’s risk of debt distress. The appropriate amount of new loans, in present value terms, would need to be assessed on the basis of the debt-sustainability framework presented in Section III, and derived in the context of the country’s macroeconomic framework. This would allow new borrowing (lending) volumes and terms to be consistent with long-term economic prospects and the risk of debt distress, but may, in some cases, require additional grants to prevent disruption to development programs. The provision of additional grants should consider a country’s needs and its ability to use resources effectively and should reward countries following sound policies.

43. Under this framework, countries with sound policies would receive a mix of loans and grants that would be consistent with their policy performance and their risk of debt distress. Provided a country’s policies are considered appropriate, the legacy of a high debt burden or vulnerability to shocks would not be a justification for denying it resources. Instead, the overall allocation of grant resources (including those embedded in the concessionality of new loans) would need to be based on policies and other relevant criteria. Thus, a country would neither be “rewarded” nor “punished” for a high debt level, in terms of the effective grant resources it receives—which is an important provision to avoid moral hazard. A country with low risk of debt distress, however, should be in a position to obtain more of its resources in the form of loans, implying higher nominal transfers for a given grant-equivalent. Box 5 examines two country examples to show what such a framework, if adopted in the past, would have implied for debt levels and the volume of grants required.

Box 5.

Adopting An Ex-Ante Framework for New Lending

This box illustrates the possible impact of an ex-ante framework that links the concessionality of new financing to debt-burden indicators, using historical simulations for Tanzania and Madagascar, HIPC countries which are past completion point and decision point respectively. Both countries have received substantial debt relief under the HIPC Initiative (due to the Initiative, Tanzania’s debt burden was reduced by about $1.9 billion at completion point and Madagascar’s by about $1 billion at decision point, in 2001 NPV terms). The historical evolution of Tanzania and Madagascar’s nominal debt-to-exports ratios from 1980 to 2001 are simulated under the stylized assumption that whenever debt reaches certain threshold ratios, the following year’s disbursements are in the form of grants rather than loans (see figure). The assumed threshold triggers are an NPV of debt-to-exports of 200 percent; an NPV of debt-to-GDP of 45 percent; and an NPV of debt-to-fiscal revenue of 200 percent (corresponding to indicative triggers for a “medium-performer” in Table 2). For Tanzania, these triggers would have necessitated switching from loans to grants from 1981 to 1994, as well as in 1996. Consequently, Tanzania’s NPV of debt-to-exports ratio in 2001 would have been 116 percent under the simulations compared with an actual ratio of about 330 percent. The annual value of grants that would have been required to prevent a fall in net flows (i.e. the value of loan disbursements withheld) if this ex-ante framework had been in place would have amounted to about $175 million in nominal terms. Similarly, a simulation for Madagascar over the same period reveals that about 70 percent of all disbursements would have had to be made in the form of grants, implying average grant flows of about $135 million per year between 1980 and 2001. Madagascar’s simulated debt-to-exports ratio at end-2001 would have been equivalent to 50 percent, compared with an actual ratio of more than 200 percent.

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Implications for New Lending

44. Given a country’s macroeconomic projections, the framework described in Section III would yield the present value of new borrowing that would be consistent with debt sustainability. Within the overall borrowing envelope, expressed in present value terms, a country would have greater scope to borrow, the higher the grant element of its new financing; at the same time, it would maintain flexibility to borrow at different terms from different creditors.

45. There could be instances where creditors’ willingness to lend to a country exceeds the level of borrowing compatible with debt sustainability. With creditors continuing to base lending decisions on their priorities, objectives, and risk-bearing capacity, there may be situations in which they can make a convincing argument for lending levels that exceed those suggested by the standardized framework—for example a high-return project, or the likelihood that certain reforms could result in a distinct improvement in growth. In these (presumably) exceptional circumstances, the country authorities, supported by their creditors, would need to make a clear case for exceeding the indicative debt thresholds, and progress would need to be monitored carefully to ensure that higher levels of lending are achieving the envisaged results. Creditors would also be expected to increase the concessionality of these additional loans to the extent possible (Table 3).

Table 3.

Concessionality of Loans by Selected Creditors ^1/

Source: Staff estimates, based on publicly available information for each Institution.

¹For some creditors, lending terms vary depending on the borrower country and/or the project financed. For simplicity, those conditions which represented the “softest” loan terms were used to calculate the grant element.

²Refers to concessionality calculations for debt ceilings in Fund-supported programs, which use 6-month (10-year) averages of CIRRs as discount rates, plus a spread subject to the maturity period, for loans with maturity of less than (at least) 15 years

³This method of calculating concessionality uses the 6-month average currency-specific CIRR, and is consistent with the HIPC framework.

⁴Levied on undisbursed amounts. For the purpose of this exercise, it was assumed that the loan is disbursed in one observation.

⁵IaDB lends in multiple currencies, in this case the discount rate used was the USD CIRR.

⁶20 percent of the loan is repaid during the first 10 years after grace period. The rest is paid afterwards.

⁷Principal repayable at 2.5 percent per annum during the first 10 years after the grace period and 5 percent per annum afterwards.

⁸1 percent during the grace period, 2 percent afterwards.

⁹Current rate ranges from 0.75 percent up to 4 percent.

¹⁰Current rate ranges from 1 percent up to 4 percent.

¹¹Current rate ranges from 0 percent up to 2.5 percent.

¹²10 percent of the loan is repaid in the 10 years following the grace period and the remaining 90% over 30 years.

Table 3.

Concessionality of Loans by Selected Creditors ^1/

										Grant Element
Creditor	Grace Period	Maturity	Interest Rate	Fees	Service Charges	Commitment Charge 4/	Repayments per year	Repayment Profile	Currency	Current IMF Method 2/	CIRR 2003 3/
IDA40	10	40	0.75%	0%	0%	0.5%	2	IDA40 6/	SDR and USD	82.0%	63.2%
IDA35	10	35	0.75%	0%	0%	0.5%	2	IDA35 7/	SDR and USD	77.8%	58.1%
IaDB 5/	10	40	1% & 2% 8/	0%	0%	0.0%	2	EQUIP	Multiple	76.3%	57.0%
IMF	5.5	10	0.5%	0%	0%	0.0%	2	EQUIP	SDR	27.1%	23.0%
African Dev Fund	10	50	0.0%	0%	0.75%	0.5%	2	Specific 12/	Multiple	84.4%	67.5%
Nordic Development Fund	10	40	0.0%	0%	0.75%	0.5%	2	EQUIP	SDR	72.0%	49.6%
IFAD1	10	50	1.0%	0%	0%	0.0%	2	EQUIP	SDR	72.6%	50.0%
OPEC	5	20	0.5%	0%	0%	0.0%	2	EQUIP	USD	56.6%	35.8%
JBIC	10	40	0.75%	0%	0%	0.0%	2	EQUIP	Yen	49.4%	33.9%
EU	10	40	0.75% 9/	0%	0%	0.0%	2	Specific	EUR	73.0%	54.6%
BADEA	10	30	1.0% 10/	0%	0%	0.0%	2	EQUIP	USD	67.5%	42.9%
EIB	10	50	1.0% 10/	0%	0%	0.0%	2	Specific	EUR	73.6%	55.2%
Asian Development Fund	8	32	1% & 1.5%	0%	0%	0.0%	2	EQUIP	USD	71.9%	51.8%
Islamic Dev. Bank	10	30	0.0%	0%	0% 11/	0.0%	2	EQUIP	SDR	74.5%	54.0%

Source: Staff estimates, based on publicly available information for each Institution.

¹For some creditors, lending terms vary depending on the borrower country and/or the project financed. For simplicity, those conditions which represented the “softest” loan terms were used to calculate the grant element.

²Refers to concessionality calculations for debt ceilings in Fund-supported programs, which use 6-month (10-year) averages of CIRRs as discount rates, plus a spread subject to the maturity period, for loans with maturity of less than (at least) 15 years

³This method of calculating concessionality uses the 6-month average currency-specific CIRR, and is consistent with the HIPC framework.

⁴Levied on undisbursed amounts. For the purpose of this exercise, it was assumed that the loan is disbursed in one observation.

⁵IaDB lends in multiple currencies, in this case the discount rate used was the USD CIRR.

⁶20 percent of the loan is repaid during the first 10 years after grace period. The rest is paid afterwards.

⁷Principal repayable at 2.5 percent per annum during the first 10 years after the grace period and 5 percent per annum afterwards.

⁸1 percent during the grace period, 2 percent afterwards.

⁹Current rate ranges from 0.75 percent up to 4 percent.

¹⁰Current rate ranges from 1 percent up to 4 percent.

¹¹Current rate ranges from 0 percent up to 2.5 percent.

¹²10 percent of the loan is repaid in the 10 years following the grace period and the remaining 90% over 30 years.

View Table

Table 3.

Concessionality of Loans by Selected Creditors ^1/

										Grant Element
Creditor	Grace Period	Maturity	Interest Rate	Fees	Service Charges	Commitment Charge 4/	Repayments per year	Repayment Profile	Currency	Current IMF Method 2/	CIRR 2003 3/
IDA40	10	40	0.75%	0%	0%	0.5%	2	IDA40 6/	SDR and USD	82.0%	63.2%
IDA35	10	35	0.75%	0%	0%	0.5%	2	IDA35 7/	SDR and USD	77.8%	58.1%
IaDB 5/	10	40	1% & 2% 8/	0%	0%	0.0%	2	EQUIP	Multiple	76.3%	57.0%
IMF	5.5	10	0.5%	0%	0%	0.0%	2	EQUIP	SDR	27.1%	23.0%
African Dev Fund	10	50	0.0%	0%	0.75%	0.5%	2	Specific 12/	Multiple	84.4%	67.5%
Nordic Development Fund	10	40	0.0%	0%	0.75%	0.5%	2	EQUIP	SDR	72.0%	49.6%
IFAD1	10	50	1.0%	0%	0%	0.0%	2	EQUIP	SDR	72.6%	50.0%
OPEC	5	20	0.5%	0%	0%	0.0%	2	EQUIP	USD	56.6%	35.8%
JBIC	10	40	0.75%	0%	0%	0.0%	2	EQUIP	Yen	49.4%	33.9%
EU	10	40	0.75% 9/	0%	0%	0.0%	2	Specific	EUR	73.0%	54.6%
BADEA	10	30	1.0% 10/	0%	0%	0.0%	2	EQUIP	USD	67.5%	42.9%
EIB	10	50	1.0% 10/	0%	0%	0.0%	2	Specific	EUR	73.6%	55.2%
Asian Development Fund	8	32	1% & 1.5%	0%	0%	0.0%	2	EQUIP	USD	71.9%	51.8%
Islamic Dev. Bank	10	30	0.0%	0%	0% 11/	0.0%	2	EQUIP	SDR	74.5%	54.0%

Source: Staff estimates, based on publicly available information for each Institution.

¹For some creditors, lending terms vary depending on the borrower country and/or the project financed. For simplicity, those conditions which represented the “softest” loan terms were used to calculate the grant element.

²Refers to concessionality calculations for debt ceilings in Fund-supported programs, which use 6-month (10-year) averages of CIRRs as discount rates, plus a spread subject to the maturity period, for loans with maturity of less than (at least) 15 years

³This method of calculating concessionality uses the 6-month average currency-specific CIRR, and is consistent with the HIPC framework.

⁴Levied on undisbursed amounts. For the purpose of this exercise, it was assumed that the loan is disbursed in one observation.

⁵IaDB lends in multiple currencies, in this case the discount rate used was the USD CIRR.

⁶20 percent of the loan is repaid during the first 10 years after grace period. The rest is paid afterwards.

⁷Principal repayable at 2.5 percent per annum during the first 10 years after the grace period and 5 percent per annum afterwards.

⁸1 percent during the grace period, 2 percent afterwards.

⁹Current rate ranges from 0.75 percent up to 4 percent.

¹⁰Current rate ranges from 1 percent up to 4 percent.

¹¹Current rate ranges from 0 percent up to 2.5 percent.

¹²10 percent of the loan is repaid in the 10 years following the grace period and the remaining 90% over 30 years.

46. Similarly, there will likely be cases in which disbursements from the pipeline of concessional loans that are deemed consistent with a country’s prospective repayment capacity fall short of its needs for implementing its development agenda. In these circumstances, the first course of action would be to mobilize additional grant resources from donors, in the context of consultative group meetings. Should adequate grant resources not be available, creditors could examine all means possible to further increase the concessionality in their lending terms so that resource flows could rise without raising the risk of debt distress. While there may be scope in individual development institutions for increasing their loan concessionality, the Fund, as a monetary institution, would not be expected to follow suit. Indeed, given that the concessionality of PRGF loans is comparatively low, the provision of new loans from the Fund would presumably be limited in these cases—though the framework is sufficiently flexible to accommodate some lending. Even after exploring these options, some countries may still be left with a gap between financing needs and appropriately concessional aid resources. In these circumstances, the Government would need to adapt its borrowing strategy to prioritize the use of scarce resources in close collaboration with creditors and donors, while simultaneously improving the conditions for strengthening its borrowing capacity, particularly through improved policies and institutional reforms. In most instances, the terms of the assistance available would play an important role in determining the financing priorities; but it is conceivable that other considerations (for example, whether the use of funds is earmarked for specific purposes, or if it requires domestic co-financing) could also apply.

47. ultimately, the extent to which countries will face dilemmas between financing needs and long-term debt sustainability depends to a large extent on the international community’s willingness to provide additional grants. Unless donors and creditors can significantly increase their pool of resources, a higher share of grant funding to some countries would have to come at the expense of reduced nominal transfers available to all. This would result in fierce competition for these resources. Increased competition may have the positive side effect of encouraging better policy performance, to the extent that strong performers are able to attract more resources (both grants and loans), thereby improving their chances of meeting the MDGs. But the reduction in aggregate new financing that would be required for a shift from loans to grants within a given aid envelope, would simultaneously lower the chances to advance for other countries with below-average policies. Thus, to reward strong performers without closing the door on others to catch up, the international community will need to combine an improved aid-allocation mechanism guided by policy performance with an overall increase in available resources.

Prospects for Increasing Aid Flows

48. Since achievement of the MDGs depends not only on adequate financing but, most importantly, on strong policies in the countries concerned, any estimate of the additional grant requirements is contingent on assumptions about the policy performance in individual countries. Using a country-based approach, a recent paper prepared by Bank staff for the Development Committee found that with continued policy and institutional reforms, developing countries could productively use additional flows of about $30 billion annually. This estimate is conservative for several reasons: (i) it does not reflect the costs of meeting all the MDGs in all countries (which would require a more optimistic policy scenario but also more financing); (ii) it reflects gaps in data and analysis at the country level, such that certain financing requirements, particularly with regard to infrastructure and capacity enhancement, are not included; and (iii) it does not consider the costs of meeting global and regional public goods, including measures to combat HIV/AIDS or achievement of broad environmental sustainability.³⁵ Importantly, the study finds that the implications for the volume and phasing of additional aid varies across countries, depending on their specific circumstances, such as prospects for improving policies and the volume of current aid flows. Nevertheless, it concludes that early commitment of additional aid is crucial to help promote reforms and build up countries’ capacity to use larger amounts of aid productively over time.

49. Aid flows would therefore have to increase significantly in comparison to their historical trend. Official Development Assistance (ODA) provided to developing (and low-income) countries has remained about the same in nominal US dollar terms since 1991 (Figure 5)—and thus, has actually fallen as a share of developed countries’ GDP, from 0.34 percent on average in 1990 to 0.23 percent in 2002. At the International Conference on Financing for Development, in Monterrey, Mexico in March, 2002, donors committed to a substantial increase in ODA to meet the MDGs. If these promises are fulfilled, ODA would rise by 31 percent in real terms (or US$ 16 billion) by 2006,³⁶ but this is well short of the estimated amounts required to finance the MDGs. Some donor pledges have been translated into programs, such as the US’s Millennium Challenge Account, which envisages providing US$ 5 billion in new grants annually, the Global Fund for AIDS, TB and Malaria, the US’s Emergency Plan for Aids Relief, and the UK’s proposal for global bonds (the International Finance Facility).

Trends in ODA Flows, 1991-2002 1/

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: OECD DAC

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Trends in ODA Flows, 1991-2002 1/

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: OECD DAC

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Trends in ODA Flows, 1991-2002 1/

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: OECD DAC

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50. Thus, the required increase in the availability of resources to low-income countries calls for increased aid allocation and broad participation among donors. Currently, approximately 75 percent of grants are provided directly by bilateral donors in the context of their bilateral aid programs. Among multilateral creditors, IDA, special IDA-administered facilities, the European Union, UN agencies, and some other multilateral organizations have facilities that provide grant financing. In addition, a small but growing share of grants is provided by NGOs, foundations, and other private sources (at end- 2001, private grants to ODA recipients totaled $7.3 billion, equivalent to 14 percent of ODA that year). Donors could increase the volumes of these flows either directly or by channeling additional grants through multilateral institutions.

51. Concessionality of new financing could also be increased by innovative financing instruments. An innovative financing instrument that is already available to donors for this purpose is the credit-buydown mechanism (CBM). Under a CBM, instead of receiving principal and interest payments from a borrower, the creditor receives the present value of these flows from a donor, effectively turning the loan into a grant for the borrowing country. The CBM uses donor resources to increase the grant element of, and reduce payments on, already contracted multilateral debt. It is conceivable that this and other instruments would be used on a wider scale in the future.

52. Besides increasing the level of aid flows, there is also room to strengthen its effectiveness and improve the delivery and allocation process. Development assistance needs to be better aligned with the recipient country’s priorities and processes, as set out in its development and poverty reduction strategy. One aspect of improved alignment is for those providing aid to coordinate their support better and to harmonize their policies and procedures around the recipient country’s own systems while ensuring that this does not come at the expense of fiduciary standards. The approach agreed at the Rome Harmonization Forum is promising and needs to be linked at the country level to the PRSP approach.³⁷ A greater proportion of aid should also be provided in forms that can help meet the incremental costs of financing the MDGs. For example, 30 percent of grants continue to be provided as technical co-operation (Figure 6). But where budgetary and financial management systems are adequate—and technical assistance can play an important role in helping countries achieve this—aid should be provided in the most productive ways to finance the higher recurrent costs associated with meeting the MDGs, namely through budget support or well-targeted sectoral programs. Finally, aid flows need to be predictable, timely, and counter-cyclical. The delivery of aid to low-income countries can be greatly improved by: (i) ensuring that year-to-year fluctuations in allocations are minimized and that aid budgets are protected from short-term pressures;³⁸ and (ii) providing quick-disbursing funds to mitigate the economic and social impact of external shocks.

Composition of Grant Funding (end-2001)

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

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Composition of Grant Funding (end-2001)

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

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Composition of Grant Funding (end-2001)

(In percent)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

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B. Designing Instruments That Mitigate the Impact of Exogenous Shocks

53. Debt distress in low-income countries is often caused by exogenous shocks that cause liquidity problems and require exceptional financing. As illustrated in Figure 7, changes in debt-burden indicators have largely reflected swings in export earnings and GDP, often caused by exogenous shocks.³⁹ Adverse shocks can be defined as unanticipated events beyond the control of authorities that can have a significant negative impact on an economy. They can arise for many reasons, including natural disasters (such as droughts), changes in relative prices (for example, commodity price shocks), political instability or civil strife (even in neighboring countries), and sudden changes in capital flows (such as the withdrawal of donor support). Commodity price shocks have often been persistent, ⁴⁰ and evidence shows that they tend to be more severe in low-income countries than in other developing countries (Figure 8), and more frequent.⁴¹ For example, between 1992-2001, the average size of a negative commodity price shock (measured by the decline in real prices from the previous year’s level) was 22 percent for low-income countries and 16 percent for other developing countries. Low-income countries experienced commodity price shocks every 3.3 years on average, while other developing countries experienced them, on average, every 4.4 years.⁴²

NPV of Debt, Exports and Output Volatility Annual percent change, 1980-2001

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NPV of Debt, Exports and Output Volatility Annual percent change, 1980-2001

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NPV of Debt, Exports and Output Volatility Annual percent change, 1980-2001

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Developing Countries’ Vulnerability to Exogenous Shocks ^1/2/

(Average size of negative shocks in real prices of export commodities)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: IMF (2003c)^1/ A shock is defined as at least 10 percent decline in the real price of the commodity from its previous year.^2/ Data covers 52 developing countries, of which 30 are low-income. Oil exporting countries are excluded.

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Developing Countries’ Vulnerability to Exogenous Shocks ^1/2/

(Average size of negative shocks in real prices of export commodities)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: IMF (2003c)^1/ A shock is defined as at least 10 percent decline in the real price of the commodity from its previous year.^2/ Data covers 52 developing countries, of which 30 are low-income. Oil exporting countries are excluded.

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Developing Countries’ Vulnerability to Exogenous Shocks ^1/2/

(Average size of negative shocks in real prices of export commodities)

Citation: Policy Papers 2004, 012; 10.5089/9781498330633.007.A001

Source: IMF (2003c)^1/ A shock is defined as at least 10 percent decline in the real price of the commodity from its previous year.^2/ Data covers 52 developing countries, of which 30 are low-income. Oil exporting countries are excluded.

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54. While shocks may be caused by a variety of factors, their impact is usually a contraction in broad macroeconomic variables, such as GDP growth and exports, and a substantial loss in welfare. Income losses from shocks tend to be higher in low-income countries than in other developing countries. For a sample of low-income countries, the direct income loss from negative export price shocks averaged 6.8 percent in the year of the shock, and over a four-year period, the income loss amounted to 14 percent of initial output, with associated consumption volatility leading to substantial welfare losses.⁴³ In many low-income countries, estimated welfare gains from eliminating volatility exceed those of an additional point of growth forever.⁴⁴ Low-income countries also experience high and persistent volatility in the real exchange rate caused, in large part, by their vulnerability to terms of trade shocks. Since contractions in GDP resulting from shocks are often accompanied by a significant depreciation in the currency, the overall burden of servicing foreign-currency debt can be particularly onerous in the period following a shock.⁴⁵

55. The impact of exogenous shocks on the debt dynamics can be addressed both ex ante and ex post. An ex ante approach would be to incorporate volatility into the baseline projections and conduct stress tests to model the consequences of possible shocks, and then translate these into prudent lending and borrowing decisions. This is the basic approach embedded in the proposed framework in Section III. It is akin to an “ex ante adjustment” that would allow countries to face “likely” shocks without experiencing debt distress. An ex post approach would be to apply insurance mechanisms that can provide effective relief once a shock is experienced. This relief could be in the form of additional financing or reduced debt service. In practice, a combination of both ex ante and ex post approaches could be considered to deal with the consequences of large shocks, for example by complementing the proposed framework with mechanisms that provide insurance-like ex post relief for shocks that substantially increase the risk of debt distress. Such a combined approach would offer the most effective protection against the possibility that large shocks undermine a country’s chances of meeting the MDGs in the event that grant resources may not be forthcoming.

56. The appropriate ex post response to exogenous shocks is typically a combination of some additional appropriately concessional financing (or reduced debt service) with adjustment in expenditures in relation to income. In principle, it is optimal to finance temporary shocks but adjust to permanent ones; however, this prescription is difficult to interpret and apply. First, it is often impossible to determine at the outset whether a shock will be permanent or temporary. Second, research indicates that even in the case of permanent shocks, foreign assistance can be very effective in dealing with its consequences, as long as it is available quickly, and is provided in a way that includes incentives for policy adjustments and measures to reduce vulnerability to future shocks.⁴⁶ Therefore, even if shocks are permanent, adjustment is less painful if it is stretched out over time and combined with upfront additional financing. Additional financing for exogenous shocks should be provided on terms that reflect a country’s risk of debt distress, with highly debt-distressed countries receiving financing in the form of grants; the importance of appropriate financing terms is underscored by cases in which new loans provided in response to shocks have created debt-servicing problems for countries where debt levels were high to begin with and where the effects of the shocks lasted for a long time.⁴⁷

57. Experience with existing schemes to help countries cope with shocks is mixed and work on designing new instruments is at a preliminary stage (Box 6). Stabilization schemes such as the EU’s Stabex and the IMF’s Compensatory Financing Facility (CFF) tried to smooth earnings in response to terms of trade shocks, but were limited in their success partly because commodity price shocks were so persistent. More recently, research on new instruments has focused on reducing the burden of debt service in the aftermath of shocks, for example, by linking debt service obligations to variables associated with volatility in export earnings or GDP growth, such as commodity prices and the real exchange rate. Work on designing new instruments for low-income countries is going on both at the World Bank and the IMF, and the Boards will be informed about progress periodically. What makes these instruments particularly difficult to design is that they need to deliver significant relief to countries experiencing a shock, but at the same time, like all insurance schemes, they need to remain financially viable over the long term.

A. Improving Policies and Institutions

59. The importance of policies and institutions for higher and more sustained growth lies at the core of the development agenda in low-income countries.⁴⁸ Good policies and institutions are critical, at the microeconomic level, to reduce corruption and strengthen property rights, the rule of law, and the quality of civil service, all of which have been shown to positively impact long-term growth—including by improving the climate for entrepreneurship and foreign investment.⁴⁹ Policies that support macroeconomic stability are also key. Sound fiscal policies can enhance domestic resource mobilization, reducing the need for external financial assistance, while trade policy reforms that lower trade barriers in low-income countries and expand their access to industrial country markets are essential to facilitate export growth.

60. Apart from supporting growth, good policies are also likely to attract higher aid flows and eventually move countries along a virtuous circle of creditworthiness and growth to an eventual graduation from donor dependence. To the extent that creditors and donors precondition new financing on the quality of policies, increased concessional lending flows will be highly dependent on improved policy performance. While few low-income countries can be considered creditworthy in the true sense of the term (that is, they have access to private international capital), success stories such as Thailand, Korea and Botswana⁵⁰ demonstrate that with the right mix of policies, institutions and financial assistance, countries can attract private capital in significant amounts and become emerging markets within the foreseeable future.

B. Strengthening Debt Management

61. Many low-income countries still have a long way to go in strengthening their capacity to pro-actively manage the maturity structure and currency composition of their debt. Debt management in low-income countries tends to involve a choice between long-term concessional external borrowing in foreign currency and short-term domestic borrowing at market rates which often reflect significant inflation and liquidity risk premia within shallow markets.⁵¹ Sometimes governments may be tempted to reduce interest costs by borrowing domestically in foreign currency—though at the expense of incurring exchange-rate risk. Stronger and deeper domestic debt markets would help low-income countries issue a larger share of their debt in longer-term, fixed-rate, domestic-currency-denominated securities, thus reducing the overall risks in the debt portfolio. But many low-income countries often do not have the luxury of such a choice. The high premia they pay on domestic financing makes it advantageous to rely almost exclusively on official development assistance from abroad.

62. Notwithstanding these constraints on actively managing risks, low-income countries can take various steps to improve their debt management. Most importantly, governments need to be in a position to track debt-service obligations effectively to avoid costly penalties, and to make well-informed and transparent decisions about the amounts and terms of new public borrowing, consistent with the broader macroeconomic framework. This requires: (i) improving the monitoring of public and publicly-guaranteed debt on a broad definition (i.e., including debt of public enterprises, and local authorities, as well as claims on the private sector that are guaranteed by public entities) to obtain a better assessment of contingent liabilities; (ii) co-ordinating debt management closely with fiscal and monetary policies; (iii) providing debt-management agencies with a clear legal mandate and an effective disclosure policy; and (iv) recruiting staff to public debt-management offices that have good financial market, public policy, and technical skills, including for undertaking debt-sustainability analyses, so that they can provide the necessary support to policymakers.⁵²

63. A number of institutions currently provide assistance to low-income countries in building capacity for debt management. The Commonwealth Secretariat and UNCTAD-DMFAS are involved in the provision of a computer-based data management system for data recording and analysis. UNITAR offers training programs on debt and financial management with a focus on legal aspects. DRI, a non-profit organization, runs a program for capacity building in HIPCs. The World Bank has provided assistance mainly through its support for regional organizations.⁵³ Additionally, the World Bank has provided assistance related to risk analysis, strategy formulation and domestic debt-market development at the country level.⁵⁴ The Fund and Bank have collaborated on a pilot project involving a series of Country Program Assessments (CPAs). The main objective is to design, in co-operation with government officials, a program of reforms and capacity building to improve a country’s capacity to manage sovereign debt. The program also provides assistance on the development and maintenance of domestic debt markets. Among low-income countries, Indonesia, Kenya and Nicaragua are participating in the program so far.

C. Increasing Resilience to Exogenous Shocks

64. Low-income countries can also take measures to increase their resilience to exogenous shocks. First, an adequate level of foreign reserves provides an obvious cushion against shocks. In addition, countries may take preventive measures that are targeted at more specific shocks. In the past, some countries, for example, have attempted to stabilize commodity prices through domestic microeconomic risk-management schemes. Like their international counterparts, however, these have only been marginally effective. More recently, a number of countries have had some success with using market-based instruments to hedge themselves against falls in export prices and revenues. In the long term, export diversification is the most effective mechanism to increase resilience to exogenous shocks. While diversification presents a number of challenges, there are some success stories which show that it is feasible over a longer horizon. Finally, the reduction of budget rigidities, combined with a well-designed tax system and social safety net, can help governments cope with the implications of external shocks.

65. A number of domestic mechanisms intended to stabilize export earnings, such as marketing boards, buffer funds, and variable taxation were used widely in the past, but have proved costly and ineffective, mostly because of the failure of governments to segregate the stabilization functions of these schemes from the provision of implicit subsidies.⁵⁵ These micro-level risk-management schemes were set up to mitigate the impact of price declines on the incomes of those hardest hit by the shock.⁵⁶ Contrary to expectations, however, domestic stabilization schemes often created large contingent liabilities for the government. Although stabilization was their official aim, once established, these schemes were quickly depleted as they invested their surpluses poorly and diverted stabilization funds to other purposes. The persistence of commodity price shocks meant that price stabilization schemes needed to accumulate large balances during peaks to support an uncertain low price period, which often proved unfeasible. These schemes are gradually being eliminated, though they continue to be prominent in Ghana, Mali and Burkina Faso, among others.

66. Some countries also had partial success using markets to reduce exposure to volatile export prices and revenues. The most widely used instruments are forward, futures, and swap contracts (Box 7). The ability of derivatives to provide effective macro-level protection against commodity price shocks is limited, however. First, it is difficult to scale-up the use of derivatives to cover a significant share of total export earnings, mainly because of lack of financial resources and the limited depth of theses markets. Second, the majority of exporters in low-income countries have limited access to these derivative markets, with insufficient expertise in using them, and inadequate funds to cover costs of buying derivative instruments (though for exchange-traded commodity futures, the upfront cost is fairly small). Thirdly, derivative markets for agricultural commodities are mainly short-term (while adverse price shocks are often long-term), and extending them beyond one year becomes very expensive, although strategies exist for a rolling hedge that offers partial protection against adverse price movements.⁵⁷

67. Overall, export diversification is likely to be the most effective protection against commodity-price shocks, though country experiences suggest that this is not an easy objective for governments to achieve. Encouraging export diversification in a way that is consistent with comparative advantage requires not only a coherent strategy but also a conducive environment for private entrepreneurs to embark on new activities and take risks. Such an environment is typically characterized by government policies devoted to macroeconomic stabilization including a realistic exchange rate, structural reforms, and growth, and supported by trade liberalization with increased market access, flexible labor markets, high quality of human capital and physical and financial infrastructure, and an investment climate that is attractive to foreign direct investment.⁵⁸ While a number of success stories, such as China, Chile, Costa Rica, Korea, Malaysia, and Thailand illustrate the potential for diversification, for most low-income countries the development of a well-diversified export base is likely to remain a long-term goal.