A. Experience with the New Joint DSA Framework

6. Since the endorsement of the DSF in April 2005, the staffs of the Bank and the Fund have produced 23 joint low-income-country DSAs.⁷ Most were conducted in the context of a Fund arrangement (16 out of 23), while two (Djibouti and Guinea) were conducted in the context of staff monitored programs (SMPs). All 23 have been presented to the Fund Board, while five have so far been presented to the Bank Board, and another five are expected to follow by end-June 2006. As had been standard practice, Bank and Fund staff also collaborated, on an informal basis, on most of the Fund-only DSAs presented to the Boards in 2005 and early 2006.⁸

7. The joint DSAs show relatively high risks of debt distress for countries with a low Country Policy and Institutional Assessment (CPIA) rating or for those that have not reached the HiPc completion point and are thus not yet eligible for MDRi relief (Table 1 and Figure 1).⁹ Of the 23 joint DSAs, 21 presented an explicit debt distress rating—with four low, nine medium, and seven high risk cases, while one country was deemed "in debt distress." Among 10 countries that have reached the HIPC completion point and 11 countries that have benefited from MDRI relief from the Fund, only two exhibited a high level of debt distress (before MDRI relief).¹⁰

Table 1.

Risk Ratings in Joint DSAs—Before MDRI Debt Relief

^1/Including Tajikistan, which is eligible for mdri relief by the rund only.

^2/For two countries, CPIA ratings were not reported. Thresholds for levels of debt distress depend on these ratings. Source: Joint Bank-Fund DSAs.

Table 1.

Risk Ratings in Joint DSAs—Before MDRI Debt Relief

		HIPC status			MDRI status		CPIA rating 2/
			of which:
Risk rating	Total	All HIPCs	Past CP	Non-HIPCs	Eligible 1/	Not eligible	Strong	Medium	Poor
Low	4	2	1	2	1	3	1	3	0
Moderate	9	6	6	3	7	2	4	4	1
High	7	4	2	3	2	5	0	3	4
In distress	1	1	0	0	0	1	0	0	1
Not specified	2	1	1	1	1	1	0	0	0
Total	23	14	10	9	11	12	5	10	6

^1/Including Tajikistan, which is eligible for mdri relief by the rund only.

^2/For two countries, CPIA ratings were not reported. Thresholds for levels of debt distress depend on these ratings. Source: Joint Bank-Fund DSAs.

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Table 1.

Risk Ratings in Joint DSAs—Before MDRI Debt Relief

		HIPC status			MDRI status		CPIA rating 2/
			of which:
Risk rating	Total	All HIPCs	Past CP	Non-HIPCs	Eligible 1/	Not eligible	Strong	Medium	Poor
Low	4	2	1	2	1	3	1	3	0
Moderate	9	6	6	3	7	2	4	4	1
High	7	4	2	3	2	5	0	3	4
In distress	1	1	0	0	0	1	0	0	1
Not specified	2	1	1	1	1	1	0	0	0
Total	23	14	10	9	11	12	5	10	6

^1/Including Tajikistan, which is eligible for mdri relief by the rund only.

^2/For two countries, CPIA ratings were not reported. Thresholds for levels of debt distress depend on these ratings. Source: Joint Bank-Fund DSAs.

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Risk Ratings in Joint DSAs—Before MDRI Debt Relief

Citation: Policy Papers 2006, 013; 10.5089/9781498332828.007.A001

Source: Joint Bank-Fund DSAs.

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8. The gradual introduction of structured DSAs has strengthened Fund surveillance and program design; however, the immediate impact of the current DSF on program design has so far been limited.

• The DSF has further integrated debt issues into Fund analysis and policy advice, through its annual frequency, the improved quality of the assessments, and comparability across countries. The key findings of the DSAs have been summarized in various staff reports—good examples are Burkina Faso and Uganda (the latter addressing, in particular, the impact of MDRI relief).¹¹ In most cases with a moderate or higher risk of debt distress, the policy implications are incorporated explicitly in the analysis and recommendations.

• In September 2004, the Fund Board called for efforts to strengthen control over excessive borrowing in the context of Fund programs, through the use of conditionality related to the NPV of external debt and more systematic use of limits on the overall fiscal deficit (including grants) for countries where debt sustainability is a concern.¹² Until the introduction of the DSF, Fund program design for low-income countries had focused on fostering growth and macroeconomic stability, and on overcoming short-term financing constraints, while relying in many cases on expected future debt relief and more highly concessional financing to help ensure long-term sustainability. So far, however, NPV-based conditionality, which, theoretically would be the more attractive measure, has remained scarce—due in part to difficulties in tracking the NPV of debt. Only the PRGF arrangement for Guyana has included an indicative ceiling on the NPV of external public and publicly guaranteed debt, introduced in July 2004. The 2005 arrangement for the Kyrgyz Republic has a separate ceiling on the contracting or guaranteeing of concessional external debt in addition to a zero ceiling on nonconcessional borrowing.¹³

9. For the Bank, the adoption of the DSF has resulted in a fundamental change in IDA's grant allocation criteria, which now focus exclusively on risks of debt distress.

• Under IDA's fourteenth replenishment, which runs from mid-2005 to mid-2008, IDA Deputies agreed to use debt distress risk as the sole criterion for allocating IDA grants. The development of the DSF played a significant role in facilitating this decision, as it gave Deputies the comfort that they could rely on objective, comparable debt sustainability analyses based on an empirical framework.

• In FY06, a "traffic light" mechanism, resting on policy-dependent indicative debt thresholds of the DSF, determined the risk of debt distress on the basis of the latest available debt-burden indicators. This was necessitated by the fact that DSAs were not available for all low-income countries. However, DSAs where the main determinant of the traffic light for four countries. Thirty-four countries were classified as "red light" (or high risk of debt distress) in FY06, while nine were classified as "yellow light" (or moderate risk of debt distress). Thirty percent of the FY06 total allocation was provided in the form of grants. Proposed revisions to the traffic light mechanism will be discussed by IDA Deputies at the IDA-14 mid-term review at end-2006; it is expected that the revisions will integrate the forward-looking aspects of DSAs more closely with the grant allocation mechanism.

10. A more finely calibrated set of ratings would enable IDA and others to better tailor their response in terms of grant eligibility, in particular for borderline cases. The current standardized ranking into four categories (low, moderate, high, and "in distress") may not allow for sufficiently calibrated risk assessments. For example, further refinement of the debt distress classification within the "moderate" risk category could be made, depending on how many of the debt stock indicators breach the indicative thresholds under stress tests and by what margin.

B. Application of the DSF

11. Bank and Fund staff teams conducting DSAs were interviewed to obtain feedback on the usefulness of the DSF and the modalities for its implementation.

Country teams reported that templates and guidelines are relatively easy to use. Nonetheless, the preparation of DSAs entailed substantial resources; Bank and Fund teams needed on average about three staff weeks to complete a DSA. Resource requirements varied substantially across teams (from half a week to five weeks), depending in particular on whether a DSA had been carried out the previous year. Country teams did not encounter significant technical problems with the templates, but they did suggest areas for improvement and further guidance, in particular on customization to country circumstances.

12. The depth of analysis varied widely, with gradual improvement over time.

Almost all DSAs contained at least a short description of the underlying macroeconomic assumptions, a discussion of the baseline and stress test scenarios, and an assessment of the risk of debt distress. Many DSAs provided additional background on debt developments, greater transparency of underlying assumptions, and a nuanced debt sustainability assessment. An overview of emerging good practices is presented in Box 2.

13. Macroeconomic projections were generally linked to past economic performance. GDP growth projections commonly relied on trend analyses—which helps ensure consistency with past experience—and a sectoral decomposition to incorporate sectorspecific knowledge. A similar approach was used for other key macroeconomic variables. In addition, teams used macroeconomic accounting and programming frameworks to maintain overall consistency. However, behavioral relationships within the macroeconomic framework—for example, the effect of structural reforms on growth—were often loosely specified. This reflects still limited knowledge on economic linkages, as well as a lack of data to quantify such relationships.¹⁴

14. Baseline projections tended to be more favorable than historical averages— reflected in consistently lower debt-burden indicators—and it remains important to guard against excessive optimism.¹⁵ Improvements in the growth and balance-of-payment outlook reflected mostly the expected impact of structural reforms or emergence from conflict (Solomon Islands, Burundi, and the Central African Republic). For the joint DSAs, the median for projected real GDP growth in 2005-25 was about 5 percent, about 1 percentage point higher than the historical average growth rate over the past ten years. The median for the projected non-interest current account deficit, adjusted for net FDI inflows, was about 1 percent of GDP lower than the historical average, yielding lower financing needs under the baseline. These more favorable projections generally did not make a substantial difference to the debt distress rating. Only in three cases (Burkina Faso, Mali, and Uganda) would substituting the historical scenario for the baseline lead to an adverse change in this rating, because of the effects on the historical scenario of past sharp, but temporary, declines of commodity export volumes and prices. DSAs for which the latter scenario was available. Under the historical scenario—a standard element of the DSA—debt dynamics are simulated with key macroeconomic variables, in particular growth and balance-of-payments variables, at their historical average throughout the projection period.

15. Most joint DSAs included customized scenarios or stress tests to capture sensitivities to various risks (Table 2). For example, recent DSAs for MDRI-eligible countries explored the impact of MDRI relief explicitly in an alternative scenario. Staff teams pointed out that in about half of the DSAs the additional scenarios and stress tests were useful or crucial in qualifying the conclusions of the baseline.

Table 2.

Alternative Joint DSA Scenarios and Stress Tests in 2005 and Early 2006

Source: Bank and Fund staffs.

Table 2.

Alternative Joint DSA Scenarios and Stress Tests in 2005 and Early 2006

Country	Alternative Scenario or Stress Test (latter only if indicated)
Burkina Faso	Lower projected revenues
Central African Republic	Full traditional debt relief
Djibouti	Reduction in flows of income from foreign military bases (stress test)
Dominica	(i) Financing projected debt of social security by direct transfers from central
	government; (ii) Adverse changes in interest rates on public debt;
	(iii) Natural disaster (stress test)
Guinea	(i) MDRI; (ii) No reform scenario
Guyana	(i) MDRI; (ii) Lower revenue-to-GDP ratio
Lesotho	Loss of trade preferences (lower export ratio)
Mali	MDRI
Mauritania	Permanent decline in oil prices
Mongolia	Terms of trade shocks on copper and gold exports in 2008 and lower export
	growth thereafter
Nicaragua	MDRI
Niger	(i) MDRI, (ii) Grant element of 50 percent
Rwanda	Reduction of the grant component in gross central government financing
	from 83 to 55 percent
Solomon Islands	Realization of half of contingent liabilities as external debt
Tajikistan	(i) MDRI; (ii) Historical scenario is modified to exclude civil war
Uganda	(i) MDRI; (ii) Financing Bujagali hydropower plant on commercial terms
Vietnam	Two banking sector reforms scenarios
Zambia	(i) MDRI; (ii) Additional borrowing for public sector investment

Source: Bank and Fund staffs.

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Table 2.

Alternative Joint DSA Scenarios and Stress Tests in 2005 and Early 2006

Country	Alternative Scenario or Stress Test (latter only if indicated)
Burkina Faso	Lower projected revenues
Central African Republic	Full traditional debt relief
Djibouti	Reduction in flows of income from foreign military bases (stress test)
Dominica	(i) Financing projected debt of social security by direct transfers from central
	government; (ii) Adverse changes in interest rates on public debt;
	(iii) Natural disaster (stress test)
Guinea	(i) MDRI; (ii) No reform scenario
Guyana	(i) MDRI; (ii) Lower revenue-to-GDP ratio
Lesotho	Loss of trade preferences (lower export ratio)
Mali	MDRI
Mauritania	Permanent decline in oil prices
Mongolia	Terms of trade shocks on copper and gold exports in 2008 and lower export
	growth thereafter
Nicaragua	MDRI
Niger	(i) MDRI, (ii) Grant element of 50 percent
Rwanda	Reduction of the grant component in gross central government financing
	from 83 to 55 percent
Solomon Islands	Realization of half of contingent liabilities as external debt
Tajikistan	(i) MDRI; (ii) Historical scenario is modified to exclude civil war
Uganda	(i) MDRI; (ii) Financing Bujagali hydropower plant on commercial terms
Vietnam	Two banking sector reforms scenarios
Zambia	(i) MDRI; (ii) Additional borrowing for public sector investment

Source: Bank and Fund staffs.

16. There is scope for some technical improvements to the template with respect to stress tests. Several teams suggested that the standard stress tests could be enhanced by allowing for general equilibrium effects or permanent rather than short-lived shocks. Given the partial nature of the stress tests, teams have instead used alternative scenarios to capture the impact of possible simultaneous shocks of a range of variables that affect debt indicators.

17. In determining the risk of debt distress, teams struck a balance between a mechanistic and a judgmental approach. Under a mechanistic approach, the risk of debt distress rating would be based solely on whether debt-burden indicators in the baseline or stress test scenarios breach the thresholds. In six of the joint DSAs, the debt ratios were either so high or so low that the debt distress rating was obvious. In the remaining cases, staff's conclusions coincided in eight cases with those suggested by the mechanistic approach, compared with six cases where staff came to a more favorable assessment. In the latter cases, staff judged that a mechanistic approach would have implied an unreasonably negative rating, taking into account, in particular, that breaches of thresholds were marginal or that debt ratios improved over the long term or would do so after further debt relief, or that the strong payment record of the authorities made a default unlikely. Nevertheless, in many cases, staff also noted downside risks, including vulnerabilities resulting from a narrow export base, risks to the macroeconomic outlook, the size of domestic debt, and contingent liabilities. In no case did staff judgments produce a less favorable rating.

18. In several countries, domestic debt issues were essential for a full assessment.¹⁶

In the sample of 23 joint DSAs, 14 contained a public debt DSA. In seven of the nine remaining cases, domestic debt was negligible; in two, lack of data prevented analysis. Issues related to poor data quality and non-comparability of data across countries continued to plague the analyses. High domestic debt was a factor in the overall risk of debt distress in seven countries (Box 3 provides an example). However, as public debt indicators generally confirmed the assessment based on the external debt burden, this did not actually change the risk rating. In the absence of pre-defined thresholds, public debt DSAs typically focused on trends in public debt ratios, vulnerability to shocks, level of debt service payments, and gross financing requirements.

19. A further issue has been that domestic obligations are difficult to integrate into a threshold approach that aims to provide signals to donors (including IDA) on the appropriate level of concessionality. Raising concessionality even partially on the basis of domestic borrowing, which is largely under domestic control, would entail moral hazard problems by creating incentives to overborrow. The resulting tension was most apparent in the assessment of Vietnam (see Box 3). In order to ensure that the distress rating reflects an assessment of all relevant debt, DSAs should specifically flag cases in which the rating would be different on the basis of external debt only. In addition, future work could usefully focus on the development of a more integrated approach toward analyzing domestic and external debt in the sustainability framework.¹⁷

20. The survey of country teams suggests that DSAs were useful to the authorities in a number of cases as they raised awareness about debt issues. ¹⁸ The results were usually discussed with the authorities, in particular in countries with a high risk of debt distress or ahead of a debt rescheduling. Some teams shared the templates with government officials; the authorities were involved in the preparation of the DSAs only in a few cases. In 2005, the Bank organized workshops in Africa to train government officials on the framework; further workshops are planned in Latin America and South Asia in 2006. Capacity building efforts continue so that authorities will be in a position to carry out their own DSAs.

C. Usefulness to Other Donors and Creditors

21. Multilateral Development Banks (MDBs) have found DSAs to be useful for informing their judgments about debt risk in client countries. Like IDA, the AfDB uses debt sustainability as the sole basis for grant allocation. The two institutions work closely to align their debt distress risk classifications for their 40 common client countries. The Asian Development Bank (AsDB) has indicated that it could adopt the assessments as the basis for future grant allocations. The Inter-American Development Bank uses the framework as an analytical tool to supplement its own assessment of debt/fiscal sustainability. While these MDBs appear to be comfortable with the Bank and Fund preparing the DSAs, they are also keen to be more closely involved in their preparation, particularly for countries where they have large exposures. Other MDBs appear to value clear guidance from the DSAs about the level of concessionality appropriate in particular countries. All MDBs would appreciate prompt publication of DSAs and sharing of templates and other underlying information.

22. Most bilateral creditors make limited use of DSAs but wanted more information.¹⁹ Creditors asked for the provision of more information on the framework as well as on the projections (in particular on new borrowing)—which would allow the DSAs to play a more central role in guiding lending decisions. Creditors would also welcome easier access to the DSAs (e.g., as stand-alone documents readily located on the Fund and Bank websites).

23. A number of NGOs have taken a critical view of the DSF.²⁰ While acknowledging that some features in this framework are improvements relative to DSAs conducted under the HIPC Initiative, they consider that the framework should have been geared to informing debt-relief decisions with the objective of supporting attainment of the MDGs. Some NGOs have also argued that such analyses should be done by an independent body rather than by the Bank and Fund—both large lenders to low-income countries.

D. Bank-Fund Collaboration

24. According to most Fund and Bank staff, Bank-Fund collaboration has led to some improvement in the quality of DSAs, without large resource implications in most cases. On average, Fund staff indicated that collaboration required 16 additional staff hours (with additional discussions more than offsetting the time saved on data collection). The division of labor was broadly in line with the established guidelines, with Fund staff taking the lead in developing the macroeconomic projections and Bank staff providing input on long-term growth projections. Bank staff also provided reconciled multilateral debt data, debt-relief simulations and, in many cases, input on financing assumptions.

25. Interviews with Bank and Fund staff confirmed that the preparation of joint DSAs by Bank and Fund staff has generally been smooth. Disagreements on assumptions and risk assessments were often minor and, in almost all cases, could be resolved within the teams. However, for a few DSAs a compromise could be reached only after extensive deliberations, although the disputes never had to be elevated to management level. In only one case, the Fund team considered that the compromise led to a change from their initial assessment. With few exceptions, Fund staff considered that collaboration did not result in a significant change in the short-run macroeconomic projections; Bank staff considered that there was effective collaboration among the teams in developing a common baseline scenario. In a few cases, the appropriate scope of the DSA write-up was a source of disagreement, with Fund staff preferring brevity and avoidance of overlap with the accompanying staff report, whereas at the Bank the DSA was to be circulated as a self-standing document in line with the DSF's implementation modalities approved by the two Boards.²¹

26. The timing of the joint DSAs was often determined by the Fund’s needs which in several cases proved problematic for Bank staff. DSAs are required by the Fund in the context of the Article IV consultations or the request for a new arrangement; by the Bank for a new Country Assistance Strategy or major lending operations. Problems arose with respect to reconciling diverging DSA timing requirements and matching the Bank staffs’ work schedules to pressing Fund deadlines. To some degree, such problems should be alleviated in the future as both country teams are expected to agree on a schedule for the preparation ofthe DSA for each calendar year—a setup that was not always followed in 2005 because the modalities for collaboration were not disseminated until May. Nevertheless, because timetables for country operations remain somewhat unpredictable, some tension will likely remain unavoidable, necessitating flexibility on both sides.

A. Indicative Debt Thresholds in Light of the MDRI

31. One reaction to the additional borrowing space provided by the MDRI could be to lower the indicative debt thresholds under the DSF. This section examines the costs and benefits of doing this.

32. The thresholds chosen for the low-income country DSF reflect the risk of debt distress, the potential development opportunities forgone from applying tighter constraints on new borrowing, and a realistic assessment of the resources available for development. The Fund and Bank Boards adopted a solution that balanced the preference for cautious thresholds with the desire to economize on scarce grant resources and ensure consistency with the HIPC Initiative.²⁶

33. Further debt relief to HIPCs under the MDRI may signal a reduction in tolerance on the part of the international community for debt in low-income countries.

Lower thresholds would be a reflection of such a shift in the balance embedded in the previous Board decisions on the DSF.

34. Lowering the DSF debt thresholds would limit the risk that MDRI recipients would reaccumulate excessive debt. These thresholds are indicative limits, not targets. However, there is a tendency built in to the system for debt levels to converge to the thresholds over time. This is because donors, particularly IDA, tend to provide a higher proportion of loans to countries with debt levels well below the thresholds and provide more grants to countries near or above the thresholds.

35. However, any adjustments to the thresholds should be undertaken with full recognition of the implications. To the extent that additional grants are not forthcoming or are inadequate, lowering thresholds could risk depriving countries of financing. This would be inconsistent with one of the goals of the MDRI: to provide additional resources for MDG achievement.²⁷ Non-MDRI countries in particular would need additional grants to avoid a sharp reduction in aid flows. This would be costly for donors, including IDA, and these countries’ access to other loan financing and hence overall financing would risk being curtailed. If, for example, the thresholds relating to the ratio of the net present value of debt-to-exports were to be lowered by 50 percentage points (to 50, 100, and 150 percent for low, medium, and high CPIA countries respectively), then the grant share of IDA would rise from an estimated 30 percent to an estimated 42 percent. There will be additional considerations depending on how the lower thresholds were to be applied:

• Lowering debt thresholds for all countries could reopen the question of HIPC eligibility. Lower thresholds would imply that the HIPC debt sustainability thresholds were too high, suggesting a need to broaden the HIPC Initiative, and presumably the MDRI as well, which could substantially increase the cost of the HIPC Initiative.

• Lowering debt thresholds for the MDRI countries alone would raise questions of uniformity of treatment. It would be hard to rationalize treating MDRI recipients differently for reasons not grounded in current and expected future economic circumstances.

36. There is reason to believe that the MDRI will not lead to an unwarranted increase in IDA lending, mitigating the need for lower thresholds. In itself, the reduction in the risk of debt distress as a result of MDRI relief would lead to an increased loan allocation to MDRI countries, but this is partially offset by the likely transition from the current traffic light system to the forward-looking joint DSA assessments, which tend to be somewhat more conservative than the static assessments under the traffic light system. Overall, a large shift in the loan/grant mix for MDRI countries seems unlikely (Box 4) although this will depend on the precise form of modifications to the present IDA allocation system, to be decided later in the year.

37. on balance, then, the case for lowering thresholds now is not compelling. Lower thresholds may help limit the risks of a rapid reaccumulation of debt, but, in the absence of a sharp increase in grant availability, they would also impede resource flows, thereby undermining a primary objective of the MDRI, and could reopen the question of HIPC thresholds.

B. Debt Accumulation Below the Thresholds

38. When a country’s debt burden is below the indicative thresholds, a key question is how fast debt should accumulate. Experience so far with the DSF provides few insights on handling the accumulation of debt from low levels, though some lessons can be drawn from historical episodes of debt accumulation (Box 5). Theoretically, this question could be answered by appealing to such variables as the rate of return on investment, absorptive capacity, the terms on available financing, the international environment, and the quality of policies and institutions of the country—in short, virtually the entire range of micro- and macroeconomic factors governing growth and stability. Practically, in the absence of perfect information on all the linkages and constraints, the determination of an appropriate debt trajectory could be answered in two ways: a one-size-fits-all rule that restricts new borrowing at a pre-determined rate; or a country-specific case-by-case approach that takes into account the unique circumstances of each country and the prevailing binding constraints to growth. Each has its advantages and disadvantages.

Rules

39. The advantage of a rule-based approach to constraining the debt trajectory is that it would set clear limits on debt accumulation. The imposition of rules could help guard against overoptimism regarding the beneficial effects of additional spending, especially in the face of uncertainty about the impact of aid. Recognizing the heterogeneity in country circumstances, the allowable rate of debt accumulation could perhaps depend, for example, on the CPIA or other variables capturing important determinants of the appropriate rate of debt accumulation, thus allowing for some country-specific variation. Exceptions could be allowed in cases where it is possible to justify convincingly that borrowing should be more than the rule would imply.

Box 4:

Will MDRI relief lead to an increase in IDA lending?

The reduction in the risk of debt distress as a result of MDRI relief raises the prospect that IDA will switch from grants to loans in MDRI countries, leading to a quick reaccumulation of debt. While the grant-loan mix of IDA financing is ultimately the decision of IDA, this Box uses illustrative simulations to examine whether IDA lending could increase significantly post MDRI.

The IDA grant allocation will be affected in the next few years not only by the MDRI, but also by a transition from the current IDA traffic light system, which is essentially a static assessment based on the latest available debt indicators, to a more dynamic assessment based on the joint DSAs. Box Table 1 simulates potential post-MDRI risk ratings for twelve MDRI countries based on the projected evolution of debt indicators over 2006-25 and compares these with the actual IDA ratings that were assigned during FY06.¹

The actual IDA ratings for FY06 were based on end-2004 debt data. These were fairly conservative to begin with, in so far as the actual IDA traffic light ratings took the results of available forward-looking DSAs into account, and, in other cases, the actual ratings were based on debt indicators using the HIPC methodology, which tend to lead to higher debt ratios than the LIC DSA methodology.

When compared with risk ratings that could emanate from forward-looking DSAs (as indicated by the simulations), it appears that on balance, dynamic assessments, even incorporating debt relief under the MDRI, would not result in a large increase in IDA grants. The table indicates that while all almost all countries could be rated at high or moderate risks in a pre-MDRI scenario, only four could be rated as low risks in a post-MDRI scenario, thereby qualifying for 100 percent loan financing. Overall, the share of loans in IDA allocations is unlikely to increase significantly simply due to the impact of MDRI relief on recipient countries’ debt burdens.

Table 1:

Actual IDA risk ratings and simulations based on data projections, pre- and post-MDRI

^1/From the IDA traffic light system.

^2/Simulations of dynamic risk of debt distress ratings based on the DSA and projections of debt indicators over 2006-25.

Table 1:

Actual IDA risk ratings and simulations based on data projections, pre- and post-MDRI

	Actual	Simulations
	IDA Ratings 1/	Dynamic Risk Ratings 2/
	FY 2006 (pre-MDRI)	Pre-MDRI	Post-MDRI
Burkina Faso	low	high	moderate
Ethiopia	moderate	moderate	moderate
Guyana	high	high	high
Mali	low	high	moderate
Nicaragua	low	high	moderate
Niger	low	high	moderate
Mozambique	low	low	low
Rwanda	high	high	moderate
Tajikistan	high	moderate	moderate
Tanzania	low	moderate	low
uganda	moderate	moderate	low
Zambia	moderate	moderate	low

^1/From the IDA traffic light system.

^2/Simulations of dynamic risk of debt distress ratings based on the DSA and projections of debt indicators over 2006-25.

View Table

Table 1:

Actual IDA risk ratings and simulations based on data projections, pre- and post-MDRI

	Actual	Simulations
	IDA Ratings 1/	Dynamic Risk Ratings 2/
	FY 2006 (pre-MDRI)	Pre-MDRI	Post-MDRI
Burkina Faso	low	high	moderate
Ethiopia	moderate	moderate	moderate
Guyana	high	high	high
Mali	low	high	moderate
Nicaragua	low	high	moderate
Niger	low	high	moderate
Mozambique	low	low	low
Rwanda	high	high	moderate
Tajikistan	high	moderate	moderate
Tanzania	low	moderate	low
uganda	moderate	moderate	low
Zambia	moderate	moderate	low

^1/From the IDA traffic light system.

^2/Simulations of dynamic risk of debt distress ratings based on the DSA and projections of debt indicators over 2006-25.

^1/ The dynamic simulations rate countries based on whether the CPIA-determined thresholds are breached by stress test and baseline projections (high risk), by stress test projections only (moderate risk), or no breaches occur (low risk).The simulations are entirely mechanical and do not take into account the role of staff judgment in determining the final risk classification in joint DSAs. Examples for the use of judgment in joint DSAs are Burkina Faso, Mali, and Zambia, which are rated in the mechanical simulations as high (Burkina Faso, Mali) and moderate risk (Zambia), whereas the joint DSAs rate them at moderate (Burkina Faso, Mali) and low risk (Zambia) even pre-MDRI, reflecting inter alia staffs’ judgment that thresholds breaches are only marginal or temporary. Guyana is rated in the mechanical simulations at high risk on account of a high NPV of debt-to-GDP ratio, whereas the joint DSA comes to a moderate risk assessment (post MDRI), reflecting staffs’ judgment that the information content of this indicator is limited as a result of measurement problems.

Box 5:

External Debt Sustainability in the CIS-5

The CIS-5 countries experienced a sharp increase in their debts in the early years of transition. The CIS-5 (Armenia, Georgia, Kyrgyz Republic, Moldova, and Tajikistan) had virtually no debt following the breakup of the Soviet Union; yet by 1995, the average NPV of debt-exports ratio had reached 106 percent.¹ Debt accumulated rapidly in some cases, but the early sharp rise in debt ratios was also due in large part to the three-year consecutive output contraction in 199193, with real GDP in the CIS-5 declining by an average 58 percent (this is based on the evolution of nominal debt and cannot be directly compared to the NPV ratios highlighted in footnote 29).

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CIS-5 NPV of Debt-to-Exports Ratio, 1992-2003

Citation: Policy Papers 2006, 013; 10.5089/9781498332828.007.A001

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Following the initial surge in debt ratios, performance varied widely within the region. Where output and exports grew faster (Armenia and Tajikistan), debt sustainability was attained. Slow reform in Georgia and Moldova constrained growth and limited access to concessional finance and debt relief (Georgia was nonetheless able to bring its ratios down; Moldova is currently seeking Paris Club treatment). In contrast, weak growth and revenue performance and rapid accumulation of debt in the Kyrgyz Republic took the country above the HIPC fiscal thresholds. Flow relief by the Paris Club (Georgia, in 2001, and the Kyrgyz Republic, in 2002 and 2005) helped stabilize debt indicators but failed to address effectively the mounting solvency problems in the Kyrgyz Republic. Both Armenia (2003) and Tajikistan (2002) sought and received debt treatment from Russia.

What accounts for the cross-country patterns in the change in the NPV of debt-to-GDP ratios between 1993 and 2003? Just under 50 percent of the variation across countries is explained by differences in net debt accumulation (in NPV terms). Differences in real growth explain about 30 percent of variation, with the remainder explained by real exchange rate movements and other factors. Debt relief has (so far) contributed little in reducing debt shares. The CIS-5 countries were generally able to stem and in some cases reduce their debt problems in the framework of Fund arrangements (Moldova and the Kyrgyz Republic since 1993, Armenia since 1994, and Georgia and Tajikistan since 1996).^2/ Early overly optimistic staff projections illustrate the difficulty in forecasting the right mix of adjustment and financing for countries facing large macroeconomic imbalances as well as shocks such as rapid rises in energy prices and the Russia crisis of 1998. The loans used to fill the large financing gaps reflected an expectation of rapid productivity gains, which in the fact did not materialize fast enough (Helbling, Mody, and Sahay 2004). More recent experience in predicting economic performance in the CIS-5 does not show a systematic bias toward overly optimistic growth and exports projections (for example Armenia has far exceeded growth and export expectations in recent years).

^1/ See for example IMF and World Bank, Armenia, Georgia, Kyrgyz Republic, Moldova, and Tajikistan: External Debt and Fiscal Sustainability February 6, 2001. ^2/ Moldova has not had an active Fund arrangement since 2001 .

40. It is difficult, however, to find a rule for the rate of debt accumulation that has any empirical basis. There are two reasons why the rate of debt accumulation may be an important indicator of the risk of debt distress. First, it may indicate that the country was investing too fast, perhaps exceeding absorptive capacity. Second, it may be difficult to slow down the rate of debt accumulation, so that rapid debt growth now signals high levels of debt down the road. No evidence was found for either proposition, however, using the same regression framework that was used to derive the current debt sustainability thresholds.²⁸

41. As important, there are two reasons why a rules-based approach would provide only a partial guard against overoptimistic assumptions. First, debt distress is usually the product of disappointing growth outcomes, not only overborrowing. Shocks to growth and exports explain more variance in debt ratios than borrowing.²⁹ And second, a rule that is not based on strong empirical foundations cannot be defended or justified. This would be particularly detrimental if staff were to be seen to reject projects with strong chances for success because of adherence to an arbitrary rule.³⁰

Country-specific case-by-case approach

42. By taking country-specific information into account, staff and the authorities could tailor new spending and borrowing plans to the country’s specific circumstances

without being hampered by an arbitrary rule. This would be particularly helpful in countries where absorptive or debt-servicing capacity is not a binding constraint or can rise rapidly in response to scaling up expenditures. A rule-based approach would prescribe a gradual increase in expenditures and such opportunities would be lost.³¹

43. A case-by-case approach acknowledges the complexities of assessing the appropriate pace of spending and debt accumulation. A well-founded view would depend on a thorough understanding of individual sectors and a careful assessment of macroeconomic and growth impacts. Key issues include: the rate of return on expenditures; the long-term effect of borrowing and expenditures on fiscal sustainability; the capacity to mobilize domestic revenues with reasonable efficiency; the implications of aid volatility; and the impact of exogenous shocks more generally.

44. These issues are increasingly analyzed by Bank and Fund staffs in their ongoing country work. MDRI relief and pursuit of the MDGs raises the prospect of sharp increases in spending and borrowing, which puts a premium on more rigorous analysis, particularly on the implications of scaling up for growth and, more generally, on a closer connection between DSAs and countries’ development strategies.³² The assessment of absorptive capacity and quantifying the linkages between spending plans and key macroeconomic variables (such as growth and the real exchange rate) pose serious challenges. Progress has been made in recent years, but practical guidance is needed to help staff come to informed judgments.³³

45. The DSF is a powerful tool to deal with debt sustainability in MDRI countries.

Its forward-looking nature helps capture the risks associated with borrowing after debt relief. In some cases, the DSA could also help to detect unrealistic assumptions in key areas. For example, the general presumption would be that absorptive capacity increases gradually, leading to a smooth path for expenditures and new borrowing. There may be arguments in individual countries for an abrupt scaling up (or eventually down) of expenditures, but the onus would be on the team to make this case. Thus, sharp kinks in productivity growth rates, spending and revenue trajectories, or financing assumptions would need to be justified in ways that can support assessment and monitoring.³⁴

46. closer attention to actual outcomes compared with past DSAs should provide additional assurance that rapid and unsustainable accumulation of debt can be identified and corrected. As a standard component of the DSA exercise, it would be incumbent to review outcomes relative to the projections of previous DSAs to identify where and why deviations emerged. A pattern of over-optimism would imply a need for greater caution in subsequent DSAs and/or adjustments to the financing mix or the fiscal trajectory. Likewise, growth pessimism should also be guarded against. The more specific the assumptions that underlie the DSA, the more useful will be this monitoring. For example, where the growth scenario depends on a sharp increase in agricultural productivity, monitoring could focus on whether expected policy reforms, investments, and productivity improvements in agriculture did indeed materialize as expected.

47. on balance, a case-by-case approach looks to be preferable to rules. While a standardized rule for debt accrual could provide a shortcut in the face of the myriad uncertainties in determining an optimal path of debt accumulation, any rule is likely to produce many inappropriate results, given country heterogeneity. Thus it is likely that any rule will impose numerous unjustifiable restrictions or will be honored only in the breach. In the end, there will be no tenable alternative to Bank and Fund staff having an informed view on the appropriate rate of debt accumulation consistent with the sustainability thresholds in particular country circumstances.

48. Of course, ultimately it is the responsibility of the countries themselves to prevent a renewed build up of unsustainable debt. Debtor countries will need to continue developing their capacity to evaluate the returns on borrowing, centralize approval and accounting mechanisms, and plan external financing using the budget and PRSP processes. Improving debt management capacity and enhancing transparency in debt management operations will be key aspects in this regard.³⁵ Similarly, creditors need to coordinate better and make more predictable the provision of external financing.

C. The DSF and the "Free Rider" Problem

49. The prospect of increased market access for MDRI recipients has raised the issue of "free riding." In the IDA context, this has come to refer to situations in which

"nonconcessional lenders indirectly obtain financial gain from IDA’s debt forgiveness, grants and concessional financing activities without paying for it."³⁶ Sharply lower debt burdens in MDRI countries create the potential for new borrowing from market and other nonconcessional sources. While such borrowing has so far been common mostly in resource-rich low-income countries, this may change with implementation of MDRI given the likely upgrades to sovereign credit risk (Box 6). Where the supply of concessional finance does not meet recipient countries’ financing needs, nonconcessional borrowing has the potential to allow projects with high rates of return to be financed that might not otherwise be possible. There are potential problems, however. First, an incentive to overborrow may result from IDA’s willingness to give increasing quantities of grants to countries with more debt. Second, nonconcessional lenders may be willing to finance even unproductive investments, secure in the knowledge that, with MDRI relief and the prospect of future IDA grants, the country could cover the debt service. The problem is most serious when there is the potential for renewed risk of debt distress. Signaling such risks is a key role of the DSF.

Box 6:

Composition of Financing Flows to Low-Income Countries I

Following the rapid debt accumulation during 1980-94 creditors recognized that the provision of aid largely in form of loans had led to excessive debt burdens in many low-income (IDA-only) countries. ^1/ Grants and multilateral concessional loans have since become the only source of financing for most IDA-only countries. Bilateral support has increasingly taken the form of grants. At the same time, as new multilateral loans became more concessional, leading to a rise in the average grant element, overall multilateral net debt flows declined. The overall decline in official debt flows combined with the decline in total official resource flows (official loans and grants) suggests that past borrowing was leveraging scarce donor resources.^2/

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Composition of Financing Flows to IDA-Only Countries

(in billions of U.S. dollars)

Citation: Policy Papers 2006, 013; 10.5089/9781498332828.007.A001

Source: World Bank Global Development Finance.

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Private net debt flows to low-income countries have declined from already low levels since the mid-1980s. Private debt flows are to a large degree related to natural resource-based economies; for example at end-2003, 63 percent of Angola’s external PPG debt was private. Of the total stock of public and publicly guaranteed debt owed by PRGF-eligible countries to private creditors at end-2003, almost 73 percent was owed by IDA blend countries, 88 percent of which was owed by India. Likewise, export credit flows to low-income countries declined since the mid-1980s and played only a minor role in most HIPCs.

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Private Debt Flows to IDA-Only Countries

(in billions of U.S. dollars)

Citation: Policy Papers 2006, 013; 10.5089/9781498332828.007.A001

Source: World Bank Global Development Finance.

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^1/While the literature on the debt overhang was originally developed in the context of middle-income countries, it has been increasingly applied to low-income countries (see Debt Sustainability in Low-Income Countries—Proposal for an Operational Framework and Policy Implications. A few prominent examples are: Cohen and Sachs (1986); Krugman (1988); Sachs (1989); Cline (1995); Agenor and Montiel (1996); and Sarel (1997). For a summary of the literature, see Pattillo (2002), as well as Loko and others (2003). ^2/ Net IDA flows on average more than doubled from the early 1980s to the post HIPC period. As a result, during 1998-2003, net IDA flows accounted for 77 percent of net multilateral flows (including the IMF) and 70 percent of net concessional flows.

50. There are a number of ways to deal with the risk of excessive nonconcessional borrowing, but complete protection will be difficult to achieve.³⁷ If feasible, a common creditor approach towards concessionality by all creditors, based on a broader acceptance of the DSA, might be most effective. In countries with access to commercial finance, however, a consensus on the appropriate degree of concessionality and lending volumes may be difficult to achieve. A less preferable approach would be if a subset of donors, such as IDA, were to reduce volumes to countries that borrow excessively on commercial terms. But this would not stop countries from making up the difference through commercial borrowing. In any case, critical components of a response should include: improved tracking and analysis of nonconcessional borrowing; strengthened debt management capacity in low-income countries; and transparent indication in the DSF that nonconcessional borrowing is unwise in instances where it imperils the recipient country’s debt sustainability.

51. For low-income countries that face serious public expenditure management or debt distress challenges, avoiding nonconcessional borrowing altogether would likely remain appropriate. In Fund programs this would translate into a zero limit on nonconcessional borrowing.³⁸ Exemptions should continue to be possible where a case can be made to support nonconcessional borrowing for a financially viable project that would not otherwise be undertaken (Box 7). Because in practice obtaining an appropriate assessment of a project’s expected rate of return is difficult, cases where the lender would share the risk (through, for example, providing some equity-like finance as well as debt) could be presumptively more suitable for exemptions.

52. It may be worth considering whether uniform application of the zero ceiling on nonconcessional borrowing makes sense in more developed and better-governed countries at low risk of debt distress. As countries reduce their debt burdens and improve public expenditure and debt management capacity, the case for such strict limits weakens. In these situations, a DSA indicating a low risk of debt distress might imply that there is no critical need for a zero limit on nonconcessional borrowing.

53. For countries without a Fund arrangement or a PSI, but where debt distress is a serious concern, the Fund would offer advice on appropriate concessionality in the context of Fund surveillance. Determining the appropriate concessionality level of public borrowing as an input to the assessment of the outlook for macroeconomic stability clearly falls within the Fund’s surveillance mandate. However, while surveillance can address inappropriate nonconcessional borrowing from the point of view of overall debt sustainability, it would not be appropriate for the Fund under its surveillance mandate to require members to provide loan-by-loan data with a view to characterizing creditors as "free riders" on concessional debt or grants.

A. Refinements to the DSF on the Basis of Experience

55. Early experience with the joint Bank-Fund low-income country DSF has been broadly encouraging. The standardized analysis and tests, and the use of indicative debt burden thresholds that depend on the quality of a country’s policies and institutions, have enhanced the quality and comparability of assessments. Most DSAs have been customized on the basis of country-specific features and risks, and—as intended—the thresholds have been used as guideposts rather than as rigid ceilings. Generally, projections do not appear overly optimistic when compared to past performance. The development of joint Bank-Fund DSAs has not entailed serious operational problems.

56. The review provides a basis for a range of further steps to enhance the usefulness of the joint DSAs:

• Technical improvements to the template. For example, there is scope to address the partial nature of the standardized stress tests.

• DSA ratings. Additional calibration within the medium risk category could be introduced, to allow a more nuanced response on grant eligibility by creditors, such as IDA.

• Domestic debt. Future work should focus on the development of an approach that integrates the analysis of domestic and external debt. In parallel, work could be done to define guidelines for staff on how to advise the authorities on domestic debt issues from the perspective of overall debt sustainability.

• Public spending and debt sustainability. Improving our understanding of the relationship between public expenditures and growth remains a serious challenge. Assessing debt risk will involve greater attention to the quantity and quality of public spending, returns to investment, absorptive capacity, and the macroeconomic impact of aid inflows and will thus require close Bank-Fund collaboration.

• Design of Fund programs. In countries with a moderate or higher risk of debt distress, there is scope for more use of tailored conditionality on total or external (concessional) government borrowing or on the NPV of external debt.

• Process and presentation. Bank and Fund country teams should agree early on the timing and scope of the DSA as well as the division of labor. DSAs will be written as stand-alone documents. Accordingly, they should offer the background and analysis of the risk of debt distress. The usefulness of the DSAs for other creditors and stakeholders could be supported through additional outreach activities, including the dissemination of more detailed information on the debt data and the assumptions underlying the projections.

57. Do Directors agree that:

• The DSF framework remains broadly appropriate and that major changes are not warranted for the moment?

• There is scope to provide a more finely calibrated set of ratings and that the staffs should elaborate an approach along the lines discussed in paragraph 10, to be issued to the Boards as a paper for information (and discussion if requested) and for use in preparing a proposal for IDA Deputies on operationalizing the forward-looking aspects of the DSA?

• Staff should work to integrate domestic debt better in the framework and undertake further analytical work on domestic debt, debt management and on the relationship between fiscal expenditures and growth?

• DSA risk assessments should incorporate domestic debt where it is significant but should also specifically flag cases in which the rating would be different on the basis of external debt only, thereby accommodating IDA requirements?

B. Issues to Consider in the Context of MDRI

58. The MDRI lowers debt burdens and raises borrowing space substantially for many countries. This creates the potential for substantial scaling up, including through nonconcessional financing. In view of the profound needs these countries face, there will be the temptation to exploit these opportunities to the fullest, even when experience suggests a clear risk of a return to excessive indebtedness and eventually debt distress.

59. On balance, staff does not recommend lowering the DSF debt thresholds for now. It would be difficult to justify either applying different thresholds to the MDRI recipients or lowering thresholds for all low income countries. In addition this would reopen the question of the thresholds for HIPC eligibility.

60. The forward-looking DSF is a powerful tool to deal with debt sustainability in MDRI countries. More systematic comparisons of actual outcomes against past DSA projections could help evaluate the reasons behind deviations, gauge risks, and set future benchmarks.

61. Experience to date provides few insights on how the DSF should be applied to the reaccumulation of debt from low levels. There are two polar approaches: simple rules (such as a restriction on change in the NPV of debt), and country-specific case-by-case application of the DSF. On balance, a case-by-case approach appears preferable, particularly because a rule not based on strong empirical foundations cannot be justified and is a crude instrument in the face of varied country circumstances.

62. Minimizing the negative impact of "free-riding," and, more broadly, managing access to nonconcessional borrowing will be a challenge, particularly in countries that do not have Fund arrangements. Enhanced creditor cooperation will help, using the DSA as a vehicle for information and analysis. The Fund’s surveillance role will also remain crucial in such instances.

63. Do Directors agree that:

• Lowering the DSF threshold in light of the MDRI is not warranted, for now?

• On balance, a case-by-case approach would be appropriate as a basis for further work on providing guidance on debt reaccumulation?

• Nonconcessional borrowing presents great risks as well as opportunities, and that the approach to free-riding taken in the paper is appropriate?