Executive Summary

In April 2006, the Executive Boards of the Bank and the Fund reviewed the debt sustainability framework (DSF) for low-income countries (LICs) and the implications of the multilateral debt relief initiative (MDRI). Directors thought that the DSF was broadly appropriate and that no major changes were warranted, but saw scope for additional guidance on the application of the framework in a context where the apparent borrowing space created by debt relief raises new challenges in terms of policy advice. Most Directors supported a case-by-case approach for assessing the appropriate pace of debt accumulation in countries with debt below the DSF thresholds, but requested the development of specific recommendations on the implementation of such a case-by-case approach.

Debt relief has led to the perception of a large borrowing space in some LICs. Simultaneously, the emergence of new creditors and the rising importance of domestic debt have led to an expansion in the volume and sources of funds available to these countries. These developments, while welcome, raise new risks. To address them, this paper proposes to improve the rigor and quality of debt sustainability analyses (DSAs) as well as their effectiveness.

Improving Further the Quality and Rigor of DSAs

To ensure that the case-by-case approach provides a rigorous and consistent treatment of debt accumulation issues across countries while still taking into account country-specific circumstances, staffs propose:

• Guidance for designing more solid baseline macroeconomic and growth scenarios, taking into account the country's policy and institutional setting, the external environment, and the likelihood of external shocks—and in this context assessing the impact of increased borrowing to finance additional public expenditures.

• A reinforcement of the precautionary features already built into the DSF.

• A detailed review of macroeconomic assumptions (particularly relating to economic growth and borrowing) and policies when the pace of borrowing exceeds a certain threshold.

A key issue is whether a minimum level of concessionality remains appropriate for countries that have benefited from debt relief. Staffs argue that concessional flows remain the most appropriate source of external finance for LICs. However, consideration could be given—on a case-by-case basis—to nonconcessional finance depending on: (i) the impact on debt sustainability; (ii) the availability of concessional resources; and (iii) the overall strength of a debtor country's policies and institutions, as well as of the quality of the investment to be financed and of the overall public expenditure program.

The paper also explores two areas where the DSF could be enhanced: the rising importance of private external creditors and domestic debt.

• Private external creditors' interest in LICs' sovereign debt instruments, including domestic debt instruments, has increased. This could provide opportunities, but may also give rise to new vulnerabilities that need to be monitored carefully. In such cases, staffs suggest that additional vulnerability analyses focusing on short-term debt-related vulnerabilities could be used on a more systematic basis in conjunction with the DSF.

• Domestic debt clearly matters for the risk of debt distress. The integration of domestic debt into the DSF poses conceptual challenges, because domestic debt is different from external debt in several important dimensions. While there appears to be no simple way to incorporate domestic debt into the existing thresholds, staffs see scope, and make specific suggestions, for integrating domestic debt more systematically into the assessment of debt sustainability and the risk of external debt distress.

Towards More Effective DSAs: Fostering Use by Borrowers and Creditors

The effectiveness of the DSF ultimately depends on its broader use by debtors and creditors, including as a device for better communication and coordination between creditors and borrowers, and among creditors. The use of the DSF is expanding but is still limited. Further outreach by the staffs to all official creditors is needed, in particular towards emerging creditors. In addition, the link between DSA results, Bank and Fund policy advice, and, where relevant, program conditionality, should be further strengthened.

The paper also suggests how the DSF combined with capacity building in public debt management can help countries develop their own medium-term debt strategy (MTDS) in support of their development objectives, including the Millennium Development Goals, while containing risks of debt distress and macroeconomic vulnerability. The MTDS can also help in guiding creditors' decisions.

Finally, the Boards asked staffs to consider possible refinements to the existing scale of debt distress risk ratings, including subdividing the moderate risk category. Staffs believe that there is no need for revising the existing debt distress categories at this point, particularly because the incidence of moderate risk ratings has declined owing to MDRI relief and more conservative growth projections. Staffs suggest, however, using a three-year moving average Country Policy and Institutional Assessment (CPIA) score to determine the appropriate indicative threshold for debt distress, and thereby avoid undue volatility in the IDA grant share for a country.