Applying the Debt Sustainability Framework for Low-Income Countries Post Debt Relief

In April 2006, the Executive Boards of the Bank and the Fund reviewed the debt sustainability framework (DSF) for low-income countries and the implications of the multilateral debt relief initiative. 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.

Abstract

In April 2006, the Executive Boards of the Bank and the Fund reviewed the debt sustainability framework (DSF) for low-income countries and the implications of the multilateral debt relief initiative. 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.

I. Introduction1

1. In April 2006, the Executive Boards of the Fund and the Bank reviewed the debt sustainability framework (DSF) for low-income countries (LICs), which had been endorsed by the Boards in April 2005, as well as the implications of the multilateral debt relief initiative (MDRI).2' 3 Directors thought that the DSF was broadly appropriate and that no major changes were warranted, but asked for further consideration of three issues: (i) the scope for using the framework to assess the appropriate level of new borrowing in LICs, especially from nonconcessional creditors; (ii) further integration of domestic debt in DSAs; and (iii) refinement of the existing scale of risk categories for debt distress ratings.

2. The apparent borrowing space created by debt relief—and the extent to which it should be filled—poses new policy challenges. Debt relief frees up resources that LICs may wish to use to make faster progress toward achieving the Millennium Development Goals (MDGs). Meanwhile, the emergence of potential new lenders, both public and private, presents new opportunities. Such lending, however, if in excessive volumes or on unfavorable terms, could contribute to the re-emergence of debt vulnerabilities in these countries and create risks to development. The increasing tendency of some governments to borrow domestically—and the impact on overall debt risks—adds to the complexity of assessing these risks. The ultimate objective of the DSF is to help countries themselves identify debt-related vulnerabilities so that they can be adequately taken into account in policy formulation.

3. During the April 2006 Board discussions, most Directors supported a case-by-case approach to assessing the pace of debt accumulation for countries with debt below the DSF thresholds. They agreed that a rules-based approach was not desirable, notably because it was not possible to find a rule with adequate empirical foundations which would apply across countries with different circumstances. An arbitrary rule constraining borrowing can entail costs in terms of missed investment and growth opportunities. It can also undermine the credibility and acceptability of the DSF and reduce the effectiveness of Bank and Fund advice in this area. On that basis, Directors requested the development of specific recommendations on the implementation of a case-by-case approach.

4. In this paper, staffs propose practical guidelines that have two main objectives.

The first is to enhance the rigor and quality of DSAs by strengthening the application of the DSF itself, reinforcing its built-in precautionary aspects, and providing clearer guidance on the design of critical aspects of underlying growth and macroeconomic scenarios. The aim is to ensure that existing and potential debt-related vulnerabilities are identified and assessed in a thorough, disciplined, and consistent manner across countries, while still taking into account individual circumstances. The second main objective is to increase the effectiveness of the DSF through its more active use by a broader group of debtors and creditors. Incorporating debt sustainability considerations in an open and coordinated manner in borrowing and lending decisions could go a long way to prevent the emergence of new debt difficulties.

5. The structure of this paper is as follows. Section II describes in more detail the new challenges faced by LICs, particularly those that have benefited from debt relief, in determining an appropriate pace of borrowing and debt accumulation. Section III provides guidelines for a more rigorous application of the DSF in this new environment, and its implications for the appropriate pace of borrowing, degree of concessionality, and treatment of private capital inflows and domestic debt. Section IV discusses the scope for making the DSF an effective tool to inform medium-term borrowing and lending strategies and foster information exchange and coordination between debtors and creditors. Section V suggests refinements to debt-distress risk ratings. Section VI discusses resource implications, and Section VII summarizes key issues for discussion.

II. The DSF and the Post-MDRI Challenges

6. The financial situation of many LICs has recently improved substantially thanks to debt relief under the HIPC Initiative and MDRI. Debt relief has reduced the debt burden of some LICs to levels that are now well below their policy-dependent thresholds under the DSF. With low debt ratios and high export prices, many LICs may wish to accelerate borrowing to address their development needs.

7. At the same time, the universe of potential creditors has expanded, with export credit agencies (ECAs) and commercial banks in particular playing an increasingly active role. Lower debt levels, strengthened macroeconomic fundamentals, and improved prospects in LICs have increased their attractiveness for ECAs. In addition to the ECAs of developed countries, emerging economies are stepping up their lending to LICs (Box 1).

The Growing Importance of Official Emerging Creditors in Financing to LICs

Over recent years, a number of emerging creditors have increased their official bilateral aid flows to LICs. According to debtor data, the share of these creditors in total official assistance to LICs is still small (around 10 percent) but is increasing steadily. In several cases, official loans from a single emerging creditor represent a large share of the recipient's GDP, but in most cases are still well below the share from traditional creditors. (The table below shows the countries with the highest debt outstanding and disbursed from emerging creditors in percent of GDP. The data is derived from IDA's Debtor Reporting System and, as explained in paragraph 64 below, may be incomplete or uneven. In some cases, large claims may correspond to the existence of protracted arrears and accrued late interest, and not necessarily recent disbursements.)

Emerging creditors are numerous. The six largest non-Paris Club bilateral creditors to LICs are Brazil, China, India, Korea, Kuwait, and Saudi Arabia. (Some of them have provided aid for many years, and therefore "emerging creditors" is used for them as a shorthand.) Available data indicate that China has become, by a large margin, the largest creditor in this group, with claims of US$5 billion as of end-2004 (compared with US$2.5 billion in 1994). Kuwait, the second-largest creditor in this group, had claims of US$2.5 billion. Although precise data are not yet available, there is evidence that lending by emerging creditors, and particularly China, has increased very sharply in 2005 and 2006.

The terms of emerging creditors' credits to LICs are not well known. Many have non-traditional financial structures (including implicit or explicit collateralization, foreign exchange clauses, and variable fees) that hamper the assessment of their impact on debt sustainability. Given the size of these loans, more extensive information from creditors on their modalities and the terms of their lending to LICs would enhance the quality of DSAs.

Debt Outstanding and Disbursed from Non-DAC and DAC Creditors in Selected LICs

(averages over 2000-04) 1/

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Source : World Bank Debtor Reporting System

5-year averages are used to smooth-out GDP fluctuations.

With abundant global liquidity and compressed spreads in emerging markets, private external creditors have also extended their activities in LICs to a number of Sub-Saharan African countries.4

8. This expansion in the volume and sources of funds available to LICs, while welcome, carries a number of risks:

  • The terms of the new financing may be nonconcessional, or less concessional than official development finance. This could burden poor countries with market interest rates and short maturities they cannot afford and raise concerns about creditor harmonization.

  • New loans from a single official creditor may sometimes represent a large share of the recipient's GDP. Financing, by its sheer volume, may raise sustainability concerns.

  • Given the relatively short maturities involved, foreign portfolio investment in public domestic debt instruments carries the risk of abrupt reversals in market sentiment that could complicate exchange rate and monetary management and raise balance sheet vulnerabilities.

9. Adding to the risk of debt distress is the substantial and rising share of domestic debt in some LICs (Appendix 1). Data for a sample of 66 PRGF-eligible countries indicate that, over 1995-2004, domestic debt averaged about 19 percent of GDP. The somewhat lower median (about 15 percent of GDP) indicates the presence of a number of outliers having high levels of domestic debt, in excess of 50 percent of GDP. Domestic debt carries vulnerabilities of its own, as interest rates tend to be much higher, and maturities much shorter, than those on external debt.5

10. As Directors have recognized, the DSF is well suited to assess and monitor debt burdens and the risk of debt distress. The framework offers a number of precautionary features that help detect current or emerging vulnerabilities. Most notably, the DSF is:

  • Proactive and forward-looking: rapid debt accumulation will lead to breaches of the indicative debt burden thresholds down the road, with direct implications for current assessments;

  • Self-regulating and country-specific: projections are scrutinized through stress tests that are automatically calibrated to historical economic performance, including GDP growth, export growth, foreign direct investment (FDI), financing terms, and other factors relevant for debt sustainability;

  • Repeated: the DSA is updated every year, allowing any incipient problems deriving from the pace of new borrowing or optimistic economic forecasts to be addressed as they arise; and

  • Transparent: DSAs must explain all the main assumptions underlying the projections (and hence reasons for optimism where this is the case) and how these drive projected debt ratios and thus risk ratings, giving the opportunity to modulate these assumptions over time as circumstances dictate.

An assessment of debt trends under stylized baseline lending scenarios (Appendix 2) illustrates how the DSF effectively identifies the risk of too rapid debt buildup under current policies.

11. However, the challenges raised by debt relief and other recent developments warrant a strengthening of application of the DSF to ensure that its potential is fully exploited. There are three reasons for this:

  • The new borrowing room created by debt relief highlights important analytical issues that have not been resolved, such as the impact of increased debt-financed public expenditures on growth;

  • New types of lenders mean new opportunities but also new risks, such as a rapid debt buildup, a return to the levels of debt distress prevailing prior to HIPC Initiative and MDRI relief, and rising rollover and liquidity risks; and

  • Only a small number of creditors (the Bank, the Fund, and certain multilateral and bilateral creditors) use the DSF actively. Other creditors and most debtors have little familiarity so far with the instrument and little incentive to use it now, limiting its overall effectiveness. In the absence of coordinated action by creditors and debtors, the benefits from debt relief could be undone.

The following section attempts to respond to the first two of these concerns. It proposes to improve the rigor and quality of assessments by strengthening the precautionary aspects of the DSF, as well as the guidance to staff on the conduct of DSAs and the design of critical elements of growth and macroeconomic scenarios. The subsequent section suggests ways to increase the effectiveness of the DSF through broadening its use among debtors and creditors.

III. Further Improving the Quality and Rigor of DSAs

12. There is scope to strengthen the application of the DSF to ensure that it captures the risks raised by the new financing environment for LICs—particularly those related to new debt accumulation, concessionality, and the treatment of private capital inflows and domestic debt.

A. Assessing the Scope for Debt Accumulation

13. This section provides practical recommendations on how to assess the scope for debt accumulation on a case-by-case basis. The approach relies on: (i) guidance in the design of more solid baseline growth and macroeconomic scenarios, specifically on the critical relationship between public investment and growth;6 (ii) a more rigorous application of the precautionary features already built into the DSF; and (iii) a detailed review of scenarios that involve rapid borrowing, or which avoid breaching the debt burden thresholds in large part because of projected growth accelerations.

Strengthened Guidance on the Impact of Debt-Financed Investment on Growth

14. A critical analytic challenge in the design of realistic growth and macroeconomic scenarios arises with debt-financed growth-oriented investment, which is generally made with the expectation that it will generate the growth, export proceeds, and fiscal revenues needed to repay the additional borrowing. Thus the baseline and alternative scenarios in the DSF necessarily incorporate a view about the effects of public investment on both GDP and export growth. If investment is scaled up, a scenario based on historical experience may under-estimate future economic prospects. Correctly incorporating the impact of increased investment in the baseline scenario is then critical. Too much optimism about the growth effects of public investment can lead to over borrowing and a return to debt distress, even if these investments are financed on concessional terms, as in the past. On the other hand, too much pessimism can lead to missed opportunities to use external resources to promote growth, reduce poverty, and achieve the MDGs.

15. The relationship between public investment and growth is hard to generalize, in part because major determinants of growth are connected to the quality of policies and of institutions, the quality of decision-making, and the management of exogenous shocks. 7 At the operational level, Bank and Fund staffs are gaining experience in developing scaled-up aid scenarios using different methodologies. Empirical studies, as well as practical experience, suggest that the relationship between public investment and growth is complex, cannot be reduced to a simple rule of thumb, and ultimately needs to be investigated country by country (Appendix 3). A DSA itself is clearly not the prime locus for this analysis.

However, the assumptions that feed into DSAs will influence the projected path of debt-burden indicators and thus the reliability of the risk assessment.

16. Careful country-specific analysis is the critical first step in assessing the likely impact of public investment on growth and hence debt sustainability. Such analysis involves examining a number of complex channels through which public investment may raise growth, notably: the expected rates of return to public investment, including the potential for crowding in (and crowding out) private investment; and the alleviation of structural and macroeconomic absorptive capacity constraints (Box 2). In addition, an assessment of the assumed aggregate effects of increased public investment, including any assumed growth in total factor productivity (TFP), is an important check on the plausibility of the assumptions underlying a DSA8 The value of combining microeconomic and macroeconomic approaches underscores the need for both Bank and Fund staff to cooperate in this analysis.

Analyzing the Relationship Between Public Investment and Growth

There is evidence of potentially high rates of return for public investment made in the right environment. Cost-benefit analyses carried out by World Bank staff suggest typical (ex post) rates of return on individual projects in a broad range of countries of the order of 15 percent globally. However, these estimates are averages across large numbers of countries and time periods and may not necessarily apply to particular country cases. Whether a particular public investment will bear similar fruit will depend on the quality of the particular investments, the overall economic environment (including susceptibility to shocks) and the institutional and policy framework. It is also important to consider the expected timeframe for the payoff of the expenditure. Some projects can be expected to lead to higher national income well within the 20-year time-frame of the DSF. Others may serve primarily to achieve other objectives. Public investment can also generate productivity spillovers, though the evidence is mixed.

Improving structural absorptive capacity increases the productivity of both the public capital stock and new investment. The link between public investment and growth depends on the skilled labor, managerial capacity, and other factors required to convert investment spending into productive capital. This underlines the importance of linking public investment to a well-designed and costed medium-term expenditure framework, in order to ensure the necessary complementary inputs, including those related to maintenance, throughout the life of the investment.

In addition to structural factors, macroeconomic absorptive capacity constraints may affect the marginal productivity of additional investment. These economy-wide interactions include the possibility of Dutch disease, crowding out, and crowding in. Dutch disease refers to the adverse effect on a country's tradable sector of large resource windfalls and the additional spending that these windfalls finance. The risk of Dutch disease may raise the stakes: if the associated investments do not pay off by increasing productivity in both the tradable and nontradable sectors, not only is aid wasted, but growth may suffer, too. However, the overall empirical evidence on Dutch disease is inconclusive and a case-by-case approach for assessing this risk is therefore necessary. Crowding out occurs when external financing is limited (whether by economic policy or by supply) and public investment uses scarce domestic savings that would have otherwise financed private investment. Crowding out is associated with domestically financed public investment and is not a concern for externally financed investment per se. But when it is reasonable to expect that reducing domestic debt would spur credit to the private sector, this may be a more productive use of external financing than scaled-up public investment. Crowding in refers to complementarities between public and private capital, which may cause public investment to increase economy-wide profitability and thus encourage private investment.

Empirical evidence on the aggregate effect of all these factors, which act in different directions, is ambiguous. While a number of studies find evidence that, on average, the net contribution of public investment to growth is positive, the robustness of most of these results is uncertain and the direction of causality remains unclear. In this context, historical growth rates, empirical evidence on TFP growth, and the results of analyses of the binding constraints on growth would all be important checks on the detailed assumptions underlying the scenario.

See Appendix 3 for a more detailed analysis and bibliographical references.

17. Box 3 suggests a list of indicators that should be taken into account, subject to availability and reliability of data, when trying to assess the potential impact of public investment on growth. Their applicability will depend on the circumstances of each case, and other indicators may be important in some countries. The box does not provide quantitative benchmarks on the grounds that false precision will provide only false comfort.9Rather, the relevant measures should be examined relative to country and regional experience, in order to reach an overall assessment.10

18. Because of the difficulties of establishing a reliable relationship between public investment and growth, it is important to use "reality checks" to scrutinize baseline projections. As discussed above, empirical research so far has not brought to light any simple and stable relationship between public investment and growth. Nevertheless, some conclusions can be drawn to guide and to scrutinize baseline projections, including, in particular, the following:

  • Caution about prolonged growth accelerations that make debt-led scaling up feasible. Even with improved policies, it is difficult to forecast persistent growth accelerations with confidence. Sustained high levels of growth tend to be difficult to maintain, and even more difficult to improve upon. Such a pattern argues against very optimistic projections, particularly when these call for a substantial deviation from the historical precedent. Relevant indicators from Box 3 that are substantially out of line with regional or other pertinent comparator groups would call for particular scrutiny.

Indicators for Analysis of the Link Between Debt-Financed Investment and Growth

When available, the indicators listed below can help establish a link between public expenditure and growth, and ultimately define the scope for debt accumulation. Relevance and availability will vary by country. In general, a comparison with their evolution in the country's past and in relevant comparator groups would provide useful potential benchmarks.

Rates of Return

  • Microeconomic studies on rates of return of projects

  • Implementation lags/gaps for investment and recurrent budgets

  • Estimates of stocks and shortfalls in public capital

  • Composition of public expenditures in terms of growth impact

Structural Constraints

  • Policy and institutional constraints as indicated by the CPIA, public governance indicators, doing business surveys, PEFA, other public expenditure management

  • Level and growth rates of public investment

  • Completion or implementation rate of public investment projects

  • Skill shortages that can only be alleviated in the long run

Macroeconomic Constraints

  • The cost of capital, as indicated through firm-level surveys and real interest rates

  • Rate (or rate of growth) of private investment

  • Excess reserves/lending capacity in banking system

  • Various real exchange rate measures (unit labor costs, export market share)

Aggregate Trends

  • Growth rate of per capita GDP

  • Growth rate of TFP

  • Results of "binding constraints to growth" analyses

  • Focus on overall return to aggregate public investment. While project-specific cost-benefit analyses should play a critical role in the design of a public expenditure program, and results from such analyses are important inputs into a DSA, the DSF appropriately takes a more aggregate approach to assessing debt sustainability. The risks to debt sustainability do not generally depend on the value of one project proposed for debt financing. Ultimately, it is aggregate export proceeds, national income, and government revenue that need to be adequate to cover the aggregate debt service resulting from the entire portfolio of government expenditures—including recurrent expenditures.11

  • Emphasis on policy reforms. Recent research has shown that the quality of policies and institutions has a large influence on the ex post rate of return on public investment and thus on the rate of growth. More broadly, the policy and institutional environment can have a profound direct effect on private sector investment and productivity growth, which are critical for overall growth performance.

  • Caution about economic volatility and shocks. In countries susceptible to negative growth shocks (for example, from terms of trade shifts or natural disasters), scenarios that do not incorporate their impact on expected growth for the entire forecast period are unlikely to be realistic.

  • The effects of scaling up depend on the nature of aid inflows. Most notably, aid volatility and unreliability will hamper productive investment. Also, the extent of donor coordination could affect the quality of the aid program and its potential returns.

Precautionary Aspects

19. The uncertainty associated with the public expenditure-growth relationship may warrant an emphasis on the precautionary features built into the DSF. Some of these aim to bring more discipline to the forecasts by detecting atypical elements in the baseline scenario. As a general rule, scenarios that require sharp shifts to fiscal policy, the investment rate, the financing mix, productivity growth, or other key policy variables deserve particular scrutiny and a convincing justification. Large shifts spread over longer periods also require justification.

20. Historical scenarios could be used more actively to detect undue growth optimism. DSAs include a comparison of the assumptions underlying the baseline scenario with historical trends, and show the evolution of debt indicators if those trends were maintained over the forecast horizon. Large differences between the baseline and historical scenarios should generally be avoided unless they can be backed by strong justifications.12 In addition, DSAs should include a critical look at the realism of staffs' previous forecasts. In situations where the previous DSA proved too optimistic—particularly, if debt ratios are already high or rapidly rising—macroeconomic and growth assumptions should be subject to an extra degree of scrutiny, and may need to be revised downwards.

21. When projected growth rates are higher than historical rates and borrowing plans appear ambitious, an additional precaution will be to include an alternative scenario exploring the impact of a more muted growth response. The inclusion of this alternative "high-investment, low-growth-payoff' scenario should be mandatory for countries where large, foreign-financed investment is included in the baseline scenario and assumed to lead to a sizeable growth acceleration (such as, for example, those implying growth rates that are about, or more than, one standard deviation above historical patterns). This alternative scenario should be explicitly taken into account in the assessment of the debt distress risk.

22. When the "high-investment, low-growth-payoff" scenario breaches or approaches the DSF thresholds, the DSF will call for a robust justification of the growth dividend. In some cases borrowing may be projected to be very rapid in the first few years of the scenario, and only a growth acceleration would keep the country from reaching excessive debt ratios, but it would be too late to scale back borrowing if the growth acceleration does not materialize. In such cases, it is essential that the DSA send the right signal to the borrower and lenders about any risks associated with the borrowing strategy. There is no room for a significant error on the growth impact. High-growth scenarios involving a significant turnaround in performance would be acceptable as baselines for DSAs only if supported by compelling evidence that the likelihood of the growth dividend emerging is very high, notably based on a detailed analysis along the lines suggested above.

23. Special attention will be given to cases where the baseline scenario includes very large upfront borrowing. Empirical work conducted by staffs for this paper (using the same data set and regression framework that was used to develop the DSF thresholds themselves) shows that countries in which debt has grown rapidly (as a share of the previous year's GDP) are significantly more likely to suffer debt distress. "Rapidly" can be considered as an annual change in the NPV of debt of about 5-7 percent of GDP or more.13 This simple and cautious definition rests on a model with relatively high economic and statistical significance and recognizes the stochastic nature of the problem, the quality of the underlying data, and the relatively preliminary stage of the investigation.14 Thus, as a general rule, scenarios that include an annual increase in the NPV of public external debt or total public debt in the 5-7 percent of GDP range or above would require a detailed discussion and justification of the expected growth dividend in the DSA write-up (for instance, in a box).15 In the Fund, this discussion should also be included in any report to which the DSA is appended. This "caution flag" would increase transparency, strengthen accountability, and reduce the risk of growth over-optimism.

B. External Borrowing on Nonconcessional Terms

24. The risk of an excessive recourse to nonconcessional external finance has increased post debt relief and thus deserves special consideration. The LIC DSF, by focusing on debt in NPV terms, explicitly takes into account the degree of concessionality of different external loans. LIC DSAs quantify the higher debt service associated with nonconcessional external debt, and stress tests capture the higher risks associated with nonconcessional external debt relative to concessional. However, the uncertainty surrounding the growth effects of public investment, and the overall poor growth and debt record of many LICs, call for caution when dealing with nonconcessional external debt, even more than with concessional debt. Partly in light of these considerations, the Boards have already indicated that nonconcessional borrowing should generally be discouraged and requested that staffs clarify when case-by-case exceptions could be considered.

25. PRGF arrangements and Policy Support Instruments (PSIs) with the Fund have limits on nonconcessional external debt.16 External debt limits were introduced in the Fund in 1979 for all upper-credit-tranche arrangements to (i) prevent the build-up of external debt during the period of the Fund arrangement to levels that may lead to debt-servicing problems in the medium term; (ii) ensure that restraint on domestic demand is not threatened by unanticipated recourse to external financing; and (iii) limit a member's external vulnerability. Concessional external financing, defined as loans with a minimum grant element of 35 percent or more in some cases, is usually excluded from external debt limits, to help balance the need for adequate financial support with the need to control future debt-service burdens (Box 4).

Defining Concessionary

Different definitions of concessionality are used for official development assistance (ODA) and export credits. The concept of concessionality was first introduced in 1969 by the Development Assistance Committee (DAC) of the OECD. It entailed a minimum 25 percent grant element calculated on the basis of a flat 10 percent discount rate. That definition is still used by the OECD for ODA. Over time the OECD refined the definition of concessionality for export credits. The minimum grant element was gradually raised, first to 30 percent and then to 35 percent (50 percent for the least developed countries), while discount rates calculated on the basis of currency-specific commercial interest reference rates (CIRRs) replaced the 10 percent flat rate. This definition, which reflects more accurately the opportunity costs to lenders, has been in place since 1996.

For operational purposes, the Bank and the Fund use a definition of concessionality that closely matches that used by the OECD for export credits. To be deemed concessional, loans should generally have a minimum grant element of 35 percent, calculated on the basis of the CIRRs published by the OECD. The only difference between the definitions used by the Fund and the OECD is that the Fund uses ten-year average CIRRs to assess the concessionality of loans with a maturity of at least 15 years, and six-month average CIRRs for loans with a short maturity, while the OECD only uses six-month average CIRRs, as export credits usually have a maturity of less than 15 years. In some Fund arrangements, the minimum grant element is higher than 35 percent. The Board of Directors of IDA recently endorsed a proposal to adopt the same method as the Fund to define concessionality in the context of IDA's new policy on nonconcessional borrowing in grant-eligible and MDRI-recipient countries. This will promote clarity and consistency across the Bank and the Fund.

26. In practice, these limits have been applied flexibly, in line with differences in the countries' observed performance and their ability to attract and manage external financing (Table 1)17 Non-zero ceilings have been included in PRGF arrangements and PSIs for two main reasons: the financing of specific large-scale projects, sometimes involving co-financing; and support for a gradual shift from concessional to market-based finance, in the case of countries that had, or were close to, "blend" status in the Fund and IDA. Non-zero limits were further justified by a financial constraint (i.e., insufficient concessional resources), a sound debt situation, and appropriate governance structures (Box 5).

Table 1:

Concessionality Requirement for New External Borrowing for Countries with PRGF Arrangements and PSIs

(Current PRGF arrangements and PSIs as of end-August 2006)

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Indicates the occurrence of a non-zero limit at any test date during the period of the PRGF arrangement or PSI.

While these countries have high concessionality requirements, the non-zero limits represent small working credits for government in Burundi and Sao Tomé & Príncipe. For the Congo, the non-concessional loan reflects investment by the national oil company.

PSI.

Following a waiver granted to Guyana for non-observance of the zero ceiling on non-concessional borrowing due to a credit letter, the ceiling was revised to incorporate the amount of the credit letter in subsequent reviews.

Non-Zero Ceilings on Nonconcessional External Debt in PRGF Arrangements and PSIs

Non-zero ceilings on nonconcessional external borrowing have been included in PRGF arrangements and PSIs for the following reasons:

Funding of specific priority projects. The PRGF arrangement for Grenada allowed for limited nonconcessional bilateral financing to help rebuild the country after two devastating hurricanes. In Uganda, an exception was granted for investment in hydroelectric power project, and in Guyana for a project to improve productivity in the sugar sector. In Sri Lanka, exceptions were made to rehabilitate a children's hospital, rebuild bridges, and finance rural development.

Preparing for graduation to market-based finance. In Cape Verde, exceptions were initially related to specific projects, but following satisfactory program implementation, the exception ceiling has been raised and projects are no longer identified ex ante. Sri Lanka had large exceptions for commercial borrowing, in addition to the funding tied to social projects mentioned above. Exceptions in countries preparing for graduation tend to provide some additional borrowing space, or make up for a shortage of concessional external financing sources, and are typically not linked to specific projects (Albania, Georgia, and Pakistan). The PRGF arrangement for Vietnam allowed for a pilot bond placement to test access to international capital markets.

Debt management and debt sustainability prospects. In Bangladesh and Cape Verde, exceptions were approved based on the authorities' track record of prudent debt management and Fund staff's finding that the new borrowing would be consistent with debt sustainability. In Azerbaijan, modest contracting of nonconcessional debt for investment projects was accepted in the PRGF arrangement in light of the low debt burden and the expected improvement in debt sustainability (anticipated rapid development of the oil and gas sectors).

27. IDA's recently approved policy on nonconcessional borrowing in grant-eligible and MDRI-recipient countries extends the notion of minimum concessionality (and the monitoring of nonconcessional borrowing) to all such countries. IDA will examine, case by case, instances of nonconcessional external borrowing by these countries. Where such borrowing is judged to be unwarranted on the grounds of the new policy, IDA may propose the application of its disincentive measures, such as a volume reduction or hardening of terms. Whenever action in an individual country is proposed, management will return to the Board of IDA.18

28. Following the Boards' guidance, the presumption should remain that concessional flows are the most appropriate source of external finance for LICs. HIPC Initiative and MDRI relief have significantly lowered debt ratios in beneficiary countries, but other economic circumstances remain unchanged. In particular, their project and debt-management capacities remain generally weak. They face large MDG-related needs, yet most of the related expenses (for example, in health and education) do not immediately generate the cash flows required to service commercial debt. A minimum concessionality requirement can help borrowers obtain more suitable credit terms by raising awareness among lenders of their financial vulnerabilities.

29. This presumption should continue to be applied flexibly, however, allowing for exceptions on a case-by-case basis. These exceptions will be discussed by Bank and Fund staffs to avoid any potential inconsistencies between the two institutions. The following elements should be taken into account when considering exceptions:

  • Debt sustainability. The DSF should be the primary means of assessing the impact of alternative financing strategies and recommending the minimum concessionality for new lending. Countries that are close to, or over, the relevant debt burden thresholds should consider nonconcessional external finance only in very exceptional circumstances. In addition, there should be a presumption that the recommended minimum grant element would increase with the risk of debt distress.

  • The availability of concessional resources, and the quality of the investment to be financed. Borrowing on nonconcessional terms may be justified for projects with high expected risk-adjusted rates of return that would otherwise not be undertaken, provided that the overall expenditure program is also judged to be well-designed. However, LICs should exhaust all avenues of access to concessional resources before considering borrowing on nonconcessional terms. In a Fund-supported program context, multilateral and bilateral lenders have sometimes increased the concessionality of their offers by combining their loans with grants from other multilateral or bilateral sources. Although this can sometimes work to meet countries' needs, care should nevertheless be taken to avoid encouraging complex financial packages designed merely to circumvent the minimum grant element through hidden fees, non-transparent pricing, in-kind grants, and other side deals. Countries with weak governance and poor debt management capacity should generally stay away from highly structured deals, including collateralized loans.19

  • The overall strength of the borrowing country's policy environment and its susceptibility to economic shocks. Projects with potentially high returns may fall short of expectations in a distorted or unstable policy context, or in an economy that is subjected periodically to exogenous shocks. Policies affecting the efficiency of public investment, including the quality of the debtor's public expenditure and debt management capacity, should figure prominently in the assessment.20 In addition, the economy's ability to absorb shocks, and the government's capacity to handle them, should also be an important consideration.

30. When relevant, DSAs could discuss more explicitly the vulnerabilities created by an increase in nonconcessional external debt. DSAs include a stress test assuming financing under less concessional terms. DSAs also show explicitly the grant element of new borrowing. In cases where the grant element is found to fall markedly, DSAs could include a discussion of the reasons for this decline and its impact on debt-distress risks.

C. Taking Private External Creditors Into Account

31. Increased private sector capital flows into both domestic and external sovereign debt instruments could provide opportunities for LICs, but may also give rise to new vulnerabilities that require careful monitoring. The widening of the investor base may help LICs increase financing options for projects with high returns, particularly in cases where concessional financing is not available on a sufficient scale and risks to debt sustainability are low. Moreover, investment in domestic instruments could foster the development of domestic debt markets and help reduce interest rates on domestic debt (see footnote 5). However:

  • Short-term private capital flows could expose LIC recipients to abrupt reversals in market sentiment, not a typical feature of official financing. In turn, sudden capital outflows could complicate exchange rate and monetary management.

  • Balance sheet problems may arise, particularly when foreign investment in domestic paper crowds out domestic banks, leading them to lend to higher risk projects, possibly including unhedged foreign currency loans. Where there are significant currency, maturity, or interest rate mismatches, such balance sheet problems may migrate across sectors, potentially giving rise to contingent liabilities for the sovereign.

  • Finally, the outlook for medium-term debt sustainability may weaken when liabilities are collateralized with future export receipts.

The scale of these risks depends on the degree of capital account openness, the exchange rate regime, the currency denomination of debt, and the soundness of financial intermediaries and policy institutions.

32. In countries where borrowing from private external creditors becomes significant, a number of policy actions could be taken to alleviate the increased risks.

These actions mainly involve improving debt-monitoring capacity; the assessment of reserve adequacy; and the quality of debt-management institutions more generally. Moreover, the experience with recent crises in emerging market countries shows that the sequencing of liberalization reforms will be important. In particular, the framework for banking supervision and prudential regulation would typically need to be strengthened prior to undertaking steps to liberalize the capital account.21

33. In such cases, additional analyses focusing on short-term debt-related vulnerabilities should be used more systematically in conjunction with the DSF. For most LICs, the external and fiscal debt sustainability templates included in the current DSF provide for adequate monitoring of a sovereign's debt situation, in particular of its longer-term solvency conditions. Where private capital inflows become significant, however, the additional indicators suggested in Table 2, subject to data availability, could contribute to capture better: (i) risks to the sovereign's liquidity position stemming from the composition of debt, including those related to its maturity structure and nonresident holdings of debt originally issued domestically; (ii) external liquidity and rollover risks, and the adequacy of reserve cover, which may need to be increased given the possibility of reversals in market sentiment;22 and (iii) weaknesses in the financial sector that may give rise to contingent liabilities for the sovereign.23 Where these factors are found to create significant debt-related vulnerabilities, they should be taken into account in the overall risk assessments under the DSF.

Table 2.

Suggested Indicators for Vulnerability Analysis

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Source: IMF.

The sum of interest and amortization of medium- and long-term debt.

Defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period.

Defined as the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of

short-term debt at the end of the last period.

External short-term debt includes amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period.

Gross official reserves in percent of the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of short-term debt at the end of the last period plus foreign currency deposits in the banking system.

34. In many LICs, improvements in public debt management are necessary prior to borrowing from private external creditors on a significant scale. In particular, a desirable debt-management framework should assign the legal authority to borrow, and identify permissible instruments and accountability mechanisms. Portfolio management should be facilitated through an effective recording of the debt stock; an adequate framework for liquidity forecasting; and the availability of critical indicators to monitor the benefits, costs, and risks associated with borrowing from private sources. In practice, this could imply a substantial need for technical assistance (See Section IV.B).

D. Better Integration of Domestic Debt in the DSF

35. The DSF's capacity to detect early debt vulnerabilities would be strengthened if the discussion of domestic debt were better integrated in DSAs.24 As mentioned in Section II, domestic debt is substantial in many LICs. However, while an integral part of the LIC DSF, domestic debt is not formally incorporated in debt distress thresholds. A growing number of LIC DSAs have included a discussion of public debt,25 but with only limited impact so far on the overall assessment of the risk of external debt distress and risk classification. An update of the recent review of experiences in the application of the DSF to LICs finds that, in a sample of 33 joint Fund-Bank DSAs, 24 included a public debt DSA. In all but one case, the risk of debt distress classification coincided with the one that would have been derived from an assessment of external debt and debt-service indicators only.

36. Domestic debt clearly matters for the risk of debt distress. A preliminary empirical analysis of the relationship between both external and domestic debt and the risk of external debt distress26 found that domestic debt (as a percentage of GDP) had an estimated effect on the likelihood of external debt distress similar in magnitude to the effect of external debt relative to GDP.27 Moreover, the inclusion of domestic debt in the regression analysis explaining the likelihood of external debt distress increased the explanatory power of the model in a statistically significant way.28 These conclusions were obtained despite the limited scope of the data, which renders the estimates less precise than those obtained on the basis of external debt alone.

37. Analyses of the behavior of domestic debt in the period leading up to episodes of external debt distress also underscore the significance of domestic debt for debt distress. There is no evidence that countries have substituted domestic debt for external debt prior to external distress or default. Both domestic and external debt have tended to grow rapidly relative to GDP in the two years immediately prior to the onset of external debt crises. In the aftermath, however, domestic debt and external debt diverged in their behavior: domestic debt has tended to decline while external debt has surged.29

38. The integration of domestic debt into the DSF poses many conceptual and practical challenges. External and domestic debt are qualitatively different, making it difficult to simply add them for use in the DSF.

  • First, the risks of default on external and domestic debt are different. Governments often resort to seignorage or financial repression, rather than default, in response to pressures from domestic debt.

  • Second, in addition to budget financing, domestic debt is often used to conduct monetary policy, manage the exchange rate, or support the development of domestic financial markets.

  • Third, the financial terms of domestic debt in LICs are significantly different from those of external debt. For instance, domestic debt generally has shorter maturities, carries higher nominal interest rates, and is denominated in domestic currency—leading to a set of risks that are different from those attached to low-interest, long-term external debt.

  • Fourth, simply adding domestic to external debt also raises data issues. The coverage of domestic debt differs across countries, making standardized comparisons of debt-to-GDP ratios across countries problematic. The quality of domestic debt data is generally lower than for external debt and these data are not fully available for all countries. In addition, the inclusion of such debt into the classification system may create adverse incentives for the transparent recording of domestic debt in some cases.

39. Explicitly linking the risk classification used by IDA (and other official donors) for its grant-share decision to domestic debt ratios also raises implementation issues.

For example, an increase in the issuance of domestic debt may bring about an increase in external grants through a higher risk classification.30 Alternatively, increased grants may actually raise the risk of debt distress if they weaken incentives for domestic revenue mobilization by the government.

40. For these reasons, it is not possible simply to incorporate domestic debt into the existing thresholds. But domestic debt can be taken into account when assessing the risk of debt distress and designing appropriate borrowing strategies. Consider, for example, the following possibilities:

  • External public debt is in excess of the indicative debt burden thresholds, while domestic debt is low. In this case, the appropriate borrowing strategy would seek to reduce external debt gradually, while keeping domestic debt in check, provided that the cost of domestic debt is not excessive compared to that of external debt.

  • External public debt is well below the indicative thresholds, while domestic debt is high. In this case, shifting from domestic to external debt (on concessional terms) could reduce not only the present value of total debt but also market risks, assuming such a shift can be brought about.

  • Both external and domestic debt are too high. In this case, the appropriate pace of reduction in each type of debt will depend on the relative cost of domestic and external debt as well as the risk embodied in the maturity structure and the government's ability to roll over its obligations.

41. Staffs see scope for integrating more systematically domestic debt considerations in the assessment of debt sustainability and the risk of external debt distress. Previous guidance to staff on the preparation of LIC DSAs was largely focused on the external DSA component and the use of the indicative debt and debt-service thresholds for assessing and classifying the risk of external debt distress.31 Limited guidance was provided on how to use the public debt DSA to inform the overall assessment and classification of the risk of external debt distress. Although the ultimate assessment would continue to rely on staffs' judgment, the following key steps could be taken to clarify and strengthen the role of the public debt DSA:

  • First, all LIC DSAs should include a public debt DSA. External and public debt DSAs need to be produced simultaneously and in a consistent manner, as they complement each another in providing inputs for the assessment of a country's debt sustainability.32

  • Second, domestic debt issues should receive a heightened attention in countries where domestic debt has an above-average weight or has increased rapidly in recent years.33Higher levels of domestic debt should point to the need for closer scrutiny—although the conclusion could be tempered by country-specific factors, including macroeconomic performance and debt management capacity. In assessing the significance of the domestic debt, staff teams should take into consideration the circumstances under which the debt has been accumulated (i.e., whether it was the result of domestic financing of budgetary spending, including the assumption of contingent liabilities, and/or the consequence of sterilization operations), and note whether such assessment is constrained by insufficient information.

  • Third, the public debt DSA should assess more thoroughly the vulnerabilities related to domestic debt. Discussion of the public debt DSA should indicate systematically whether the primary balance in the baseline is consistent with debt sustainability, and whether it is realistic in view of historical experience. To complement the analysis, additional indicators of domestic debt-related vulnerabilities, particularly relating to the maturity of domestic debt, could be added to the public debt DSA template when the requisite information is available.

  • Fourth, the DSA should explicitly flag situations whereby the inclusion of domestic debt in overall debt and debt-service prospects would lead to a different classification from consideration of external debt and debt service alone. Such situations are expected to be rare: as domestic debt constitutes only about 20 percent of total public debt in the typical LIC, in most cases the assessment of risk of debt distress would be the same as that based only on considerations of external debt only. But if such a difference were to emerge, it should be explicitly acknowledged. This would enable IDA and other multilateral donors to base their grant allocation decisions on a risk assessment unbiased by questions of moral hazard.

42. Incorporating domestic debt into some countries' DSAs poses a data challenge that may take time to address. Improving the quality of domestic debt reporting will be particularly challenging. In cases where domestic debt is believed to be significant but where data quality is deficient, DSAs will have to signal clearly that their results depend on assumptions. Improved debt reporting is a key objective of ongoing efforts to build debt management capacity in LICs.

IV. Towards More Effective DSAs: Fostering Use by Borrowers and Creditors

43. To be most effective, the DSF must be used widely by borrowers and creditors.

This should start at the Bank and the Fund, and the question here is whether the link between DSA results and policy advice—and, where relevant, program conditionality—should be tightened. This section explores the scope for the DSF to guide both borrowing and lending strategies in a way that will foster information sharing both among creditors and between debtors and creditors, and thus promote the efficient use of resources and minimize the risk of crises.

A. Strengthening Links from DSAs to Policy Advice and Conditionality

44. The adoption of the DSF has already resulted in fundamental changes at the Bank and the Fund. IDA's grant allocation criteria now focus exclusively on risks of debt distress as assessed in DSAs. 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. In most cases with a moderate or higher risk of debt distress, the policy implications are incorporated explicitly in analysis and recommendations.

45. However, the link between DSA results and policy advice could be strengthened further. A higher risk of debt distress should generally be associated with a lower recommended increase (or a higher decrease) in the NPV of external debt. The variety of country circumstances and the number of factors contributing to debt-distress risk advises against the establishment of a mechanistic link between the two. For example, as discussed above, a country can have a relatively low debt-distress risk post debt relief, but still limited capacity to absorb and manage commercial debt. Rather, there should be a presumption that the recommended minimum grant element will increase with the risk of debt distress, and the recommended volume of new debt (including concessional debt) will decrease.34 A shift to a higher risk category should trigger a comprehensive reassessment of Bank and Fund staffs' recommendations on the appropriate debt accumulation strategy.

46. In the Fund, DSA results should be taken more closely into account for program design and conditionality, where relevant. In September 2004, the Fund Board called for efforts to strengthen control over excessive borrowing in the context of Fund-supported 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. However, the impact of DSAs on program design has so far been limited. Minimum concessionality requirements exceeding 35 percent should also continue to be used when needed.

47. The easing of limits on nonconcessional external finance for countries graduating from concessional financing should be subject to the authorities' track record and DSA results . 35 In a Fund-supported program context, sub-ceilings on nonconcessional external debt could be adjusted upward throughout the program period, based on the member's debt management capacity and other criteria.36 The DSF could provide the platform to assess alternative financing mixes and scaling up scenarios and their implications for external and public debt sustainability. In LICs with no Fund-supported program, the Boards would discuss the staffs' advice on an appropriate borrowing strategy in the context of Article IV consultations and Country Assistance Strategies (CASs). In countries with increased creditworthiness, IDA and Fund staffs would collaborate closely to engage the authorities in a constructive dialogue to discuss debt strategies and capacity-building issues.

B. DSA Use by Borrowers: Towards Medium-Term Debt Strategies and Stronger Debt Management Capacities

48. The ultimate objective of the DSF is to identify debt-related vulnerabilities so that they can be adequately taken into account in the formulation of a country's policies. Regular DSAs should become part of sound policy design and pave the way for the elaboration of a country-owned medium-term public and external debt strategy (MTDS). The MTDS would seek to address vulnerabilities uncovered in DSAs. It should lead to borrowing which: (i) is consistent with the country's development plans and macroeconomic program; (ii) is sustainable; and (iii) minimizes borrowing costs over the medium to long term, consistent with a prudent degree of risk. The first two points imply that an MTDS should be closely linked to the medium-term fiscal framework, while the third point implies the need to strengthen debt management capacities at the operational level.

49. The Fund's Medium-Term Strategy emphasized the importance of debt sustainability in LICs and suggested that the Fund support low-income members in developing such debt strategies. Similarly, the Bank's Board—and the IDA Deputies— have emphasized the importance of Bank staff support for better strategic debt management in Bank CASs.37 A well-designed and operational MTDS would be an important tool for helping the authorities make informed policy decisions, avoid the accumulation of onerous debt burdens and other vulnerabilities, and coordinate with creditors. An MTDS would be particularly useful for countries that have benefited from debt relief and perceive that they now have a potentially large borrowing space.

50. An MTDS should have a number of features. As a pre-condition, the authorities need the capability of monitoring existing debt-service obligations so that they can make well-informed decisions about new borrowing. The contracting of new debt should be subject to oversight by the appropriate authorities and set firmly in an agreed macroeconomic framework. An MTDS should be linked to a full-fledged, medium-term fiscal framework that contains prudent revenue projections and planned expenditures consistent with the country's poverty reduction strategy (PRS). It should recognize cost and risk tradeoffs in setting sustainable borrowing limits, ensuring that debt can be serviced under a wide range of circumstances.38 Once a sustainable fiscal stance has been determined, the MTDS would also address: (i) the terms of new borrowing, including the appropriate mix between fixed and variable rate; and (ii) the appropriate mix between domestic and external debt (or alternatively local currency and foreign currency debt). An MTDS should be updated regularly, integrated into the government's decision making, and enjoy full ownership by all relevant government institutions.

51. The design and implementation of an MTDS raises significant operational challenges. To ensure country ownership and accountability, an MTDS should be prepared by the authorities themselves. Such an undertaking will be challenging, as debt management offices in many LICs lack adequate capacity to monitor and record debt information and new resource flows accurately, let alone manage them effectively. According to analysis by Bank and Fund staff and other organizations,39 the key debt management challenges in HIPCs include: (i) the need for comprehensive institutional and legal frameworks; (ii) the need for greater and more effective coordination across different units involved in debt management and with other areas of macroeconomic policy; (iii) the lack of public or parliamentary oversight over new borrowing, (and lack of a framework to evaluate new borrowing decisions and limited transparency and reporting requirements); (iv) the recruitment and retention of staff (and resource constraints in general); and (v) limited political support.40

52. As a first step, the capacity to monitor existing debt should be strengthened. This will require: (i) improving not only the monitoring of direct central government liabilities, also of a broad definition of public debt that includes public enterprises, local authorities, and publicly guaranteed debt; (ii) providing debt-management units with a clear operational mandate, accompanied by appropriate accountability arrangements; and (iii) recruiting appropriately skilled staff. The establishment of an investors relations office could also be considered. As mentioned earlier, this will likely require substantial technical assistance (TA), including a strengthening of established mechanisms and close coordination with other providers of TA.

53. Current TA provision of debt management in LICs does not comprehensively address the gaps and weaknesses that prevail. While some aspects of debt management are addressed through TA on public expenditure management, liquidity management and monetary operations, the TA directly targeted at debt management remains largely focused on "needs identification" or on limited aspects of debt management. Some TA has been provided to help countries improve the quality of their debt statistics, although in many cases the focus has been on providing debt management software, which by itself does not guarantee high quality data.41 Systematic approaches to help countries develop their debt management function and operationalize a medium-term debt management strategy are needed. TA for staff training in central banks or debt management units often focus mainly on creating a cadre of trained "debt recorders" rather than on building capacity to undertake more comprehensive debt management functions. Senior level policy makers are also not fully sensitized to the importance of debt management and may lack a proper understanding of the interlinkages between debt management, monetary and fiscal policies, and financial market development. Consequently, debt management capacity building is rarely anchored by political commitment or broader institutional reform in LICs.

54. IDA's Board has repeatedly stressed that public debt management is a core mandate of the Bank. Recognizing the broad scope of the challenge, the need for a harmonized approach among donors, and the importance of technical assistance and capacity building to address deficiencies in debt management in LICs, the Bank is proposing that, in addition to the preparation of MTDSs, a diagnostic tool and reporting framework also be developed and applied to assess debt management capacity in LICs.42 IDA staff, in collaboration with others, would establish a partnership with other stakeholders to assess capacity and identify needs, in order to guide the design of reforms and the provision of technical assistance and capacity building, and to monitor debt management performance over time. The proposed approach would be firmly embedded in country programs to ensure client ownership, donor coordination, and continuous tracking. It is also critical that these new activities fit within country strategies and available operational budgets. The high resource costs associated with diagnosing and addressing shortcomings in public debt management will imply difficult tradeoffs at the country level unless additional resources are made available to fund this mandate.

55. Given the time needed to develop capacity in many countries, having an MTDS in all LICs can only be a medium-term goal. More advanced LICs could have an MTDS in place over the medium term. Fund- or IDA-supported programs would be expected to include a detailed plan for developing an MTDS or at least making significant progress during the program period, depending upon initial conditions. Such progress could, on a case-by-case basis, be an element of either Fund or Bank conditionality, although in considering this the importance of government ownership of the MTDS should be a key consideration.

56. Meanwhile, a more intensive use of the DSF by country authorities can help pave the way to a homegrown MTDS. To allow for a transfer of know-how, the authorities would need to be involved more closely in the preparation of DSAs.43 The results of the DSA should also be discussed systematically at a high level to ensure adequate involvement of decision makers. Such activities are likely to entail additional resource costs to country teams, particularly when the administrative capacity of the country is limited. DSAs (and eventually MTDSs) could serve as a basis for discussions with creditors and donors in consultative group (CG) meetings.44

C. Fostering Creditor Coordination Around DSAs

57. The DSF, and ultimately an MTDS, can also be a useful tool to inform and guide all creditors' decisions. DSAs can be used to disseminate concerns about risks to debt sustainability and in some cases guide recommendations on the appropriate level of concessionality in new borrowing. Broad acceptance by all creditors of the results of DSAs would contribute to enhance creditor coordination and minimize the risks of crises.

58. The use of the DSF by creditors is expanding but still limited. The recent review of the DSF showed that it is actively used by a few multilateral creditors and donors, but to a much smaller extent by others, in particular export credit agencies (ECAs) and commercial creditors. Nonetheless, early feedback from creditors indicates that, despite their limited use of the DSF, they value the informational and analytical content of DSAs. There is thus scope for the Bank and the Fund to disseminate DSAs more broadly among creditors and for creditors to seek to use these DSAs in their own lending decisions.

59. The use of the DSF and of its results is an individual choice for each creditor.

The DSF has no institutional or contractual basis and does not seek to bind creditors around a given course of action such as an overall lending envelope for a borrowing country, the appropriate degree of concessionality, or the relative priority of investments. Its main objective is to allow creditors and borrowers to make informed decisions about the preferred financing strategy. The ultimate responsibility for such decisions rests with borrowing governments, and it is therefore most important that governments understand DSAs and use them to define their borrowing strategy. Nonetheless, broadening awareness among creditors of the concept of debt sustainability and of the results of Bank-Fund assessments in specific countries can facilitate creditor coordination through a shared understanding of the impact of individual lending decisions on a debtor's overall debt outlook.

60. Since the last Board meeting, staffs have intensified outreach on the DSF with traditional official lenders, including ECAs. Staffs have attended meetings of the export credit group of the OECD, of European ECAs, and of the Paris Club, where the implications of the DSF for ECA lending in a post-MDRI context were discussed. Contacts with multilateral development banks have also continued with a view to fostering their more active use of the DSF.45

61. Contacted creditors were generally aware of the risks of excessive debt buildup in LICs. Many ECAs acknowledged that, although officially-supported lending to LICs represents a small part of their total portfolio, it can be large in relation to the recipients' budgets. Therefore, increasing nonconcessional lending to LICs could put debt sustainability at risk. DSAs could inform ECAs' country risk analysis and provisioning decisions. Some ECAs are making efforts to develop "responsible lending" practices that take into account the results of DSAs. An informal group of 16 ECAs from OECD countries has also been established to develop their own framework along similar lines. This group is expected to present a proposal at the OECD export credit group meeting in November 2006, with a number of non-OECD countries invited as observers.

62. Efforts are underway to broaden public access to existing DSAs. Outreach confirmed the interest of many creditors in increased and easier access to the conclusions and underlying assumptions of joint Bank-Fund DSAs. DSAs will shortly be easy to locate on dedicated pages in the Bank and Fund websites. A grant element calculator is available on the IDA website to facilitate calculation of the level of concessionality of new loans under consideration for the purposes of IDA's policy on nonconcessional borrowing. Information on concessionality as well as a concessionality calculator developed by Fund staff will soon be posted on the Fund's website. Posting of a given DSA remains subject to the consent of the authorities. There would be merit in allowing web access to the templates themselves, as well as fostering more regular exchanges between the staffs of the Bank and Fund and those of other creditors. In addition, staffs could post on the web a summary table listing the countries for which a LIC DSA has been undertaken, their dates, and, whenever the authorities have consented to publication, a direct link to the document.

63. Further outreach, particularly to emerging creditors, is planned. These creditors are generally not represented in existing donor-coordination organizations such as the OECD or the Paris Club, and in part for this reason there is little information on the amount and terms of the financial support they provide, which in some cases can significantly complicate the preparation of DSAs.

64. Efforts are also ongoing to improve the information available on overall lending to LICs. The only comprehensive source of loan-by-loan data now available is the World Bank's Debtor Reporting System (DRS). But approximately half of the LICs expected to report public external debt data to the DRS do not submit at all or have moderate to major problems with the information they submit. Efforts are underway to strengthen and tighten countries' adherence to quarterly and annual reporting requirements. Since annual data are obtained with a lag and coverage can be uneven, these data need to be complemented with detailed information from creditors' records. Staffs of the IMF and the World Bank, together with staffs of the OECD, the BIS, and the Berne Union, are trying to develop reporting mechanisms to measure official lending to LICs, which could be used to validate and supplement data collected through the DRS. Eventually this information could be integrated into the web-based Joint External Debt Hub (JEDH). However, this would still not cover financing flows from emerging and private creditors that are not members of the OECD or the Berne Union. As mentioned above, outreach efforts towards these emerging creditors should aim, inter alia, to improve the information available on their lending activities.

V. Refining the Debt-Distress Ratings

65. In their April 2006 discussions, the Boards asked staffs to consider possible refinements to the existing debt-distress risk ratings, including the possibility of subdividing the moderate risk category. Indeed, of the 21 DSAs that were completed in time to be included in the review and that had given a risk rating, nine (43 percent) had received a moderate risk rating. This frequency led the Boards to request further reflection on the risk categories used in the DSF and in particular whether the moderate risk category should be split so as to allow a more nuanced risk assessment. A related concern is whether the risk classifications allow IDA and other lenders sufficient precision in tailoring the proportion of grants to countries' debt sustainability.

66. The implementation of the MDRI, among other factors, has reduced the incidence of moderate risk ratings. Since the first DSF Review, DSF implementation has evolved. The main change has been the provision of MDRI stock debt relief to 20 countries, with more expected to follow.46 Although a country's initial debt burden is only one factor in the risk assessment—six MDRI recipients47 still receive IDA grants—the effect has been to reduce risk in many cases, and to move certain countries (e.g., Benin, Cameroon, Uganda and Zambia) from IDA-grants recipients to countries that receive 100 percent loans from IDA.

67. Revising the risk category definitions thus appears unnecessary at this point.

A recent review of existing DSAs found that existing DSF guidelines were being applied appropriately. In addition, increasing the number of risk categories would entail refining the DSF guidelines on assigning risk ratings. This could implicitly overstate the precision of the underlying 20-year forecasts. A higher number of categories would also increase the frequency with which the grant share for a given country was altered over time, placing greater administrative burdens on country authorities.

68. A related concern is that CPIA fluctuations—as opposed to secular improvement and deterioration—may translate into undue volatility in the IDA grant share of a given country. There are several instances in which changes in CPIA ratings resulted in changes in performance category which were only temporary. This occurred when seemingly lasting reforms or deteriorations in policy or institutions were reversed, or simply as a result of inevitable "noise" in the rating process. Such occurrences, if translated directly into the DSF, may introduce undesirable uncertainty regarding the country's financing terms from IDA (and possibly other donors), hindering efficient planning in the country.

69. To mitigate this problem, a three-year moving average CPIA score to determine the performance category is recommended. Basing performance categories on a three-year moving average of the CPIA, in conjunction with the same two CPIA cutoff values between categories,48 will smooth out undue fluctuations in grant share.

70. Staffs recommend that the DSF should be allowed to build a longer track record before revisiting the question of the risk categories. Even if the categories remain unchanged, clearance and review functions in the Bank and the Fund must continue to be used carefully to ensure that the guidelines for assigning the risk rating are applied appropriately and consistently. In particular, given the role of the risk rating in setting IDA grant allocations, IDA will look to staff from the Bank's Economic Policy and Debt Department to execute a standardized approach to the ratings and, inter alia, to ensure that moderate risk ratings do not over-proliferate.

VI. Resource Costs

71. TA aimed at helping governments develop capacity and preparing MTDSs will entail large resource costs. Given the generally weak capacity in most LICs to manage even existing debt, a substantial, multi-year, multi-institution TA effort would be required. Developing the MTDS and capacity building will be an evolutionary process. Ideally, it would be preceded by a short phase of some developmental work in the headquarters, followed by an initial mission to determine the state of institutional and operational arrangements in the identified country. Key priority areas would be decided in consultation with the authorities, and followed up with a series of shorter, more focused missions. In some cases, substantial capacity building engagement will be needed. At different stages this might involve collaboration with other agencies and the private sector, with some technical assistance contracted out. Preliminary estimates suggest that this could require, on average, 1-1.5 Fund staff-years,49 as well as significant recourse to external experts and additional travel costs. Bank staff and travel costs over the next three years are estimated at about US$6 million. Such an effort would require a major reallocation of existing resources away from current activities.

72. Expanding outreach activities on the DSF will also require resources, but to a much smaller extent. Such activities would consist of Fund and Bank staff regularly participating in various ECA meetings and extending outreach to emerging creditors.50 In the case of the Fund, this would involve additional travel costs that could be covered from the Fund-wide budgetary contingency for implementation of the Fund's Medium-Term Strategy. In the case of the Bank, such costs will need to come from additional budget allocations for the relevant departments. Other proposals made in this paper, such as designing more solid baseline macroeconomic and growth scenarios or taking account of domestic debt more systematically, will have staff resource implications, but these could be covered within the existing budget.

VII. Conclusions and Issues for Discussion

73. This paper proposes practical guidelines to enhance the rigor and quality of DSAs and the effectiveness of the DSF. The challenges raised by debt relief and the emergence of new types of lenders warrant a strengthening of the application of the DSF to ensure that its potential is fully exploited. The limited number of creditors currently taking into account DSAs in their lending decisions poses additional challenges to ensure that the benefits from debt relief are not rapidly undone.

74. To improve the quality and rigor of DSAs and ensure that the case-by-case approach provides a thorough and consistent, but flexible, treatment across countries of issues associated with debt accumulation, staffs make the following proposals:

  • Guidelines to design more solid baseline macroeconomic and growth scenarios.

  • Reinforcement of the precautionary features already built into the DSF, including through an active use of historical or other alternative scenarios.

  • Where a debt buildup is expected to be sudden and rapid, the DSF will call for a robust justification of the expected growth dividend.

  • Concessional flows remain the most appropriate source of external finance for LICs, but consideration would continue to be given—on a case-by-case basis—to nonconcessional finance. This should, however, take into account explicitly (i) the impact on debt sustainability; (ii) the availability of concessional resources; (iii) the overall strength of a debtor country's policies and institutions, including the overall quality of the public expenditure program; and (iv) the quality of the investment to be financed.

  • The increasing interest of private external creditors in LICs' sovereign debt instruments requires careful monitoring. Additional analyses focusing on short-term debt-related vulnerabilities should be used on a more systematic basis in conjunction with the DSF.

  • All LIC DSAs should include a public debt DSA, produced simultaneously and in a consistent manner with the external DSA. Particular attention is required in cases where domestic debt has an above-average weight or has increased rapidly in recent years.

75. The effectiveness of the DSF ultimately depends on its broader use by debtors and creditors, including as a device for better communication and coordination.

  • Borrowers: countries need to develop their own MTDS in support of their development objectives and the MDGs while containing risks of debt distress. At the same time, renewed efforts will be needed to help build capacity in public debt management among borrowers.

  • Creditors: further outreach by the staffs is needed. The link between DSA results and policy advice should be strengthened further.

76. There is no need for revising the debt distress categories at this point. Instead, a three-year moving average CPIA score to determine the appropriate indicative threshold for debt distress could be used to avoid undue volatility in the IDA grant share for a country.

77. Resource costs to provide TA for capacity building, particularly to help countries develop their own MTDS, would be substantial. Given budget constraints, this would require a reduction in current activities.

78. Do Directors agree that:

  • The DSF is well suited to assess and monitor debt and the risk of debt distress but the challenges raised by debt relief and the emergence of new types of lenders warrants strengthening its application?

  • Improving the quality and rigor of DSAs as proposed by staffs would allow for a satisfactory case-by-case approach to debt accumulation, the more careful use of nonconcessional financing, and the more systematic consideration of vulnerabilities related to private creditors and domestic debt?

  • Outreach is needed to foster the use of DSAs by creditors and debtors? For the former, efforts could foster the wider application of the DSF and similar exercises? For the latter, substantial capacity building is needed to help them develop their own MTDS?

  • A refinement of the debt distress ratings is not warranted at this time, but introducing a three-year moving average CPIA score would avoid undue volatility in IDA grant allocation?