Debt Limits in Fund-Supported Programs - Proposed New Guidelines

Low-income countries (LICs) face significant challenges in meeting their development objectives, while maintaining a sustainable debt position. To address this dilemma, the international community has largely advocated recourse to concessional external finance. The Fund’s existing policy and practice on external debt limits conforms to this preference.

Abstract

Low-income countries (LICs) face significant challenges in meeting their development objectives, while maintaining a sustainable debt position. To address this dilemma, the international community has largely advocated recourse to concessional external finance. The Fund’s existing policy and practice on external debt limits conforms to this preference.

Executive Summary

Low-income countries (LICs) face significant challenges in meeting their development objectives, while maintaining a sustainable debt position. To address this dilemma, the international community has largely advocated recourse to concessional external finance. The Fund’s existing policy and practice on external debt limits conforms to this preference.

Various factors warranted revisiting the Fund’s policy and practice. The situation of LICs has evolved and the patterns of financing of LICs has changed substantially in recent years: many LICs have strengthened their macroeconomic management; debt burdens have been relieved; and official financing is available through a broader group of creditors. In addition, the Bank-Fund Debt Sustainability Framework (DSF) introduced in 2005 is now widely used by countries and integrated with donors’ operations.

A review of the Fund’s current framework on external debt limits in Fund-supported programs was initiated in March 2009. The Executive Board agreed that the policy had played an important role in preventing the build-up of unsustainable debts, while allowing for adequate external financing. It broadly supported a new framework that moved away from a single design for concessionality requirements towards a more flexible approach. The new framework for concessionality requirements:

  • Includes a menu of options to reflect better the diversity of situations in LICs, notably on their debt vulnerabilities and macroeconomic and public financial management capacity.

  • Has stronger analytical underpinnings given its systematic link to debt sustainability analyses (DSAs). It clarifies how and when flexibility should be exercised in a consistent way. It also provides a clear path towards graduation from concessionality requirements.

In support of the new framework, this paper proposes new guidelines on debt limits and provides commentary on key issues. These include:

  • The capacity to manage public resources adequately encompasses a range of dimensions from policy design to implementation. The budget formulation process should identify which public goods need to be produced and, together with debt policy, how this can be financed in a sustainable way while minimizing risks. Strong public financial management is then critical to ensure effective and efficient implementation of the budget.

  • A two-step process to assess capacity is proposed to ensure uniform treatment of LICs. First, two quantitative indicators with broad coverage of LICs allow for a preliminary identification of higher-capacity countries, in a way consistent with uniformity of treatment. Second, the preliminary classification is refined using all other available information. The initial assessment would be done simultaneously for all LICs with a Fund-supported program.

  • The application of more flexible options for concessionality requirements needs to maintain donors’ incentives to provide highly concessional financing For example, it should avoid leading some donors to reduce the grant element of their new lending, particularly in a period of tight fiscal constraints. It should also address possible concerns that flexibility be used to contract too much (nonconcessional) debt and issues of cross-subsidization.

  • The new framework seeks to mitigate concerns in this area by: the tight link to DSAs; the incentive to seek concessional terms under all options in the proposed new framework; the emphasis on capacity, which provides confidence that resources are going to be put to good use, and that any nonconcessional borrowing will be contracted to complement scarce concessional resources; and attention paid to the quality and intensity of the dialogue with donors.

  • The new framework includes a presumption that non-LIC debt limits would not include concessionality requirements, as these members generally have no, or very limited, access to concessional financing. In the exceptional cases where concessionality requirements are relevant for non-LICs, the framework would apply as for LICs.

I. Introduction1

1. In March 2009, the Executive Board reviewed the policy and practice on external debt limits in Fund-supported programs for low-income countries (LICs).2 The Board emphasized the important role of the Fund’s framework in preventing the build-up of unsustainable debts in LICs, while allowing for adequate external financing. Directors noted that many LICs continue to be in fragile debt situations, while their development and financing needs remain large. Recourse to external concessional resources, including grants, therefore remains highly desirable for these countries. Nonetheless, the diversity of individual country situations warrants a review of the policy on debt limits to allow for more flexibility in its application.

2. The Board broadly supported staff’s proposal to move away from a single design for concessionality requirements toward a menu of options. While current policy and practice already entail a significant amount of flexibility, the new approach introduces a formal framework to use this flexibility in a more systematic and consistent fashion. The approach would reflect better the diversity of situations in LICs, in particular with regard to the extent of debt vulnerabilities and macroeconomic and public financial management capacity (henceforth “capacity”). The current policy could continue to be applied to lower-capacity countries, but with more flexibility for those with lower debt vulnerabilities. More flexible options, eschewing the debt-by-debt approach of the current policy, could be considered for higher-capacity countries. For more advanced LICs, consideration could be given to dropping concessionality requirements altogether in setting external debt limits.3 Unless debt sustainability is a serious concern and capacity is limited, these options, which are summarized in the matrix below (Table 1), offer LICs more flexibility than current practice.4

Table 1.

Concessionality Options Matrix

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Source: IMF (2009)6.

3. This paper clarifies a number of issues raised by Directors in March and proposes revised guidelines on debt limits for Board approval; the proposed decision to implement these proposals will be circulated in a supplement to this paper. While Directors agreed that debt sustainability analyses (DSAs) provided an appropriate basis for assessing debt vulnerabilities, they emphasized the need for objective and credible criteria to assess capacity under the new approach.5 Section II proposes a simple analytical framework for assessing capacity, which allows a wide range of information to be taken into account while providing uniformity of treatment. Section III specifies how some of the options for concessionality requirements would work in practice and discusses the issue of maintaining donors’ incentives to provide highly concessional financing under the more flexible options. Because the policy on debt limits applies to all members seeking a Fund-supported program, Section IV highlights the implications of the proposed amendments to the policy on debt limits for non-LICs. Section V addresses transitional arrangements. Section VI discusses resource implications. Revised guidelines on debt limits are proposed in Supplement 1.

4. A companion paper prepared jointly with the World Bank reviews some aspects of the debt sustainability framework (DSF) with a view to making it more flexible.7 In this review, staffs have been mindful that the DSF is essentially an analytical tool whose integrity should be preserved. A more appropriate vehicle for the Fund to respond flexibly to the needs of its membership is the policy on debt limits, whose increased flexibility is the subject of the present paper.

II. Assessing Capacity

5. This section specifies the critical functions that need to be covered by an assessment of capacity; reviews the information available in this area; proposes an analytical framework based on quantitative indicators to initiate identification of higher-capacity countries; and then suggests a process for staff to incorporate other relevant information and reach a more comprehensive assessment of capacity.

A. What are we trying to assess, and what information is available?

6. The more flexible options for concessionality requirements would be appropriate for countries with higher capacity to manage public resources. These options—average concessionality requirements or targets on the present value (PV) of new debt—would give more flexibility to the authorities to determine which projects to implement, and how to finance them.8 Adequate capacity to identify and implement suitable projects, raise the required financing and manage the corresponding debt, and more generally manage public resources well would therefore be critical to ensure that the authorities can handle directly the whole gamut of donors and creditors and their various financing instruments, and more generally make the best possible use of (concessional and) nonconcessional financing. Adequate capacity would also go a long way towards addressing donors’ concerns about modifying the Fund’s traditional gate-keeper role (see Section III.B). Finally, adequate capacity would be required to ensure that the authorities can meet the more demanding operational requirements of the more flexible options.

7. The capacity to manage public resources adequately encompasses a range of dimensions, from policy design to implementation. The budget formulation process should identify which public goods need to be produced and, together with debt policy, how this can be financed in a sustainable way while minimizing risks. Strong public financial management (PFM) is then critical to ensure effective and efficient implementation of the budget. Critical elements that should figure prominently in the assessment would include: the overall design of the expenditure program, including budget planning and execution; mechanisms of oversight and internal and external control; design and implementation of a medium-term debt management strategy; and the track record of performance in these areas. For all these elements, the quality of institutions (including legal frameworks and regulations), processes, and staff matter. Efficiency also requires transparency and accountability for these policies and processes to ensure appropriate incentives and reduce the scope for governance problems.

8. A number of these dimensions are already the subject of formal assessments. Table 2 provides a summary of the main available indicators. The selection was based on the following principles: (i) relevance; (ii) quantifiable nature, which allows for benchmarking and facilitates cross-country comparisons; (iii) country coverage; and (iv) frequency of update, to allow progress in strengthening capacity to be taken into consideration.

Table 2.

List of Available Indicators (as of June 30, 2009)

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9 Two indicators stand out in terms of relevance and country coverage:

  • Components of the World Bank’s Country Policy and Institutional Assessment (“sub-CPIA”). While the overall CPIA index is very broad in scope—a point made by some Directors during the March 2009 discussion—five of its components appear particularly relevant. They cover fiscal policy, debt policy, the quality of budgetary and financial management, the quality of public administration, and transparency, accountability, and corruption in the public sector. They could be used to derive a new index, a “sub-CPIA” (see below and Annex 1 for more details). An important feature of the sub-CPIA is its availability for 74 PRGF-eligible countries, giving it the broadest coverage of all surveyed indices.

  • The Public Expenditure and Financial Accountability (PEFA) framework measures performance of a country’s public financial management (PFM). It offers a comprehensive analysis using 28 indicators grouped in three areas: credibility of the budget, comprehensiveness and transparency, and budget processes, which include elements of both ex-ante and ex-post scrutiny (see Annex 2). PEFA assessments are done every three years and are currently available for 57 countries.

10 Other sources of information would be mobilized in the assessment of capacity. They include, inter alia, other formal assessments such as fiscal ROSCs, the World Bank’s Debt Management Performance Assessment (DeMPA), Project Performance Assessments (PPA), Worldwide Governance Indicators (WGI), and self-assessments of debt management capacity made in the context of the HIPC Capacity Building Program (CBP) (see Annex 3 for details). Just as importantly, they would include less formal but highly relevant information, such as Fund staffs views on fiscal policy, public financial management, debt management, and any other relevant recent developments or ongoing reforms.

B. A framework to identify higher-capacity countries

11. The diversity of available information, while welcome for the assessment of capacity, raises challenges for a uniform treatment of countries. Many formal assessments are available for only a small set of LICs, and therefore limit cross-country comparisons. Identical issues arise with softer information, which may not fully reflect a broad cross-country perspective.

12. To address this issue, staff suggests a two-step process. The first step relies on relevant quantitative indicators with broad coverage of LICs. This would allow for a preliminary identification of higher-capacity countries, in a way consistent with uniformity of treatment. In a second step, this indicative classification would be used as a starting point to determine a more precise classification, using all other available information.

13. For the first step, staff suggests using the sub-CPIA and PEFA as guideposts. These two indicators are the most relevant and have the broadest coverage (see Box 1 for the methodology used to construct them and some of their properties). While there is some overlap between the two indicators, they are complementary and using both provides a robustness check on the assessments.

14. Thresholds need to be defined to identify higher capacity, as neither guidepost provides absolute benchmarks. Staff suggests defining the threshold for each guidepost as the average score of countries classified as “blend” by IDA, i.e., LICs that are considered creditworthy enough to borrow from IBRD (Table 3).9, 10

Table 3.

Average Sub-CPIA and PEFA Scores

(Index)

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Sources: CPIA database, World Bank; and PEFA database; and staff estimates.

Simple average.

Excludes Zimbabwe, in view of the large deterioration in its economic situation in past years.

15. For the 55 LICs for which both the sub-CPIA and PEFA indicators are currently available, a preliminary classification of “higher capacity” would require having a score above the threshold for each indicator. The sub-CPIA index and the PEFA measure different dimensions of capacity, and there is no reason a priori to give a greater weight to one indicator over the other. Countries with both sub-CPIA and PEFA scores below the thresholds would be initially classified in the lower category. Countries with one score above the relevant threshold and the other below the other threshold would be temporarily placed in a “grey area”.

16. The 21 LICs for which only one indicator is available would initially either be placed in the grey area or classified in the lower category on the grounds that information on only one indicator would not be sufficient for a classification in the higher category.11 To be placed in the grey area, the available indicator should be above a lower bound that would be defined as the “higher capacity” threshold minus one standard deviation for the score of blend countries. This approach would be consistent with the treatment of countries for which both indicators are available, under which placement in the grey area requires either one of two indicators to be above the relevant threshold.12

The Sub-CPIA and PEFA Indices

The sub-CPIA is constructed using two CPIA components that are policy-related (debt and fiscal) and three that rate the quality of public financial management and institutions. Each component is given equal weight, reflecting the assumption that all dimensions are equally important for the assessment of capacity and consistent with CPIA methodology. In the remainder of the paper, the sub-CPIA is based on 2008 CPIA data, reflecting the latest available information. The sub-CPIA is highly correlated with the overall CPIA (see table below). However, Annex 1 shows significant divergences between the two indices in some countries, which justifies the use of the sub-CPIA in the assessment rather than the use of the CPIA itself.

Correlation Coefficients of the Indices of the Various Sub-Components and with the Overall CPIA

(in percent)

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Source: CPIA database, World Bank; and staff’s estimates.1/ The correlation coefficients are significant since their t values are higher than 3.

PEFA ratings for its 28 components are based on an ordinal scale (A to D) and were converted into numerical values and then aggregated using equal weights to construct the PEFA indicator.1/ This indicator is highly correlated with the sub-CPIA.

Correlation Coefficients of PEFA and Sub-CPIA Index

(in percent)

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Source: CPIA database, PEFA database and staff estimates.1/ The coefficient are significant ranging from 4.86 to 5.84.
1/ This is consistent with other reports using PEFA aggregation techniques (see Annex 2).

17. In a second step, all relevant information would be mobilized to arrive at a more precise assessment of capacity. As indicated above, this would include staff’s qualitative assessments on relevant issues as well as the indicators mentioned in paragraph 10. An important consideration would be the country’s ability to articulate a sound borrowing strategy in the context of a DSA and a Medium-Term Debt Management Strategy (MTDS).13 Other relevant considerations include: the country’s track record of accessing market financing and managing nonconcessional borrowing; the timely provision of debt data; the country’s track record in selecting high-return public investment projects in a transparent and competitive manner; the quality and intensity of the dialogue with donors (to minimize the risk that nonconcessional borrowing leads to reduced donor efforts to provide concessional support);14 the recent evolution of the sub-CPIA index, particularly if it is close to the threshold; and the country’s classification by IDA (e.g., IDA-only or blend).

18. To further ensure uniformity of treatment, this second step would involve a simultaneous assessment of LICs with a Fund-supported program in the Fall of 2009. The preliminary classification derived from the use of the sub-CPIA and PEFA indices would be the starting point for an inter-departmental discussion. World Bank staff with relevant expertise would be invited to provide their views. All assessed countries would be reviewed in this second step. For those assessed in the higher or lower category in the first step, clear evidence would need to be presented to justify a change in the preliminary assessment. The outcome of this exercise would be to place all LICs with a Fund-supported program in either the lower or the higher category.

19. An annual stock-taking exercise would be conducted subsequently, to assess the need for changes in the classification based on new information, including evidence provided by the authorities. This would allow any progress made by a country in the course of a year to be taken into account, possibly leading to a reclassification from the lower to the higher category.15,16 The possibility of a reclassification from the higher to the lower category could not be ruled out if capacity deteriorates. This could happen, for instance, if a country has proved unable to implement the more flexible options satisfactorily. While reclassifications would be expected to take place at the time of the annual stock-taking exercises, individual changes may need to be considered in between on a case-by-case basis. This would obviously be the case if a member not previously assessed were to request a Fund-supported program. This could also be justified in exceptional circumstances, such as a major development affecting substantially capacity. The classification would be communicated to the Board for information after the annual stock-taking.17 The authorities’ views would be reflected in staff reports, in the event of a disagreement on the assessment.

III. How Would the Various Options for Concessionality Requirements Work in Practice?

A. Operational issues

20. This section clarifies a number of operational issues regarding some of the options in the matrix. In particular, it provides guidance on how to (i) determine the size of nonconcessional borrowing limits in countries with lower capacity and lower debt vulnerabilities; and (ii) operationalize the more sophisticated approaches—average concessionality requirement or PV targets—in countries with higher capacity.

Setting nonzero limits on nonconcessional borrowing

21. As general rule, the size of a nonzero limit on nonconcessional borrowing in countries with lower capacity and lower debt vulnerabilities should not be so large that, if fully used, it would lead to a downgrading of the DSA risk rating. The DSA should use realistic assumptions for nonconcessional borrowing beyond the period for which a nonzero limit is proposed. For instance, it would not be realistic to assume a large nonzero limit in the near future followed by little or no nonconcessional borrowing in the remainder of the DSA’s 20-year forecasting period.

22. This approach could be complemented by a “speed bump” in some cases. In countries with large borrowing space—such as post-MDRI countries where debt ratios are far below their DSF thresholds in the baseline and alternative scenarios―the rule proposed in the previous paragraph may leave excessive room for borrowing, including from an absorptive capacity perspective. In such cases it would be appropriate to use a “speed bump”, i.e. an indicative limit on the pace at which debt ratios can rise.18

23. Within this group of lower-capacity/lower-debt-vulnerability countries, untied limits—limits not linked to a specific project―would normally be reserved for those with relatively better capacity levels. Those countries would typically have sub-CPIA and/or PEFA scores close to the above-defined thresholds, or be countries that were initially assessed as being in the grey area.

Setting PV targets or average concessionality requirements.

24. The solutions proposed to set PV targets or average concessionality requirements were designed to meet two basic criteria: (relative) simplicity to facilitate implementation and monitorability; and consistency with the DSA. Box 2 explains how these more advanced and flexible options could work. Some issues raised by these options are discussed below. Box 3 clarifies how grants should be treated under the more flexible options.

25. PV targets (and average concessionality requirements) could be set based either on disbursements or contracting. The former option would have the advantage of a closer link to the DSA, which is based on disbursements, while the latter would simplify monitoring, as there are typically more disbursements than debts contracted over any period of time. Staff suggests making both options available.

How Would Average Concessionality and PV Targets Work in Practice?

  • Disbursements vs. contracting. A single loan can generate several disbursements over a period of time. Concessionality calculations in the current debt-by-debt approach are done at the time of contracting, assuming full upfront disbursement. This approach has the advantage of being very simple—a loan is assessed once and for all at contracting—and it does not require a projected schedule of disbursements. By contrast, DSAs are closely linked to balance of payments and fiscal projections and are therefore based on disbursements. To make things tractable, the DSA does not distinguish whether a disbursement corresponds to a new or existing loan, and typically applies standardized terms to all disbursements from a given creditor or donor (e.g., IDA).

  • Setting and monitoring a PV target based on disbursements. The easiest approach to set the target is to use the projected PV of new disbursements in the DSA. Monitoring of compliance with the target requires getting information on all new disbursements (irrespective of whether they correspond to an existing or new loan) and corresponding schedules of repayment. All new disbursements are converted in U. S. dollars using the same exchange rates as in the DSA, and corresponding PVs are calculated using the DSA discount rate.19 Individual PVs are then added up and the total is compared to the target for the period.

  • Setting and monitoring an average grant element based on disbursements. The DSA can provide directly a target, by comparing the projected PV of new disbursements with their nominal values. Monitoring requires the same information and steps as for a PV target.

  • Setting and monitoring a PV target based on contracting. The DSA cannot be used directly to set such target. However, it is possible to set a target on contracting consistent with the DSA. This would require, when the DSA is conducted, information on which future disbursements are linked to debt expected to be contracted in the coming period. The PV of this debt can then be calculated, using DSA parameters, and be used as a target. Monitoring involves the same information (on new debt contracted) and steps as for a disbursement-based approach.

  • Setting and monitoring an average grant element based on contracting. The PV of new debt contracted in the coming period needs to be calculated first and then compared to the corresponding nominal value. Monitoring requires the same information and steps as for a PV target.

26 Targets on average grant elements may vary significantly across countries, even among countries with the same degree of debt vulnerabilities For a given country, they may also vary significantly from one year to the next. Thus, in any given year and country, such a target may exceed or fall short of 35 percent by large margins. These potential variations reflect the diversity of country situations with regard to financing needs and access to concessional resources: for instance, some countries may benefit from very large volumes of highly concessional finance, while others may receive lower volumes of somewhat less concessional finance. It also reflects the timing of delivery of concessional finance and lumpiness of development projects. These variations are illustrated in Figure 1, which shows the grant element of new financing for a sample of countries with low DSA risk ratings, as assumed in these countries’ DSAs.

The Treatment of Grants

Under the options relying on a debt-by-debt approach to concessionality, grants can play a role in determining the overall concessionality of a financing package. The Fund may indeed assess on a case-specific basis whether an envisaged combination of financing instruments, including grants, can be treated as a package for purposes of meeting concessionality requirements.

However, the essence of the more flexible options, including average concessionality requirements, is to move away from the debt-by-debt approach, which implies a different treatment of grants.

  • PV targets or average concessionality targets would be based on PVs of debt calculated in DSAs. These PVs are not affected by grants, since a grant’s PV is equal to zero.

  • Once a target for average concessionality has been set, countries may have an incentive under this approach to substitute planned grants for highly concessional loans. This would indeed allow them to raise more nonconcessional resources. This seems, however, to be a largely theoretical issue. In practice, countries have limited choice on whether to get a grant or a loan from a donor, as this decision is generally driven by the donor’s own policies.

  • In some rare cases, grants may need to be taken into account in the monitoring of targets. This would be the case, for instance, if a concessional loan expected from a donor at the time of the DSA ended up being a grant. This grant would need to enter the average concessionality calculations to avoid penalizing the country for getting better-than-expected terms. Conversely, an expected grant eventually materializing as a concessional loan should not be taken into account in average concessionality calculations.

Figure 1.
Figure 1.

Projected Grant Element of New Financing for Selected Low-Risk Countries

(in percent)

Citation: Policy Papers 2009, 038; 10.5089/9781498335744.007.A001

27. Both average concessionality requirements and PV targets need to be consistent with the fiscal framework. There may be cases where debt limits solely based on sustainability considerations would allow for too much borrowing from a demand management perspective20. In such cases, binding limits on the overall fiscal deficit or nominal debt should take precedence.

28. PV targets or average concessionality requirements would be more appropriate as annual indicative targets than as performance or assessment criteria, at least in an initial phase. Setting these targets requires many assumptions (e.g., on the expected timing and terms of new disbursements or contracting) and is significantly more complex than setting debt limits tied to specific projects. Moreover, while targets in Fund-supported programs for LICs are typically set semi-annually to coincide with six-monthly program reviews, PV or average concessionality targets should preferably be set on an annual basis, since they are derived from DSAs that use annual data. Compliance with indicative annual targets would be an important element of program reviews.

29. For the most advanced LICs, concessionality requirements could be dropped. These countries, in addition to being assessed as higher capacity, would be expected to have higher per capita income, a strong track record of macroeconomic and public resource management, significant market access, and satisfactory experience in dealing with nonconcessional financing. As pointed out in IMF (2009), these countries would likely be classified as gap or blend countries by IDA and therefore not subject to IDA’s Nonconcessional Borrowing Policy. Such a treatment would be applied on a case-by-case basis and clearly justified in the relevant program document.

B. Addressing concerns with the flexible approaches

30. During the March 2009 discussion, Directors stressed the need for adequate safeguards to maintain donors’ incentives to provide highly concessional financing in the more flexible options. As discussed in the previous paper, the issue of donors’ incentives is a real one, particularly for those for which concessionality requirements have proved binding. In the absence of a requirement applying to all new debt, some donors may be tempted to reduce the grant element of their new lending, particularly in a period of tight fiscal constraints. Possible additional concerns about the more flexible options include (i) the risk that this flexibility be used unwisely, either to contract too much debt in general or too much nonconcessional debt in particular; and (ii) cross-subsidization issues, i.e., the perception of a donor that its efforts benefit ultimately a less concessional donor or creditor―by creating space for such lending―rather than the country itself.

31 Staff is of the view that these concerns should be mitigated by the following considerations

  • The risk of excessive borrowing is addressed through the tight link to DSAs. PV targets set a limit on total new borrowing, while average concessionality requirements would only be considered for lower-vulnerability countries. Should an average concessionality requirement lead to excessive borrowing one year, the problem could be fixed the next year through a more constraining target.

  • The risk of excessive nonconcessional borrowing is also addressed in both options. The scope for nonconcessional borrowing is limited by the need to meet the target for the average grant element or the PV of new borrowing. In both options, the authorities have an incentive to seek concessional terms so as to get a higher nominal amount of resources for a given target.

  • Making sure the country, not another creditor, benefits from a donor’s efforts. First, it should be stressed that this issue already arises in the current approach to concessionality. Many traditional donors provide grants, and are therefore much more concessional than other donors or creditors providing loans. A significant share of programs also include some space for nonconcessional borrowing. Second, this concern is addressed in the more flexible options by making them available only to higher-capacity countries. This requirement should provide confidence to donors that their resources are going to be put to good use, and that any nonconcessional borrowing will be contracted to complement scarce concessional resources and finance expenditures that will ultimately benefit the country. Third, as mentioned in Section II, the quality and intensity of the dialogue with donors will be taken into account in determining higher capacity. An ongoing and open dialogue on spending plans and financing options should go a long way towards addressing donor concerns.21

32 While the new approach to concessionality may lead donors to reallocate some of their concessional resources across LICs, it should not be perceived as an invitation to reduce their overall efforts. Concessional resources remain the most appropriate mode of financing for most activities in LICs. More such resources are needed, not less, including to address the implications of the ongoing financial crisis.

IV. Implications for Non-LICS

33. The changes to the policy on debt limits have implications for both LICs and non-LICs, as the current guidelines apply to all Fund members. They were drafted to allow for sufficient flexibility to account for the diversity of individual country circumstances.22 The same coverage and flexibility are suggested for the proposed new guidelines. Two aspects of the reforms with particular implications for non- LICs are discussed below.

34. There would be a presumption that debt limits in Fund-supported programs for non-LICs, if any, would not include concessionality requirements.23 This would be consistent with the fact that such countries, because of their higher per-capita income, generally have limited or no access to concessional financing. Having concessionality requirements in this context would therefore be largely irrelevant. This presumption would also be consistent with the philosophy behind the concessionality matrix for LICs, which provides a path towards graduation from concessionality requirements. This would also be consistent with recent practice in non-LICs, for which only a few have debt limits and out of those most programs do not include concessionality requirements (Table 4). Where appropriate, debt limits would be established in Fund-supported programs for non-LICs, including possibly nominal debt limits.24

Table 4.

Minimum Concessionality Requirement and Debt Limits in Selected Non-LIC Program Countries (in millions of USD, unless otherwise specified)

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Includes cases where targets are set on the primary balance.

Romania has a ceiling on the issuance of guarantees.

35. The definition of external debt in the context of the guidelines on debt limits should follow the principles discussed in March 2009 on the use of the residency criterion for all members.25 In countries with open capital accounts, the distinction between external and domestic debt based on residency is very difficult to make in practice―raising the issue of the monitorability of external debt limits. For members with still relatively closed capital accounts or very limited financial integration with the rest of the world, the use of the residency criterion would still be relevant with some amendments26. Otherwise, where there is a need to mitigate the exchange rate risk associated with foreign currency nonconcessional borrowing, a currency denomination criterion could be used.

V. Transitional Arrangements and Review

36. It is expected that the new debt limits policy will be implemented over time. If the Executive Board approves the proposed decision, the capacity assessment of each LIC will be finalized through an interdepartmental consultation. Staff expects that this could be completed by end-November and thus, it is proposed that the new Guidelines enter into effect on December 1, 2009. Countries that are subject to a performance criterion on external debt limits under a Fund-supported program and for which the status will change under the matrix approach would continue to be subject to the old policy on external debt limits until the relevant performance criterion is amended following the entry into force of the new Guidelines.

37. A review of experience with this new approach could be conducted after a fairly short period of time, say two years. An early review would be justified given the number of conceptual and technical innovations embedded in the new approach. It would allow to take stock of the experience with it, and to address any teething problems with some of the technical aspects (e.g., setting and implementing limits on PVs).

VI. Resource Implications

38 Staff believes that the additional resource requirements to implement the proposals set forth in this paper are manageable. As of July 2009, there were 35 programs with concessionality requirements. Staff estimates the gross resource needs to be about 1/3 of a staff-year to conduct the initial capacity assessment. Subsequent updates would be significantly less resource-intensive.27

39 Resource savings from the streamlining of DSA requirements (see companion paper on the DSF) would offset these costs. In the absence of major changes in the debt sustainability outlook and of program requirements, staff proposes to conduct full DSAs only once every three years with lighter annual updates in between. Once the global economic environment has stabilized, the implied annual resource savings are estimated at slightly less than one staff-year.28 Some of these savings could be allocated to deeper analysis of the public investment-growth nexus.

VII. Issues for Discussion

  • Do Directors agree with the proposed two-step approach to measure capacity?

  • Do Directors agree that the first step should rely on the sub-CPIA and PEFA indices?

  • Do Directors agree that the assessment of capacity should be conducted annually for program countries and be communicated to the Board for information?

  • Do Directors agree that staff s proposals sufficiently address the issue of maintaining donor incentives to provide highly concessional resources?

  • Do Directors agree that in certain circumstances the residency criterion could be replaced by a currency of denomination criterion?