A Review of the LIC DSF MDB Meeting Washington DC, July 8 Bank-Fund Debt Sustainability Framework (DSF)

A Review of the LIC DSF

MDB MeetingWashington DC, July 8

Bank-Fund Debt Sustainability Framework (DSF)

Outline

I. IntroductionII. Meeting Flexibly Members’ Financing NeedsIII. Adding Flexibility to the Analytical Tool


I. INTRODUCTION


Introduction

• The DSF was introduced in 2005 and reviewed in 2006

• Its aim is to inform Bank-Fund analyses on debt vulnerabilities and allow better informed decision making by lenders and borrowers

• Over the past four years its use has increased significantly


Introduction

• The DSF has been criticized as being pro-cyclical and too restrictive on countries’ borrowing needs to meet their development goals

• The G20 and the IMFC called on the Bank and the Fund to review the DSF seeking for ways to increase its flexibility


II. MEETING FLEXIBLY MEMBERS’ FINANCING NEEDS


Meeting flexibly members’ financing needs

• The DSF, an analytical tool, is used to assess a country’s debt burden (i.e., its probability of debt distress): the thermometer.

• Policies set by the Bank and the Fund on non-concessional borrowing, as well as grant allocation decisions, use the analytical tool as an input: the treatment.


Meeting flexibly members’ financing needs

• In reviewing the DSF staffs have been mindful that the integrity (reliability) of the analytical tool must be preserved.

• The non-concessional borrowing policies are better suited to respond flexibly to members’ financing needs.

• There is scope for flexibility in the borrowing policies of the institutions, and flexibility has been applied in many instances.


III. ADDING FLEXIBILITY TO THE DEBT SUSTAINABILITY FRAMEWORK


How the DSF Works• The DSF consists of the following set of policy-

dependent indicative debt thresholds.• 20 year projections of debt burden indicators in a

baseline and alternative scenarios, and subjected to stress tests, are compared against these thresholds to determine a country’s risk of debt distress rating


Table: Debt Sustainability Framework Thresholds

PV of debt in percent of Debt service in percent ofExports GDP Revenue Exports Revenue

Weak Policy (CPIA < 3.25) 100 30 200 15 25Medium Policy (3.25 < CPIA < 3.75) 150 40 250 20 30Strong Policy (CPIA > 3.75) 200 50 300 25 25

How the DSF WorksIn assigning one of the four risk of debt distress ratings the staffs are expected to exercise judgment and not follow a mechanistic approach.• Low risk: all debt burden indicators are well below the thresholds.• Moderate risk: debt burden indicators are below the thresholds

in the baseline scenario but thresholds could be breached in stress tests and alternative scenarios.• High risk: one or more debt burden indicators breach the

thresholds on a protracted basis under the baseline scenario.• Debt distress: the country is already experiencing difficulties in

servicing its debt (i.e., is in arrears) irrespective of its capacity to repay based on a forward looking analysis.


How the DSF WorksNote that the thresholds imply different probabilities of debt distress for countries with different CPIAs.


10%

15%

20%

25%

30%

35%

2.50 2.75 3.00 3.25 3.50 3.75 4.00 4.25 4.50

Pro

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bil

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of

Deb

t D

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ess

CPIA

Adding flexibility to the DSF

The potential to enhance flexibility in the following five areas could be considered:

a)Investment-growth nexusb)Remittancesc) Threshold effectsd)Discount ratee)SOE debt


The investment-growth nexus: 2006 Advice

• The (public) investment growth dividend problem was acknowledged in 2006 and a country specific approach recommended.

• The empirical literature still does not provide a clear cut answer allowing a general way to quantify the effect of investment on growth.

• The indicators proposed then to operationalize this approach remain largely valid (historical rates of return, structural/macro constraints, etc.)


The investment-growth nexus:What more might be done?

• Using a more complete growth-diagnostic approach to uncover the main constraints to growth could enhance the country-specific analysis.

• Emphasizing more country efforts to “invest in the investment process”, i.e., efforts to improve the policy making and institutional environment, would be helpful.

• Assessing countries’ capacity to capture financial returns on investments is important as it affects fiscal solvency in the long run.


The investment-growth nexus:What more might be done?

• Where a significant up scale in investment is taking place and where policy and institutional capacity appears strong, a country specific model-based analysis (using a dynamic stochastic general equilibrium model) or a micro-level study may be warranted.


RemittancesAn important source of FX for LICs


Figure 1: Workers' remittances

and other inflows in low-income countries (% of GDP)

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Gross official development assistanceForeign direct investment (net)Workers' remittances

Source: World Bank, World Development Indicators (2009)


Figure 2: Workers' remittances as a percentage of exports and GDP (average 2002-2007) for PRGF-eligible and IDA-only countries 1/

as a percentage of exports

0% 25% 50% 75% 100% 125% 150% 175% 200%

Côte d'IvoireBurundi

Congo, Republic ofVanuatuMalawi

TanzaniaMadagascar

DjiboutiMozambique

LesothoZambia

CameroonGhana

MyanmarSolomon Islands

CambodiaRwandaGuinea

NigerKenya

EthiopiaNigeria

São Tomé & PríncipeMali

MongoliaBenin

SierraLeoneTogo

GuyanaKyrgyz Republic

Sri LankaMoldovaSenegal

HondurasGuinea-Bissau

NicaraguaGambia, The

SudanCape Verde

UgandaTajikistan

BangladeshNepalTonga

Haiti

Source: World Bank, World Development Indicators (2009)1/ Average over 2002-2007 of available data.

as a percentage of GDP

0% 5% 10% 15% 20% 25% 30% 35%

Côte d'Ivoire Burundi Malawi

TanzaniaVanuatu

MadagascarCongo, Republic ofPapua New Guinea

MozambiqueDjibouti

CameroonRwandaZambiaGhana

Lesotho Armenia

Niger Solomon Islands

EthiopiaGuinea

São Tomé & PríncipeKenya

Georgia Benin

CambodiaSierra Leone

MaliSt. Lucia

Bolivia Nigeria

St. Vincent & Grens.Sudan

UgandaDominicaGrenada Senegal

BangladeshTogo

MongoliaSri Lanka

Guinea-Bissau Kyrgyz Republic

Nicaragua Moldova

Cape VerdeGambia, The

AlbaniaNepal

HondurasGuyana

TajikistanHaiti

Tonga

Remittances: How are they treated in the DSF?

• Remittances were not included in the empirical model used to derive the thresholds

• The DSF currently allows some flexibility in recognizing remittances in assessing a country’s risk of debt distress, although it has seldom been used


Remittances: What more might be done?

• Limitations related to the quality and coverage of data preclude re-estimating the empirical model (thresholds) including remittances

• Expanding the scope for flexibility in recognizing remittances in the assessment of a country’s risk rating could be considered


Threshold effects: What is the problem?

• For countries close to the cut off points of CPIA ranges, small changes in a country’s CPIA may imply “large” changes in debt thresholds (50 pp of PV Debt/Exports; 10 pp of PV Debt/GDP)

• This is hard to relate to the country’s underlying capacity to service its foreign debt

• Resulting changes in debt distress ratings could make it harder for countries to borrow.


Threshold effects: What might be done?• Add granularity to the DSF: This implies introducing

more CPIA cut offs, adjusting thresholds accordingly.• In choosing among options the following criteria

should be considered:a) Tolerance for risk of debt distress: threshold levels should

maintain this risk at levels considered tolerable by Boardsb) Consistent treatment of countries: thresholds applicable to

each country should imply similar probabilities of debt distress

• Ideally, greater granularity should not imply thresholds that are more stringent than the current ones.


Discount rate• The current rule establishes that the discount rate (used to

calculate PV of Debt) needs to be adjusted (with a lag) following market trends. A lowering of the rate by 100 basis points is now due.

• Consideration as to whether mechanical (inflexible) application of this rule might lead to a significant change in risk of debt distress assessments is needed.

• Simulations show that a change in the discount rate to 4 percent would generally result in relatively small increases in PV of debt.

• And a very small number of countries would experience small and temporary breaches of their respective thresholds.


SOE debt• The current rule is that all SOEs external debt is included

in the DSA, although exceptions have occurred.• Critics argue that this treatment is too rigid and staffs

should consider increasing flexibility.• Staffs are proposing to exclude SOE debt whenever

firms can borrow without government guarantee and their operations pose a limited fiscal risk.

• Going forward, staff will consider if it may be feasible to include SOEs debt in DSAs in the same proportion as the government’s equity share (instead of 100%).


Other issues: Streamlining DSAs

• Staffs are also considering how to streamline the production of DSAs.

• One possible option could be to do full DSAs less often, with lighter annual updates in the interim.


A Review of the LIC DSF

MDB MeetingWashington DC, July 8


Documents

A Review of the LIC DSF MDB Meeting Washington DC, July 8 Bank-Fund Debt Sustainability Framework (DSF)