A Review of the LIC DSF

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

2. Bank-Fund Debt Sustainability Framework (DSF) Outline • Introduction • Meeting Flexibly Members’ Financing Needs • Adding Flexibility to the Analytical Tool

3. Bank-Fund Debt Sustainability Framework (DSF) Introduction

4. Bank-Fund Debt Sustainability Framework (DSF) 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

5. Bank-Fund Debt Sustainability Framework (DSF) 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

6. Bank-Fund Debt Sustainability Framework (DSF) MEETING FLEXIBLY MEMBERS’ FINANCING NEEDS

7. Bank-Fund Debt Sustainability Framework (DSF) 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.

8. Bank-Fund Debt Sustainability Framework (DSF) 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.

9. Bank-Fund Debt Sustainability Framework (DSF) ADDING FLEXIBILITY TO THE DEBT SUSTAINABILITY FRAMEWORK

10. Bank-Fund Debt Sustainability Framework (DSF) 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

11. Bank-Fund Debt Sustainability Framework (DSF) How the DSF Works In 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.

12. Bank-Fund Debt Sustainability Framework (DSF) How the DSF Works Note that the thresholds imply different probabilities of debt distress for countries with different CPIAs.

13. Bank-Fund Debt Sustainability Framework (DSF) Adding flexibility to the DSF The potential to enhance flexibility in the following five areas could be considered: • Investment-growth nexus • Remittances • Threshold effects • Discount rate • SOE debt

14. Bank-Fund Debt Sustainability Framework (DSF) 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.)

15. Bank-Fund Debt Sustainability Framework (DSF) 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.

16. Bank-Fund Debt Sustainability Framework (DSF) 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.

17. Bank-Fund Debt Sustainability Framework (DSF) Remittances An important source of FX for LICs

18. Bank-Fund Debt Sustainability Framework (DSF)

19. Bank-Fund Debt Sustainability Framework (DSF) 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

20. Bank-Fund Debt Sustainability Framework (DSF) 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

21. Bank-Fund Debt Sustainability Framework (DSF) 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.

22. Bank-Fund Debt Sustainability Framework (DSF) 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: • Tolerance for risk of debt distress: threshold levels should maintain this risk at levels considered tolerable by Boards • 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.

23. Bank-Fund Debt Sustainability Framework (DSF) 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.

24. Bank-Fund Debt Sustainability Framework (DSF) 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%).

25. Bank-Fund Debt Sustainability Framework (DSF) 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.

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