DEBT SUSTAINABILITY FRAMEWORK FOR LOW INCOME COUNTRIES

1. DEBT SUSTAINABILITY FRAMEWORK FOR LOW INCOME COUNTRIES Nihal Kappagoda

2. OBJECTIVES • Assist Low Income Countries that benefited from debt relief to avoid the future accumulation of unsustainable external debt levels • Enable the World Bank to assess current and future prospects of debt distress of IDA only countries and determine grant eligibility within IDA 14 allocations • Enable the IMF to monitor external debt levels and the ceilings on non-concessional borrowing set in program countries • Provide a framework for Joint Debt Sustainability Analyses by the Bank and Fund for IDA only, PRGF eligible LICs

3. ISSUES FOR DISCUSSION DSF has become complex due to linkages to various policies and institutional changes by the IMF, World Bank and LICs. These are: • The conduct of DSAs, the selection of debt indicators and threshold values for them; • Country Policy and Institutional Assessments performed by the World Bank in LICs; • Estimation of debt distress; • Implementation of the IDA 14 Grant Allocation Framework;

4. ISSUES FOR DISCUSSION (Contd) • Implementation of the MDRI and HIPC Initiative and action remaining after the end of 2006; • Non-concessional borrowing by LICs after receiving debt relief and the “free rider” problem; • Implications of the DSF on the IMF’s policy agenda in LICs; and • Action to be taken by the LICs to improve debt management capacity and formulate a Medium Term Debt Strategy to guide future borrowings

5. DEBT SUSTAINABILITY • External debt sustainability of a country is its ability to service all foreign public and publicly guaranteed and PNG debt without compromising its long–term goals and objectives • Causes of debt stress are high levels of the stock of debt outstanding measured by the absolute amount or NPV as a ratio of GNI, exports or government revenue; weak policy and institutional environment; and exogenous shocks to the economy • Outward manifestations of crisis are the accumulation of arrears, an application to the Paris Club for the restructuring of official debt when it is judged that a breakdown in payments is imminent and agreement with the IMF on a program

6. DEBT INDICATORS Use of debt indicators to judge debt sustainability raise a number of conceptual issues • Definition of debt – public and publicly guaranteed external debt, total public debt or total external debt • Stock of debt – nominal stock expressed in a single currency and NPV of future debt service payments • Capacity to pay – size of the economy (GDP or GNI), exports of goods and services or government revenue

7. THRESHOLD VALUES OF DEBT INDICATORSGlobal Development Finance

8. THRESHOLD VALUES OF DEBT INDICATORS (Contd) HIPC Initiative • NPV of public and publicly guaranteed external debt to exports of goods and services – 150 percent • NPV of public and publicly guaranteed external debt to government revenue – 250 percent

9. THRESHOLD VALUES OF DEBT INDICATORS (Contd)Debt Sustainability Framework

10. COUNTRY POLICY AND INSTITUTIONAL ASSESSMENTS • Based on criteria covering policy and institutional developments needed for an effective poverty reduction growth strategy and effective use of development assistance • Ratings done annually and based on actual policies and institutional changes that are implemented • Sixteen criteria in four groups under Economic Management, Structural Policies, Policies for Social Inclusion and Equity, and Public Sector Management and Institutions • CPIAs used for estimating IDA Country Performance Ratings which with per capita income determine IDA country allocations and assessing debt distress in LICs

11. DEBT DISTRESS • Indicators dependent on government revenue are not used for assessing debt distress • The average of the two stock indicators – NPV of debt to GDP and exports of goods and services – and debt service ratio are used to assess debt distress of LICs • Two bands, 10 percent above and below the thresholds, are used to assess grant eligibility • If the operational ratio - the composite stock indicator or the debt service ratio - is 10 percent or more below the threshold, IDA provides its assistance as credits. If it is 10 percent or more over the threshold, IDA assistance will only be provided as grants. A mixture of grants and credits is provided when the ratio is between the two

12. IDA ALLOCATIONS AND GRANTS • The CPIA has a 80 percent weight in estimating the Country Performance Rating used for determining IDA allocations for each replenishment • The balance 20 percent is provided by the Bank’s assessment of its performance on its portfolio of outstanding loans • A governance factor is applied to the two ratings to determine the CPR • Governance factor is based on the five criteria in the cluster on Public Sector Institutions and Management in the CPIA and portfolio performance • Heavy weightage given to the governance factor than is warranted by its share in the CPIA • Performance based on the CPR and need based on per capita GNI are used to determine the allocation to each LIC • Grant eligibility is determined by the debt distress assessment

13. IMPLEMENTATION OF MDRI AND HIPC INITIATIVES HIPC INITIATIVE • 40 countries met the income and indebtedness criteria to receive assistance. 21 reached the Completion Point and qualified to receive full debt relief. 9 are between the Decision and Completion Points and received some debt relief • 10 are pending agreement on macroeconomic reforms, poverty reduction strategies and plans to clear arrears. Remaining countries grandfathered provided they met the income and indebtedness criteria for data at the end of 2004 and permitted to qualify for debt relief at their own pace • Debt service payments in the 30 countries that had debt relief packages approved declined by two percent of GDP on the average between 1999 and 2005. • Before the Initiative, eligible countries spent more on debt service than on health, education and social services. Now they spend five times the amount on the latter services than on debt service

14. IMPLEMENTATION OF MDRI AND HIPC INITIATIVES (Contd) MULTILATERAL DEBT RELIEF INITIATIVE • The MDRI provides full debt relief from the participating institutions (IMF, IDA and the AfDF) unlike the HIPC Initiative that required coordinated action by all creditors to reduce the external debt of qualifying countries to sustainable levels with each institution providing debt relief separately • The IMF provided debt relief to countries reaching the Completion Point on the full stock of debt at the end of 2004 from January 2006. Two non-HIPCs with per capita incomes of less than $380 were also provided assistance • IDA provided debt relief from July 2006 on all debt outstanding at the end of 2003 when countries reach the Completion Point

15. NON-CONCESSIONAL BORROWING BY LICs • Debt relief under the two initiatives and grant funding by the IDA enabled LICs to keep debt burdens below the threshold values in the DSF • OECD donors and IFIs have coordinated their approach in assisting LICs • Commercial creditors and non-OECD bilateral creditors have not done so and begun lending on non-concessional terms. This is referred to as the free rider problem and reflects differences between collective and individual interests of creditors • IFIs have begun a dialogue with other creditors based on the DSF and an exchange of information on debt relief, grants and the problems created by lending by this group of creditors

16. CHALLENGES AHEAD • Review the debt indicators and thresholds used in the DSF • Integrate domestic public debt to the DSAs conducted on external public debt • Monitor the vulnerabilities that could arise from non-concessional PNG debt and high levels of domestic debt • Foster creditor coordination and broader use of the DSF by both LICs and creditors • Improve data quality and reporting to the IFIs • Strengthen capacity for public debt management

17. DEBT INDICATORS AND THEIR THRESHOLD LEVELS • DSF based on threshold levels of three selected debt indicators • Adopt a broad definition of public debt that takes account of all the liabilities of the public sector • Develop a methodology to assess the sustainability of total public debt • Assess macroeconomic stability taking account of the domestic and external borrowings of the public sector • Include debt indicators that use government revenue as a variable in the DSF

18. INTEGRATION OF DOMESTIC DEBT IN DSAs • Domestic public debt is significant in some LICs • It carries higher risks due to shorter maturities and higher interest rates than external public debt • Methodology is being developed to prepare DSAs for total public debt • A DSA for domestic public debt should be done at the same time as that for external public debt using indicators similar to those used in the DSF with government revenue replacing exports of goods and services • Examine vulnerabilities arising from domestic debt that may lead to a different classification of indebtedness from that obtained by reviewing only external public debt

19. FOSTERING CREDITOR COORDINATION • The IFIs have begun listing the countries for which external debt DSAs have been done and the dates on their web sites. A direct web link is provided to the document once the countries agree • Bank and Fund have begun outreach programs among creditors by attending meetings such as those of the OECD Export Credit Group. Coordination efforts focus on the DSF • Much needs to be done with the non-OECD official creditors called emerging creditors and their share is of the order of 10 percent of total official assistance • The largest are Brazil, China, India, Korea, Kuwait and Saudi Arabia. China is the largest and Kuwait the second • G7 Finance Ministers have called for greater coordination among lenders possibly leading to the formulation of a charter for lending

20. IMPROVED DATA QUALITY AND REPORTING TO THE IFIs • Collection of data on domestic debt and government revenue and reporting them to the IFIs • Half the LICs do not report their external debt to the World Bank’s Debtor Reporting System or there are moderate to major problems with the data submitted • Country data is checked and supplemented with that obtained from the OECD, BIS and Berne Union • IFIs have included mandatory advance reporting of non-concessional loans in grant and credit agreements in post-MDRI countries. A web page on concessionality including a facility to calculate it has been set up

21. IMPROVEMENTS IN PUBLIC DEBT MANAGEMENT • Strength the legal and regulatory framework and institutional framework for public debt management • Establish a debt information system for recording, retrieving and analyzing public debt • Formulate a public debt policy and a Medium-Term Public and External Debt Strategy with a link to the Medium-Term Fiscal Framework • The MTDS should cover the terms of new borrowing, the mix between fixed and variable rates and domestic and public debt and the currency mix for external borrowing • Staff of PDMOs need to undertake comprehensive debt management functions