The Joint World Bank-IMF Debt Sustainability Framework for Low-Income Countries

April 7, 2016

Low-income countries (LICs) have often struggled with large external debts. Debt burdens have been reduced, thanks in large part to international debt relief initiatives. As part of the Millennium Development Goals (MDG), the IMF and the World Bank have developed a framework to help guide countries and donors in mobilizing the financing of LICs' development needs, while reducing the chances of an excessive build-up of debt in the future. The joint World Bank–International Monetary Fund Debt Sustainability Framework (DSF) was introduced in April 2005, and is periodically reviewed, to address this challenge. The most recent review was discussed in 2012 and work on the next review is ongoing.

Strategic approach in order to reach goals

The framework is designed to guide the borrowing decisions of LICs in a way that matches their financing needs with their current and prospective repayment ability, taking into account each country’s circumstances.

Under the DSF, debt sustainability analyses (DSAs) are conducted regularly and consist of:

  • an analysis of a country’s projected debt burden over the next 20 years and its vulnerability to external and policy shocks—baseline and stress tests are calculated;
  • an assessment of the risk of external debt distress in that time, based on indicative debt burden thresholds that depend on the quality of the country’s policies and institutions; and
  • recommendations for a borrowing (and lending) strategy that limits the risk of debt distress.

Assessing debt to avoid risks

The DSF analyzes both external and public sector debt. Given that loans to LICs vary considerably in their interest rates and length of repayment, the framework focuses on the present value (PV) of debt obligations. This ensures comparability over time and across countries. Following an extended period of historically low interest rates in advanced economies, the discount rate used to calculate the PV had become a poor measure for discounting over the longer term. In view of this, in October 2013 the IMF and the World Bank approved the reform of the discount rate, which is presently set at 5 percent .

To assess debt sustainability, debt burden indicators are compared to indicative thresholds over a 20-year projection period. A debt-burden indicator that exceeds its indicative threshold suggests a risk of experiencing some form of debt distress. There are four ratings for the risk of external public debt distress:

  • low risk , when all the debt burden indicators are well below the thresholds;
  • moderate risk , when debt burden indicators are below the thresholds in the baseline scenario, but stress tests indicate that thresholds could be breached if there are external shocks or abrupt changes in macroeconomic policies;
  • high risk , when the baseline scenario and stress tests indicate a protracted breach of debt or debt-service thresholds, but the country does not currently face any repayment difficulties; or
  • in debt distress , when the country is already having repayment difficulties.

Countries with significant vulnerabilities related to public domestic debt or private external debt, or both, are assigned an overall risk of debt distress that flags these risks. This assessment of overall debt vulnerability complements the rating on the risk of external public debt distress.

LICs with weaker policies and institutions tend to face repayment problems at lower levels of debt than countries with stronger policies and institutions. The DSF, therefore, classifies countries into one of three policy performance categories (strong, medium, and poor) using the World Bank's Country Policy and Institutional Assessment (CPIA) index, and uses different indicative thresholds for debt burdens depending on the performance category. Thresholds corresponding to strong policy performers are highest, indicating that in countries with good policies debt accumulation is less risky.

Debt Burden Thresholds under the DSF

PV of debt in percent of

Debt service in percent of

Exports

GDP

Revenue

Export

Revenue

Weak Policy

100

30

200

15

18

Medium Policy

150

40

250

20

20

Strong Policy

200

50

300

25

22

Integrating debt issues into policy advice

The DSF has enabled the IMF and the World Bank to integrate debt issues more effectively in their analysis and policy advice, through improved frequency and quality of the analysis. It has also allowed comparability across countries.

The DSF is important for the IMF’s assessment of macroeconomic stability, the long-term sustainability of fiscal policy, and overall debt sustainability. Furthermore, debt sustainability assessments are taken into account to determine access to IMF financing, as well as for the design of debt limits in Fund-supported programs while the World Bank uses it to determine the share of grants and loans in its assistance to each LIC.

The effectiveness of the DSF in preventing excessive debt accumulation hinges on its broad use by borrowers and creditors. The IMF and the World Bank encourage LICs to use the DSF or a similar framework as a first step toward developing medium-term debt strategies. Creditors are encouraged to take into account the results of debt sustainability assessments in their lending decisions. In this way, the framework should help LICs raise the finance they need to meet the MDGs, including through grants when the ability to service debt is limited.

More Information about the DSF:

http://imf.org/dsa or http://www.worldbank.org/debt