Debt Sustainability in Low-Income Countries—Further Considerations on an Operational Framework and Policy Implications
September 10, 2004
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On September 24, 2004, the Executive Board of the International Monetary Fund (IMF) discussed a paper prepared jointly by the staffs of the IMF and the Word Bank on "Debt Sustainability in Low-Income Countries—Further Considerations on an Operational Framework and Policy Implications." The paper presents further considerations on an initial proposal discussed by the Executive Board on February 23, 2004.
Low-income countries striving to meet their Millennium Development Goals (MDGs) have large financing requirements. To ensure that progress toward these goals is lasting, financing needs have to be met on terms that will not lead to an unsustainable build-up of debt. The proposed framework is intended to provide guidance to low-income borrowers and their creditors on designing financing strategies that will keep debt-burden indicators at manageable levels.
On the occasion of the earlier discussion of the proposed debt sustainability framework, Directors supported its key elements. These include (i) a standardized forward-looking analysis of the debt and debt-service dynamics under a baseline scenario and in the face of plausible shocks; (ii) assessment of debt sustainability guided by indicative country-specific debt-burden thresholds related to the quality of a country's policies and institutions; and (iii) an appropriate borrowing (and lending) strategy that contains the risk of debt distress.
At the same time, Directors identified a number of issues requiring further consideration before the framework could become operational. In particular, Directors requested refinements and further elaboration on elements of the analytical framework; the modalities for implementing debt sustainability analyses (DSAs); and the implications for World Bank and IMF operations. In guiding this follow-up work, they cautioned against an overly mechanical application of the framework to borrowing and lending decisions and stressed the need for the Bank and Fund to reach consistent assessments, within well defined roles for each institution.
The design of the analytical framework builds closely on the earlier proposal. In light of the strong empirical evidence that a country's policy performance is a significant determinant of debt distress, the originally proposed thresholds are maintained as indicative guideposts. In addition, a number of operational rules are re-examined to clarify the implementation of the framework. As a result, it is proposed that the assessment of policies be primarily based on the World Bank's Country Policy and Institutional Assessment (CPIA) and that DSAs include an analysis of both external and domestic debt, with the latter not informed by thresholds but closely tailored to individual country circumstances. These and other operational rules, as well as their interaction with an indispensable measure of judgment, will be reviewed periodically and revised if warranted in the light of experience and new information.
The Board paper proposed debt sustainability analyses be prepared by Bank and Fund staffs in a collaborative manner, providing a coherent view to the country authorities as well as the donor and creditor community. At the same time, each institution would be responsible for its own assessment and for reporting its view to its respective Board. To minimize the resource implications, DSAs would be made part of the operational practices of both the Bank and the Fund—presented to the Boards of the two institutions respectively as an annex or supplement to the Country Assistance Strategy (CAS) and the Article IV staff report. DSAs would include a concluding paragraph presenting an assessment of the level of debt risk where the Bank and Fund staff would seek to reach agreement.
The DSA framework forms the basis for proposals for some operational changes in the World Bank's International Development Association and the IMF's Poverty Reduction and Growth Facility operations. For IDA, debt sustainability would form the basis for grant allocation in IDA-14. IDA Deputies have recently indicated broad support for allocating grants to debt distressed countries, and Bank staff are finalizing a rules-based allocation framework that currently uses the indicative thresholds in the framework, but would gradually incorporate results of DSAs as they become available. For the Fund, the framework would form the basis for incorporating debt sustainability considerations more explicitly in Fund conditionality. It is proposed that the framework be used to develop indicative targets on the net present value of external debt and on the overall fiscal deficit (including grants as a revenue item). The objective of these indicative targets would be to signal to creditors and borrowers the point beyond which additional resources would need to be provided on more concessional terms to avoid a significant increase in a country's risk of debt distress.
Executive Board Assessment
Executive Directors welcomed the opportunity to revisit the Fund and Bank staffs' joint proposals for an operational debt sustainability framework for low-income countries and endorsed the general principles underlying the proposed framework. They underscored the importance of such a framework to help ensure that the large financing needs associated with efforts to achieve the Millennium Development Goals do not lead to an unsustainable build-up of debt, and that countries having received debt relief under the HIPC Initiative will stay on a sustainable track.
Directors generally supported the use of empirical debt-burden thresholds as guideposts for future financing decisions rather than firm ceilings for borrowing. Such an approach acknowledges the limitations of empirically-based thresholds, which can only capture those determinants of debt distress that are common across countries, and may not in and of themselves allow adequate consideration of individual country circumstances. Nonetheless, in light of the empirical evidence, most Directors agreed that the quality of policies and institutions should be incorporated into debt sustainability analysis. Others were concerned that the use of forward-looking thresholds that varied across countries and deviated from the uniform HIPC approach could be confusing at a time when the Initiative was still being implemented, and emphasized the importance of a clear communications strategy. These Directors were supported by most others in their preference for more conservative thresholds to limit the prospects of future debt distress. However, they recognized that a lower tolerance for debt distress would require higher levels of grant financing in pursuit of the MDGs. Directors recognized that applying the framework remains a challenge, and further work is needed on resolving some critical issues, including thresholds, before the full framework is operationalized. They therefore asked the staffs of the IMF and the Bank to prepare a joint note on alternative options for thresholds and their implications along with other analytical work.
Most Directors agreed that, in applying the DSA framework, the assessment of policies and institutions required a consistent approach across countries. Directors generally endorsed the use of the World Bank's Country Policy and Institutional Assessment. Although a number of Directors continued to be concerned about possible over-reliance on the CPIA, they acknowledged that alternative comprehensive indicators would be unlikely to provide more objective or more accurate assessments. Many Directors noted that remaining concerns would be alleviated by continued work to refine this assessment and a prospective move toward more disclosure and a corresponding opening of the CPIA to outside scrutiny. They asked that use of the CPIA in this process be reviewed periodically.
Directors stressed the need for judgment in assessing a country's debt sustainability, particularly when debt-stock and debt-service indicators gave conflicting signals. While ratios of the net present value (NPV) of debt to exports or to income provide appropriate indicators of solvency, caution in their interpretation must be exercised in an environment of changing world interest rates. Indeed, while most Directors accepted the proposal for filtering out temporary interest rate fluctuations in determining the discount rate used under the framework, a number of Directors remained unconvinced about the reliability of signals embedded in world interest rates more generally; others favored a discount rate rule that is consistent with that in the HIPC Initiative. Directors agreed that the proposed discount and exchange rate rules should be subject to periodic reviews. Given the uncertainties in interpreting NPV ratios, Directors stressed the importance of a balanced consideration of both stock and flow ratios, as well as consideration of their robustness to shocks in assessing debt sustainability.
Directors broadly endorsed the suggested country-tailored approach to the treatment of public sector domestic debt. While domestic obligations impose similar, and sometimes, more serious, constraints on the envelope for other expenditures, they are difficult to integrate into a threshold approach that is intended to guide new concessional lending. Directors therefore supported an approach to domestic debt that involved close monitoring, including through the use of the standardized public-sector debt template; a careful interpretation of the benefits and risks; and a tailored response to perceived problems, including conditionality in the context of Fund-supported programs where appropriate. They encouraged the staff to conduct further research with a view to developing more specific operational guidance on domestic debt.
On the modalities for preparing DSAs, Directors agreed to an annual presentation alongside Article IV staff reports, typically as an annex or supplement, noting that some circumstances may warrant an analysis outside the Article IV consultation cycle, such as presentation of a new program, substantial new borrowing, or cases of debt distress. There might also be some cases of good performance where every other Article IV consultation cycle would be considered appropriate for preparing DSAs.
Directors endorsed a collaborative process between the Bank and the Fund in the preparation of debt sustainability analyses, with the objective of the IMF and the World Bank agreeing a single DSA, based on a clear division of labor, and in line with the mandates of the two institutions. Several Directors considered that the Fund should take the lead on developing a common DSA, with input from the Bank, while a few others felt that this issue falls within the mandates of both institutions. Some Directors considered that in view of the different mandates of the two institutions, it might not always be possible to reach a common assessment. In light of the discussion, the staff will revisit the modalities for collaboration for further consideration by the Board.
Directors supported the conclusion that changes to IMF conditionality stemming from DSAs should be limited and that these changes should ensure consistency with PRGF conditionality. However, they agreed that current conditionality does not necessarily address risks of debt distress and thus they supported the more systematic use of indicative targets on the NPV of external debt. They noted that these were inappropriate for inclusion as performance criteria.
Directors also recognized the need for increased flexibility in the application of limits on nonconcessional debt. Given the impracticality of setting performance criteria on the NPV of debt, Directors recognized that performance criteria on a minimum level of concessionality for newly contracted debt would remain necessary. These limits, however, can be made more flexible than is now generally the case, with higher minimum concessionality levels for countries at high risk of debt distress. Most Directors supported allowing exceptions to this rule for high-priority and high-return projects, as well as a norm of nonzero ceilings on non-concessional debt for PRGF/EFF blend countries, in cases where debt distress is not a concern.
Directors generally agreed that conditionality could be strengthened by including an overall fiscal deficit limit more systematically in PRGF-supported programs. Recognizing that such limits are already in place in many programs and that their use will be handled with due regard for country-specific circumstances, most Directors agreed that indicative targets would be the most appropriate modality at the outset, but that in cases of high risk of debt distress, or outright debt distress, then performance criteria might be needed. Directors noted, however, that such performance criteria would need to include adjusters to allow for varying capacity for forecasting disbursements for project lending, as current performance criteria on domestic financing often do.
IMF EXTERNAL RELATIONS DEPARTMENT