Debt Sustainability in Low-Income Countries—Proposal for an Operational Framework and Policy Implications
February 3, 2004
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IMF Discusses Operational Framework for Debt Sustainability in Low-Income Countries
On February 23, 2004, the Executive Board of the International Monetary Fund (IMF) discussed a paper on "Debt Sustainability in Low-Income Countries—Proposal for an Operational Framework and Policy Implications," which was prepared jointly by the staffs of the IMF and the World Bank.
Low-income countries face significant challenges in financing their development while at the same time ensuring that their external debt remains sustainable. The aim of the proposed framework is to guide borrowing decisions of these countries in a way that matches their need for funds with their current and prospective ability to service debt, tailored to their specific circumstances. At the same time, the framework provides guidance for the lending and grant-allocation decisions of official creditors and donors. The proposed framework is to serve as a forward-looking analytical tool beyond the HIPC Initiative and will have no bearing on the implementation of the Initiative itself.
The re-emergence of excessive debt levels would be a serious problem in low-income countries, although given these countries' reliance on official flows, the concept of debt sustainability is somewhat different there than in middle-income countries. High debt levels can be problematic as they may require debt restructuring and forgiveness which is disruptive and costly and the burden of a debt overhang may undermine urgent progress on policy reform. High debt levels also force lenders to allocate scarce concessional resources keep high debtors afloat, often at the expense of other deserving countries.
The proposed debt sustainability framework is based on two pillars: (i) indicative country-specific external debt-burden thresholds related to the quality of the country's policies and institutions; and (ii) an analysis and careful interpretation of actual and projected debt-burden indicators under a baseline scenario and in the face of plausible shocks. These two pillars, in combination with other relevant country-specific considerations, provide an informed basis for the design of an appropriate external borrowing strategy under which the amount and terms of new financing would facilitate progress toward achieving the Millennium Development Goals (MDGs) while generating a sustainable debt and debt-service outlook.
The proposed framework has important policy implications for donors, creditors, and borrowers. First, creditors and donors would need to review current financing policies to ensure that they appropriately reflect countries' risk of debt distress. This would almost certainly require an increase in the overall concessionality of financing to low-income countries, including an increase in the volume of grants. Second, since an appropriate mix of concessional loans and grants may provide only limited capacity to absorb large, unforeseen exogenous shocks, creditors and donors may also wish to consider new or modified instruments to deal with such eventualities. Most importantly, while donors and creditors can help low-income countries achieve debt sustainability, the primary responsibility lies with the countries themselves. As they strive to reach the MDGs, low-income countries will need to preserve debt sustainability by keeping new borrowing in step with their capacity to repay, adopting better policies and institutions that help accelerate growth, managing debt prudently, and increasing resilience to exogenous shocks.
Executive Board Assessment
Executive Directors welcomed the opportunity to discuss the joint staff proposal for an operational framework for forward-looking debt sustainability assessments in low-income countries and their policy implications. Directors viewed the development of this framework as an important step forward to help ensure that borrowers and lenders share a common approach that maintains low-income country indebtedness on a sustainable track, while contributing to the achievement of sustainable growth and the Millennium Development Goals (MDGs) set out in the United Nations Millennium Declaration.
Directors broadly endorsed the key elements of the debt sustainability framework: (i) the analysis and careful interpretation of actual and projected debt-burden indicators—including measures of the debt stock in present value terms and debt service—under a baseline scenario and in the face of plausible shocks; and (ii) an assessment of these indicators in relation to indicative thresholds taking into consideration the quality of the country's policies and institutions.
In view of the heterogeneity of low-income countries, Directors saw the ability of the framework to incorporate country-specific information and judgments in the assessments as one of its key merits. This element of judgment is important in several aspects of the framework: with respect to the long-term projections of the macroeconomic variables underlying the debt dynamics; the interpretation of stress tests, linked to countries' historical experience; and the assessment of policies for the purpose of determining the indicative benchmarks for the main debt-burden indicators. Overall, most Directors believed that the proposed framework could strike an appropriate balance between rules and discretion, provided that care is taken to ensure that the indicative debt-burden thresholds are used as a guide and not as a rigid ceiling, and cautioned against an overly mechanical application of the framework to borrowing and lending decisions.
While supporting the general thrust of the framework, Directors noted a number of issues on which further consideration would be needed before the framework could become fully operational. These issues were in three main areas: the modalities for implementing debt sustainability analyses; the specification of indicative thresholds; and the operational implications for the IMF and for other international financial institutions and donors. Directors agreed that, as an interim arrangement pending resolution of these issues, Fund staff, in close consultation with World Bank staff, would begin cautiously applying the part of the framework that relates to the analysis of the long-term debt dynamics, using the proposed templates, as background for Article IV surveillance in low-income members.
Directors generally supported the proposed framework for analyzing the debt dynamics, although they noted some issues requiring further work. With regard to the discount factor used in deriving the net present value of debt stocks, Directors noted that a long-term market interest rate is a useful benchmark but recognized the problems that can result from the use of volatile international market rates for this purpose. The staff is continuing to work in this area and will come back to the Executive Board. Directors also noted the need for further work on the inclusion of public sector domestic debt into the analysis, stressing the need for a carefully designed strategy that takes account of country-specific circumstances. They also asked the staff to give further consideration to the implications for debt sustainability of the debt incurred by state enterprises.
A number of Directors raised questions concerning proposed thresholds that would be used in assessing whether debt indicators pointed to a high risk of debt distress. They focused in particular on the assessments of policies and institutions underlying these thresholds and especially on the use of the World Bank's Country Policy and Institutional Assessment (CPIA) index. They asked the staff to explore these issues further and return to the Board for further consideration, before these thresholds could begin to be applied to lending decisions.
Directors commended the joint work of the IMF and World Bank staff in developing this framework. They saw a need for further consideration of the modalities for arriving at an assessment of debt sustainability agreed to by both institutions, drawing fully on the special expertise of each institution's staff. Many Directors stressed the need for a suitable division of labor in preparing these assessments. Beyond this, Directors stressed that in applying the framework to lending decisions and program conditionality, it would be important for the two institutions to reach consistent positions, and more generally to coordinate their work closely and to involve other multilateral development banks in their work.
Directors had a wide-ranging discussion of the broader implications of the proposed framework. A key implication of the debt sustainability framework for donors is that they will be expected to tailor the terms of new external financing to countries' risk of debt distress. Directors concurred that, to the extent that additional resources beyond low-income countries' capacity to carry debt can be productively employed to generate growth and achieve the MDGs, overall grant resources to low-income countries will have to be increased to match their need for funds without undermining debt sustainability. In this context, some Directors were concerned that prospects for additional grants may not be favorable. They called on donors to make a stronger effort to provide good performers facing high risk of debt distress with the necessary grant financing, in line with the Monterrey consensus.
Directors noted that the treatment of shocks is an important issue requiring further consideration. They generally supported the ex ante approach discussed in the paper: prudent planning on the basis of stress tests, complemented by various other policies to increase economic resilience to shocks—including economic diversification, trade liberalization and increased market access for exports of low-income countries, and strengthening of financial sectors. At the same time, a number of Directors encouraged the staff to explore the feasibility of complementary ex post mechanisms, including innovative financial instruments that would strengthen countries' ability to deal with those shocks that occur.
Directors shared the view that low-income countries themselves bear the primary responsibility for achieving their development objectives without compromising debt sustainability. Besides a careful approach to new borrowing and improvements in debt management, they believed that countries can best boost their resilience to debt distress by strengthening policies and institutions, stressing the role of prudent macroeconomic policies and structural reforms that improve governance and strengthen private sector incentives, combined with sound public sector management. In this context, Directors highlighted the importance of providing the right incentives and resources, including technical assistance, for countries to become strong policy performers.
Directors addressed the relationship between the proposed debt sustainability framework and the HIPC Initiative. They stressed that the HIPC Initiative should be implemented in full, while noting that the proposed new framework serves a different purpose: in contrast to the HIPC Initiative, which establishes a uniform set of rules for dealing with an existing debt overhang and coordinating action to deliver debt relief, the new framework serves as forward-looking guidance on new borrowing policies in relationship to individual countries' circumstances. These different objectives will need to be communicated clearly to avoid sending conflicting signals.
Directors asked staff to return with two papers that would form a basis for further discussions on these issues. One, to be prepared jointly with World Bank staff, will give further consideration to issues related to the sustainability framework itself. A second, to be prepared by Fund staff in consultation with their World Bank counterparts, will examine the operational issues for the Fund, especially in setting debt limits in Fund-supported programs; it is envisaged that a similar operational paper will be prepared in parallel at the World Bank.
IMF EXTERNAL RELATIONS DEPARTMENT