The Debt Sustainability Framework for Low-Income Countries

Introduction

Low-income countries (LICs) face significant challenges in meeting their development objectives, including the Millennium Development Goals (MDGs), while at the same time ensuring that their external debt remains sustainable.

In April 2005, the Executive Boards of the Fund and the Bank endorsed a joint framework for debt sustainability assessments (DSAs) in low-income countries. The debt sustainability framework (DSF) for LICs was reviewed by the Boards in April 2006, as well as the implications of the multilateral debt relief initiative (MDRI). In November 2006, the Boards discussed further the challenges arising from the perceived increase in borrowing space created by debt relief in some LICs, the emergence of new creditors, and the rising weight of domestic debt. While welcome, these developments also raise new risks. In light of this, the Boards called for improving the rigor and quality of debt sustainability analyses (DSAs) and increasing their effectiveness by fostering their use by borrowers and creditors.

The primary aim of the DSF is to guide borrowing decisions of low-income countries in a way that matches their need for funds with their current and prospective ability to service debt, tailored to their specific circumstances. Given the central role of official creditors and donors in providing new development resources to these countries, the framework simultaneously provides guidance for their lending and grant-allocation decisions to ensure that resources to LICs are provided on terms that are consistent with their long-term debt sustainability and progress towards achieving the MDGs. The forward-looking nature of the DSF allows it to serve as an "early warning system" of the potential risks of debt distress so that preventive action can be taken in time.

DSAs conducted under the DSF consist of:

• A standardized forward-looking analysis of the debt and debt service dynamics under a baseline scenario and in the face of plausible shocks;

• An assessment of debt sustainability in relation to indicative country-specific debt burden thresholds that depend on the quality of policies and institutions; and

• An advisable borrowing (and lending) strategy that limits the risks of debt distress.

The DSF uses two separate templates for external debt and for public sector debt. Given that concessionality is an important element in financing LICs, the debt concept used in the templates focuses on the net present value (NPV) of debt. Both templates generate output tables that display debt and debt-service dynamics under the baseline scenario and summarize the results of standardized alternative scenarios and stress tests. Templates are, however, flexible enough to be adapted to country-specific circumstances.

The assessment of external debt-burden indicators in relation to policy-dependent thresholds reflects the key empirical finding that a low-income country with better policies and institutions can sustain a higher level of external debt. 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 Corresponding to these categories, the framework establishes three indicative thresholds for each debt burden indicator (with respect to exports, GDP and revenues). Thresholds corresponding to strong policy performers are highest.

On the basis of these thresholds, DSAs include an assessment of the risk of external debt distress based on four categories: low risk; moderate risk; high risk; and in debt distress.

The quality of a DSA depends on a sound debt database, as well as realistic macroeconomic projections and assumptions regarding the mix of adjustment and new financing, and the terms of this new financing. These elements are generally discussed in the text of the DSA and transparently shown in the DSA tables.