## _110606 ## Source details **Canonical URL:** [_110606](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_110606.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_110606.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_110606.pdf.json) --- ### Context and key challenges - In April 2006, the Executive Boards of the Bank and the Fund reviewed the debt sustainability framework (DSF) for low-income countries (LICs) and implications of the multilateral debt relief initiative (MDRI). - Directors found the DSF broadly appropriate and requested work on: - (i) scope for using the framework to assess appropriate levels of new borrowing in LICs (notably nonconcessional creditors); - (ii) further integration of domestic debt in DSAs; - (iii) refinement of the risk-category scale for debt distress ratings. - Post-HIPC and MDRI relief created an apparent borrowing space; concurrent developments include emerging official and private creditors and rising domestic debt. - New creditor universe: debtor data indicate emerging creditors account for around 10 percent of total official assistance to LICs; China had claims of US$5 billion as of end-2004 (compared with US$2.5 billion in 1994); Kuwait had claims of US$2.5 billion. Evidence suggests lending by emerging creditors, particularly China, increased very sharply in 2005 and 2006. ### Improving the quality and rigor of DSAs (policy guidance) - Objectives of staff proposals: - Enhance rigor and quality of DSAs by strengthening DSF application and reinforcing precautionary aspects. - Provide clearer guidance on baseline macroeconomic and growth scenarios and on reviewing assumptions when borrowing accelerates. - Promote broader use by debtors and creditors. - Specific measures: - Guidance to design baseline macroeconomic and growth scenarios considering: country policy and institutional setting; external environment; likelihood of external shocks; impact of increased borrowing to finance additional public expenditures. - Reinforce precautionary features already in the DSF (proactive, self-regulating, repeated, transparent). - Require detailed review of macroeconomic assumptions (particularly economic growth and borrowing) and policies when the pace of borrowing exceeds a certain threshold. - Operationalize a case-by-case approach rather than a rigid rules-based approach. - Reality checks and precautionary scenarios: - Baseline and alternative scenarios must explicitly incorporate expected effects of public investment on GDP and export growth. - Mandatory “high-investment, low-growth-payoff” alternative scenario where baseline assumes large foreign-financed investment implying growth rates about, or more than, one standard deviation above historical patterns. - Scenarios with annual increases in NPV of public external debt or total public debt in the 5-7 percent of GDP range or above require detailed discussion and justification; historical evidence: countries with debt growth >7 percent of GDP subsequently suffered debt distress in 61 percent of cases; >5 percent led to distress in 23 percent of cases. ### Concessionality and nonconcessional borrowing - Core position: concessional flows remain the most appropriate source of external finance for LICs. - Case-by-case consideration of nonconcessional finance based on: - (i) impact on debt sustainability; - (ii) availability of concessional resources; - (iii) overall strength of policies and institutions, quality of investment, and overall public expenditure program. - Operational definitions and practice: - For operational purposes, loans should generally have a minimum grant element of 35 percent (CIRR-based) to be deemed concessional; Fund uses ten-year average CIRRs for loans with maturity ≥15 years and six-month average CIRRs for short maturities. - IDA endorsed adopting the same method as the Fund for its policy on nonconcessional borrowing in grant-eligible and MDRI-recipient countries. - PRGF arrangements and PSIs have applied non-zero ceilings flexibly for reasons such as financing specific large projects, preparing for graduation to market-based finance, or when concessional resources are insufficient. - IDA policy (paragraphs 27–40): - IDA will examine nonconcessional external borrowing by grant-eligible and MDRI-recipient countries case by case; where borrowing is unwarranted, IDA may propose disincentives (volume reduction or hardening of terms). - Presumption in favor of concessional finance remains; exceptions allowed case by case with staff coordination. - Measurement challenges: defining and measuring concessionality can be difficult; resource-rich LICs accumulating nonconcessional debt backed by future export receipts pose distinct challenges. ### Private external creditors, ECAs, and associated vulnerabilities - Private external creditor activity in LICs has increased amid abundant global liquidity and compressed spreads; examples of increased foreign investor interest include Cameroon, Ghana, Kenya, Malawi, Nigeria, Tanzania, Uganda, and Zambia (Zambia: share of government securities held by foreigners rose from negligible in April 2005 to over 20 percent by April 2006). - Risks: - Nonconcessional terms expose LICs to market interest rates and short maturities; creditor harmonization concerns. - Large loans from a single official creditor may represent a large share of recipient GDP. - Foreign portfolio investment in short-maturity domestic paper carries reversal risk, complicating exchange rate and monetary management and increasing balance sheet vulnerabilities. - Balance-sheet and contingent liability risks may arise if foreign investment crowds out domestic banks or if liabilities are collateralized with future export receipts. - Policy actions where private external creditors become significant: - Improve debt-monitoring capacity. - Strengthen assessment of reserve adequacy. - Improve quality of debt-management institutions. - Strengthen banking supervision and prudential regulation prior to capital account liberalization. - Additional indicators for vulnerability analysis (selected from Table 2): - Public sector stock imbalances: NPV of public sector debt-to-GDP; NPV of external public sector debt-to-GDP (exports); NPV of foreign-currency denominated public sector debt-to-GDP; public sector debt-to-GDP (external, foreign currency denominated, CPI-indexed), primary deficit that stabilizes public sector debt-to-GDP. - Public sector flow imbalances (liquidity, rollover): public sector debt service-to-revenue; external public debt service-to-exports; public sector gross financing need (percent of GDP); short-term public debt-to-total debt (remaining maturity); domestic public debt held by nonresidents-to-GDP. - External sector flow imbalances: external gross financing need (billions of U.S. dollars); gross official reserves-to-short-term external debt (remaining maturity); extended reserve cover; gross official reserves-to-broad money (M2); foreign currency deposits-to-foreign assets of banking system. - Financial system soundness: regulatory capital-to-risk-weighted assets; nonperforming loans-to-total loans; claims on government and central bank-to-total banking sector claims; private sector credit growth; foreign currency loans-to-total loans; share of foreign currency deposits held by nonresidents. - Footnote definitions preserved from source (examples): 1/ The sum of interest and amortization of medium- and long-term debt. 2/ Defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period. 3/ Amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period. 4/ Defined as the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of short-term debt at the end of the last period. 5/ External short-term debt includes amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period. 6/ Gross official reserves in percent of the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of short-term debt at the end of the last period plus foreign currency deposits in the banking system. ### Domestic debt: magnitude, characteristics, and integration into DSAs - Magnitude (1995–2004, sample of 66 PRGF-eligible countries): - Mean domestic debt (percent of GDP): 18.72 - Median domestic debt (percent of GDP): 15.0 - Standard deviation (percent of GDP): 16.5 - 1/3 Percentile (percent of GDP): 9.8 - 2/3 Percentile (percent of GDP): 20.7 - Max (percent of GDP): 80.9 - Min (percent of GDP): 0.8 - Number of Observations (for % of GDP column): 627 - Number of Countries (for % of GDP column): 66 - Two-thirds of countries have average domestic debts below 21 percent of GDP. - Median domestic debt as percent of total public debt: about 17 percent; domestic debt represents about one-fifth of LICs total public debt in the period. - Cost, maturity, and interest burden: - Typical LIC paid, on average, about 8 percent of public revenues to cover the domestic interest bill. - This domestic interest bill represented more than 40 percent of total interest. - Short-term domestic debt (percent of total domestic debt) sample statistics: - Mean: 67.2 - Median: 85.3 - 1/3 Percentile: 47.2 - 2/3 Percentile: 100.0 - Standard Deviation: 37.2 - Max: 100.0 - Min: 10.0 - Number of Observations: 384 - Number of Countries: 44 - Ex-post real annual interest rate on domestic debt (annual percent): - Mean: 3.2 - Median: 3.1 - 1/3 Percentile: 1.9 - 2/3 Percentile: 5.0 - Standard Deviation: 5.9 - Max: 19.8 - Min: -17.9 - Number of Observations: 579 - Number of Countries: 64 - Empirical and behavioral findings: - Preliminary regression analysis: inclusion of domestic debt (as percent of GDP) increased explanatory power of model for likelihood of external debt distress from 21 percent to 27 percent. - Domestic and external debt tended to grow rapidly relative to GDP in the two years immediately prior to external debt crises; afterwards domestic debt tends to decline while external debt surges. - Challenges integrating domestic debt: - Domestic debt differs qualitatively from external debt (shorter maturities, higher nominal interest rates, domestic currency denomination, role in monetary policy), complicating direct addition to external-debt thresholds. - Data coverage/quality vary; inclusion in classifications may create adverse incentives for underreporting domestic debt. - Staff recommendations on domestic debt in DSAs: - All LIC DSAs should include a public debt DSA; external and public debt DSAs should be produced simultaneously and consistently. - Domestic debt should get heightened attention where its weight is above average or has increased rapidly. - Public debt DSA should indicate whether baseline primary balance is consistent with debt sustainability and realistic compared with historical experience. - Add indicators of domestic debt vulnerabilities (notably maturity structure) to the public debt DSA template where data permit. - DSAs should explicitly flag cases where inclusion of domestic debt would change risk classification. ### Empirical econometric findings (domestic debt and debt distress) - Export-denominator specifications (Table 8) summary: - Domestic debt coefficients not statistically significant in several export-denominator specifications though point estimates were positive and similar in magnitude to external debt in the restricted sample. - External debt to exports marginal effects in selected columns ranged from 0.0945 to 0.605 with various significance levels; external debt service-to-exports was significant in some specifications (e.g., 3.81** (0.95) in specification VII). - Pseudo R2 values across specifications ranged: 0.113 to 0.340. - GDP-denominator specifications (Table 9) — preferred analysis: - External debt to GDP marginal effects (selected columns): - Column I: 2.35** (0.60) - Column II: 3.05** (0.93) - Column III: 2.50** (0.94) - Domestic debt to GDP marginal effects (columns III, VI, IX): - Column III: 2.97** (1.44) - Column VI: 2.69* (1.42) - Column IX: 2.78* (1.43) - Interpretation: - Using debt-to-GDP ratios, coefficients on domestic debt are significant in the preferred specifications and similar in magnitude to external debt effects. - Conclusion: domestic debt has a robust effect on the likelihood of external debt distress when analyzed using GDP as the denominator. - Debt behavior around distress episodes (Tables 10 and 11): - Two years before debt distress (mean annual changes, percent of GDP): Domestic +2.7; External +3.9 (No. observations: 27 each). - Two years into debt distress (mean): Domestic -1.1; External +11.7 (No. observations: 32 each). - During distress episodes (Table 11 mean): Domestic +0.7; External +4.7 (No. observations: 89 each). - Interpretation: both domestic and external debt increase prior to distress; post-onset external debt rises sharply while domestic debt often declines. ### Public investment, absorptive capacity, and growth linkages (Box 3, Box 2, and related) - Indicators to analyze link between debt-financed investment and growth (Box 3 highlights): - Rates of return: microeconomic studies on project rates of return; implementation lags; estimates of stocks and shortfalls in public capital; composition of public expenditures by growth impact. - Structural constraints: CPIA, public governance indicators, doing business, PEFA, level/growth of public investment, completion/implementation rates, skill shortages. - Macroeconomic constraints: cost of capital, private investment growth, banking system excess reserves/lending capacity, real exchange rate measures. - Aggregate trends: growth rate of per capita GDP; growth rate of TFP; results of “binding constraints to growth” analyses. - Aggregate and project-level caveats: - Project-specific high ex post rates of return do not guarantee aggregate debt sustainability if governments cannot tax incremental income, negative shocks occur, real exchange rate depreciates, or projects do not earn foreign exchange when external constraint binds. - Empirical evidence ambiguous: aggregate production-function estimates may imply average rates of return in the range 20-30 percent in some studies, but country-specific applicability varies. - Absorptive capacity and diminishing returns: - Aggregate evidence suggests diminishing returns when public investment reaches, on average, 9.5 percent of GDP (Isham and Kaufman, 1999). - Measured inefficiencies exist (e.g., Herrera and Pang (2005) estimate inefficiencies in health and education in the range of 35-50 percent). - Precautionary DSF aspects: - DSAs should compare baseline with historical trends and avoid large unexplained departures. - Scenarios requiring sharp shifts in fiscal policy, investment rate, financing mix, or productivity should face particular scrutiny and require convincing justification. - Countries susceptible to negative growth shocks should incorporate such scenarios across the forecast period. ### Fostering broader use of DSAs and MTDSs (policy implementation) - Broader use by creditors and borrowers: - Broader uptake by debtors and creditors is critical for DSF effectiveness for communication, coordination, and policy guidance. - Use of DSF expanding but limited; outreach to all official creditors and emerging creditors is needed. - Strengthen links between DSA results, Bank and Fund policy advice, and program conditionality where relevant. - Medium-Term Debt Strategies (MTDS): - Regular DSAs should pave the way for country-owned MTDSs ensuring borrowing is consistent with development plans, sustainable, and minimizes costs subject to prudent risk. - Preconditions/elements: capability to monitor debt-service obligations; oversight on contracting new debt; linkage to medium-term fiscal framework; recognition of cost-risk tradeoffs; consideration of mix of fixed vs variable rates and domestic vs external debt; regular updates and government ownership. - Operational challenges: many LIC debt-management offices lack capacity; first-step priorities include strengthening monitoring of broad public debt definition; providing debt-management units clear mandates; recruiting skilled staff; consider investor relations office. - Technical assistance (TA) needs: systematic approaches to build debt management functions and operationalize MTDSs; TA should go beyond training “debt recorders” to building comprehensive capacity. - Resource implications: - Preliminary TA estimates: on average 1-1.5 Fund staff-years plus significant external experts and travel; Bank staff and travel costs over next three years estimated at about US$6 million. - Outreach resource needs smaller but require additional travel and budget allocations; substantial reallocation of existing resources may be necessary to deliver large-scale TA. ### Debt-distress risk ratings and CPIA volatility - Boards asked to consider refinements (including subdividing moderate risk); staffs recommend: - No need to revise existing risk categories now given MDRI effects and conservative growth projections. - Use a three-year moving average CPIA score to determine performance category to avoid undue volatility in IDA grant share. - CPIA cutoff values: 3.25 between weak and medium; 3.75 between medium and strong performance. - Allow longer DSF track record before revisiting categories; continue clearance and review functions to ensure consistent application. ### Conclusions and decision questions for Directors - Staff proposals summarized: - Guidelines for solid baseline macroeconomic and growth scenarios. - Reinforce precautionary features and use historical/alternative scenarios. - Require robust justification where debt buildup is sudden/rapid and reliant on growth dividends. - Concessional flows preferred; nonconcessional borrowing considered case by case with explicit assessment criteria. - Systematic additional analyses for private creditor-related vulnerabilities. - All LIC DSAs to include public debt DSA produced consistently with external DSA; special attention where domestic debt is above average or rising rapidly. - Foster borrower MTDSs and capacity building; intensified outreach to creditors. - No immediate change to debt-distress categories; adopt three-year moving average CPIA for smoothing IDA grant shares. - Questions posed to Directors include whether DSF is well suited to assess and monitor debt but needs strengthened application; whether proposed improvements are appropriate; and whether outreach and capacity building priorities and the CPIA smoothing proposal are endorsed. *Source: Executive Summary, _110606 - Executive Summary (IMF World Bank joint staff paper, April 2006).* ### Executive Summary....................................................................................................... ### _110606 - Executive Summary....................................................................................................... ### Context and key challenges - In April 2006, the Executive Boards of the Bank and the Fund reviewed the debt sustainability framework (DSF) for low-income countries (LICs) and the implications of the multilateral debt relief initiative (MDRI). - Directors considered the DSF broadly appropriate and asked for further work on: (i) the scope for using the framework to assess the appropriate level of new borrowing in LICs, especially from nonconcessional creditors; (ii) further integration of domestic debt in DSAs; and (iii) refinement of the existing scale of risk categories for debt distress ratings. - Debt relief (HIPC Initiative and MDRI) has reduced debt burdens in many LICs to levels well below their policy-dependent thresholds under the DSF, creating an apparent borrowing space that raises new policy challenges. - Concurrent developments include the emergence of new official and private creditors and a rising importance of domestic debt—offering opportunities but also creating new vulnerabilities to be monitored. ### Improving the quality and rigor of DSAs (policy guidance) - Objectives of staff proposals: - Enhance rigor and quality of debt sustainability analyses (DSAs) by strengthening application of the DSF and reinforcing its precautionary aspects. - Provide clearer guidance on the design of baseline macroeconomic and growth scenarios and on reviewing assumptions when borrowing accelerates. - Increase the DSF’s effectiveness by promoting broader use by debtors and creditors. - Specific proposed measures: - Guidance for designing more solid baseline macroeconomic and growth scenarios that take into account: the country’s policy and institutional setting; the external environment; the likelihood of external shocks; and the impact of increased borrowing to finance additional public expenditures. - Reinforcement of the precautionary features already built into the DSF. - Detailed review of macroeconomic assumptions (particularly relating to economic growth and borrowing) and policies when the pace of borrowing exceeds a certain threshold. - Development of specific recommendations to operationalize the case-by-case approach favored by Directors (rather than adopting a rules-based approach). ### Concessionality and nonconcessional borrowing - Core position: - Staffs argue that concessional flows remain the most appropriate source of external finance for LICs. - Case-by-case consideration of nonconcessional finance where warranted, based on: - (i) the impact on debt sustainability; - (ii) the availability of concessional resources; and - (iii) the overall strength of a debtor country’s policies and institutions, the quality of the investment to be financed, and the overall public expenditure program. - The Boards asked for consideration of whether a minimum level of concessionality remains appropriate post-debt relief. ### Accounting for private external creditors and domestic debt - Private external creditors: - Private external creditors’ interest in LICs’ sovereign debt instruments, including domestic debt instruments, has increased. - This development can provide opportunities but may give rise to new vulnerabilities that need careful monitoring. - Staffs suggest more systematic use of additional vulnerability analyses focusing on short-term debt-related vulnerabilities in conjunction with the DSF. - Domestic debt: - Domestic debt clearly matters for the risk of debt distress. - Integrating domestic debt into the DSF is conceptually challenging because domestic debt differs from external debt in important dimensions. - No simple way to incorporate domestic debt into existing external-debt thresholds, but staffs make specific suggestions for more systematic integration of domestic debt into assessments of debt sustainability and external debt distress risk. ### Fostering broader use of DSAs by borrowers and creditors - Raising the effectiveness of the DSF depends on broader uptake by debtors and creditors for communication, coordination, and policy guidance. - Current situation and recommended actions: - Use of the DSF is expanding but still limited; further outreach by staffs to all official creditors is needed, particularly emerging creditors. - Strengthen links between DSA results, Bank and Fund policy advice, and program conditionality where relevant. - Use the DSF combined with capacity building in public debt management to help countries develop medium-term debt strategies (MTDS) that support development objectives, including the Millennium Development Goals, while containing risks of debt distress and macroeconomic vulnerability. - MTDS can also help guide creditors’ decisions. ### Debt-distress risk ratings and related adjustments - Boards asked staffs to consider refinements to the existing scale of debt-distress risk ratings, including subdividing the moderate risk category. - Staffs’ view: - No need to revise existing debt distress categories at this point, particularly because the incidence of moderate risk ratings has declined owing to MDRI relief and more conservative growth projections. - Suggest using a three-year moving average Country Policy and Institutional Assessment (CPIA) score to determine the appropriate indicative threshold for debt distress and thereby avoid undue volatility in the IDA grant share for a country. ### Purpose and structure of the paper (implementation focus) - The paper aims to provide practical guidelines to: - Ensure DSAs identify and assess debt-related vulnerabilities in a thorough, disciplined, and consistent manner across countries while preserving country-specific judgment. - Increase the DSF’s effectiveness through greater use in borrowing and lending decisions and improved coordination and information exchange between debtors and creditors. - Core sections include: description of post-MDRI challenges; guidelines for more rigorous DSAs (pace of borrowing, concessionality, private inflows, domestic debt); steps to foster use by borrowers and creditors; potential refinements to debt-distress ratings; resource implications; and issues for discussion. *Source: Executive Summary, _110606 - Executive Summary (IMF World Bank joint staff paper, April 2006).* ### 7. At the same time, the universe of potential creditors has expanded, with export ### _110606 - 7. At the same time, the universe of potential creditors has expanded, with export ### Expansion of creditor universe and recent patterns - Export credit agencies (ECAs) and commercial banks are playing an increasingly active role in financing LICs. - Lower debt levels, strengthened macroeconomic fundamentals, and improved prospects in LICs have increased their attractiveness for ECAs. - Emerging economies are stepping up their lending to LICs. - According to debtor data, the share of emerging creditors in total official assistance to LICs is still small (around 10 percent) but is increasing steadily. - The six largest non-Paris Club bilateral creditors to LICs identified are Brazil, China, India, Korea, Kuwait, and Saudi Arabia. - Data indicate China had claims of US$5 billion as of end-2004 (compared with US$2.5 billion in 1994); Kuwait had claims of US$2.5 billion. - Evidence suggests lending by emerging creditors, particularly China, increased very sharply in 2005 and 2006. ### Risks associated with new financing sources - Terms and concessionality: - The terms of new financing may be nonconcessional, or less concessional than official development finance, exposing LICs to market interest rates and short maturities and raising creditor harmonization concerns. - Concentration and scale: - New loans from a single official creditor may sometimes represent a large share of the recipient’s GDP, potentially raising sustainability concerns. - Short maturities and portfolio flows: - Foreign portfolio investment in public domestic debt instruments (given relatively short maturities) carries the risk of abrupt reversals in market sentiment, complicating exchange rate and monetary management and increasing balance sheet vulnerabilities. - Private external creditors have extended activities in LICs (notably in Sub-Saharan Africa) amid abundant global liquidity and compressed spreads; examples of increased foreign investor interest include Cameroon, Ghana, Kenya, Malawi, Nigeria, Tanzania, Uganda, and Zambia. - Zambia example: share of government securities held by foreigners rose from negligible in April 2005 to over 20 percent of the total stock by April 2006. ### Domestic debt trends and vulnerabilities - For a sample of 66 PRGF-eligible countries over 1995-2004: - Domestic debt averaged about 19 percent of GDP. - The median was about 15 percent of GDP, indicating outliers with domestic debt in excess of 50 percent of GDP. - Domestic debt vulnerabilities: - Interest rates on domestic debt tend to be much higher, and maturities much shorter, than on external debt. - Positive features of domestic debt (noted): - Can raise funds for government, foster financial sector development, increase transparency in treasury auctions, and lower risk premia on government debt. ### Debt Sustainability Framework (DSF): features and role - The DSF is well suited to assess and monitor debt burdens and the risk of debt distress; precautionary features include: - Proactive and forward-looking: rapid debt accumulation will lead to breaches of indicative debt burden thresholds down the road, affecting current assessments. - Self-regulating and country-specific: projections are scrutinized through stress tests automatically calibrated to historical economic performance (GDP growth, export growth, FDI, financing terms, and other relevant factors). - Repeated: the DSA is updated every year to address incipient problems from new borrowing or optimistic forecasts. - Transparent: DSAs must explain main assumptions underlying projections and how they drive projected debt ratios and risk ratings. - An assessment of debt trends under stylized baseline lending scenarios (Appendix 2) illustrates the DSF's ability to identify risk of too rapid debt buildup under current policies. ### Need to strengthen DSF application — three main reasons - New borrowing room from debt relief raises unresolved analytical issues, notably the impact of increased debt-financed public expenditures on growth. - New types of lenders introduce new opportunities and risks: rapid debt buildup, potential return to pre-relief levels of debt distress, and rising rollover and liquidity risks. - Limited use and familiarity: only a small number of creditors (the Bank, the Fund, and certain multilateral and bilateral creditors) actively use the DSF; other creditors and most debtors have little familiarity or incentive to use it, limiting overall effectiveness and risking undoing benefits from debt relief without coordinated creditor-debtor action. ### Improving the quality and rigor of DSAs — assessing scope for debt accumulation - Approach relies on: - Guidance in designing more solid baseline growth and macroeconomic scenarios, specifically the public investment–growth relationship. - More rigorous application of DSF precautionary features. - Detailed review of scenarios involving rapid borrowing or scenarios that avoid breaching debt thresholds largely because of projected growth accelerations. - Strengthened guidance on debt-financed investment and growth: - Baseline and alternative scenarios must explicitly incorporate expectations about effects of public investment on GDP and export growth. - Overly optimistic projections about growth effects of public investment can lead to over-borrowing and renewed debt distress even if financing is concessional. - Excessive pessimism can cause missed opportunities to use external resources to promote growth, reduce poverty, and achieve the MDGs. - Country-specific analysis is critical: - Examine expected rates of return to public investment, potential for crowding in/out of private investment, and alleviation of structural and macroeconomic absorptive capacity constraints. - Assess assumed aggregate effects of increased public investment, including any assumed growth in total factor productivity (TFP). - Combine microeconomic and macroeconomic approaches; Bank and Fund staff cooperation is underscored. - Box 3 indicators: - A list of indicators should be used where available and reliable to assess potential impact of public investment on growth; applicability depends on country circumstances and no quantitative benchmarks are provided to avoid false precision. - Reality checks for baseline projections: - Be cautious about prolonged growth accelerations that make debt-led scaling up feasible; sustained high levels of growth are difficult to forecast and maintain. - Indicators from Box 3 substantially out of line with regional or comparator groups should trigger particular scrutiny. ### Analytical considerations on public investment and growth (Box 2) - Evidence and caveats: - Cost-benefit analyses by World Bank staff suggest typical (ex post) rates of return on individual projects of the order of 15 percent globally, but these are averages and may not apply to specific country cases. - Payoff timeframes vary; some projects may yield higher national income within the 20-year DSF timeframe, others serve different objectives. - Productivity spillovers from public investment have mixed evidence. - Structural absorptive capacity: - Skilled labor, managerial capacity, and complementary inputs (including maintenance) determine how investment converts into productive capital; linking public investment to a well-designed and costed medium-term expenditure framework is important. - Macroeconomic absorptive constraints: - Risks include Dutch disease, crowding out, and crowding in. - Dutch disease: adverse effect on tradable sector from resource windfalls and associated spending; empirical evidence is inconclusive and requires case-by-case assessment. - Crowding out: when public investment consumes scarce domestic savings, potentially reducing private investment (mainly a concern for domestically financed investment). - Crowding in: public investment may raise economy-wide profitability and encourage private investment. - Empirical evidence is ambiguous; historical growth rates, empirical evidence on TFP growth, and analyses of binding constraints on growth are important checks on scenario assumptions. *Source: Excerpts from the provided IMF content unit.* ### Box 3: Indicators for Analysis of the Link Between Debt-Financed Investment and Growth ### Box 3: Indicators for Analysis of the Link Between Debt-Financed Investment and Growth ### Indicators to establish links between public expenditure and growth - Rates of Return - Microeconomic studies on rates of return of projects - Implementation lags/gaps for investment and recurrent budgets - Estimates of stocks and shortfalls in public capital - Composition of public expenditures in terms of growth impact - Structural Constraints - Policy and institutional constraints as indicated by the CPIA, public governance indicators, doing business surveys, PEFA, other public expenditure management - Level and growth rates of public investment - Completion or implementation rate of public investment projects - Skill shortages that can only be alleviated in the long run - Macroeconomic Constraints - The cost of capital, as indicated through firm-level surveys and real interest rates - Rate (or rate of growth) of private investment - Excess reserves/lending capacity in banking system - Various real exchange rate measures (unit labor costs, export market share) - Aggregate Trends - Growth rate of per capita GDP - Growth rate of TFP - Results of “binding constraints to growth” analyses ### Aggregate approach and caveats about relying on project-specific returns - Focus on overall return to aggregate public investment: - Project-specific cost-benefit analyses are critical inputs, but the DSF takes a more aggregate approach to assessing debt sustainability. - Risks to debt sustainability depend on aggregate export proceeds, national income, and government revenue adequate to cover aggregate debt service from the entire portfolio of government expenditures—including recurrent expenditures. - Even ex post high rates of return on aggregate public investment are not a guarantee of debt sustainability if: - (a) governments are unable to tax or charge the incremental income sufficiently; - (b) countries are subject to negative shocks; - (c) the real exchange rate depreciates, requiring additional domestic resources to be mobilized for the same debt-service payments stream; or - (d) the marginal project does not earn foreign exchange, if the external constraint is binding. ### Emphasis on policy reforms and volatility - Policy and institutional quality influence ex post rates of return on public investment and overall growth. - The policy and institutional environment affects private sector investment and productivity growth. - Caution about economic volatility and shocks: - Countries susceptible to negative growth shocks require scenarios that incorporate their impact on expected growth for the entire forecast period. - Effects of scaling up depend on nature of aid inflows: - Aid volatility and unreliability will hamper productive investment. - Extent of donor coordination can affect the quality of the aid program and its potential returns. ### Precautionary aspects in DSAs - Uncertainty in the public expenditure–growth relationship warrants emphasis on DSF precautionary features to discipline forecasts and detect atypical baseline elements. - Scenarios requiring sharp shifts in fiscal policy, investment rate, financing mix, productivity growth, or other key policy variables deserve particular scrutiny and convincing justification; large shifts spread over longer periods also require justification. - Use of historical scenarios: - DSAs should compare baseline assumptions with historical trends and show evolution of debt indicators if historical trends persist. - Large differences between baseline and historical scenarios should be avoided unless strongly justified. - DSAs should critically assess realism of staff’s previous forecasts; if prior DSA proved too optimistic—particularly when debt ratios are high or rising—assumptions should face extra scrutiny and may be revised downwards. - Mandatory alternative scenario for large foreign-financed investment: - Include a “high-investment, low-growth-payoff” alternative scenario for countries where baseline includes large, foreign-financed investment assumed to yield sizeable growth accelerations (notably those implying growth rates about, or more than, one standard deviation above historical patterns). - This alternative scenario must be explicitly taken into account in the assessment of debt distress risk. - When the “high-investment, low-growth-payoff” scenario breaches or approaches DSF thresholds: - DSF will call for robust justification of the growth dividend. - Particularly where borrowing is rapid in early years and only a growth acceleration would prevent excessive debt ratios, the DSA must clearly signal associated risks to borrower and lenders. - High-growth turnaround baselines acceptable only if compelling evidence shows the growth dividend is very likely, based on detailed analysis. - Special attention to cases with very large upfront borrowing: - Empirical work shows countries in which debt has grown rapidly (as a share of the previous year’s GDP) are significantly more likely to suffer debt distress. - “Rapidly” can be considered as an annual change in the NPV of debt of about 5-7 percent of GDP or more. - Countries in which debt grew by more than 7 percent of GDP subsequently suffered debt distress in 61 percent of cases. - Countries in which debt grew by more than 5 percent of GDP went on to experience debt distress in 23 percent of cases. - As a general rule, scenarios that include an annual increase in the NPV of public external debt or total public debt in the 5-7 percent of GDP range or above require a detailed discussion and justification of the expected growth dividend in the DSA write-up. ### External borrowing on nonconcessional terms - Post-debt-relief, risk of excessive recourse to nonconcessional external finance has increased and deserves special consideration. - LIC DSF focuses on debt in NPV terms and takes degree of concessionality into account. - LIC DSAs: - Quantify higher debt service associated with nonconcessional external debt. - Use stress tests to capture higher risks associated with nonconcessional external debt relative to concessional debt. - Because of uncertainty about growth effects of public investment and weak growth/debt records in many LICs, extra caution is warranted with nonconcessional external debt; Boards have indicated that nonconcessional borrowing should generally be discouraged and staffs should clarify when case-by-case exceptions could be considered. - PRGF arrangements and Policy Support Instruments (PSIs) with the Fund have limits on nonconcessional external debt: - External debt limits were introduced in 1979 for upper-credit-tranche arrangements to (i) prevent build-up of external debt to problematic levels, (ii) ensure restraint on domestic demand is not threatened by unanticipated external financing, and (iii) limit member’s external vulnerability. - Concessional external financing, defined operationally in some cases as loans with a minimum grant element of 35 percent or more, is usually excluded from external debt limits. ### Defining concessionality (Box 4) - Historical and operational definitions: - The DAC/OECD 1969 definition entailed a minimum 25 percent grant element using a flat 10 percent discount rate; that definition is still used by the OECD for ODA. - OECD refined concessionality for export credits: minimum grant element raised to 30 percent and then 35 percent (50 percent for the least developed countries), and discount rates based on currency-specific commercial interest reference rates (CIRRs). - For operational purposes, the Bank and the Fund use a definition closely matching OECD export credits: - To be deemed concessional, loans should generally have a minimum grant element of 35 percent, calculated on the basis of the CIRRs published by the OECD. - The Fund uses ten-year average CIRRs to assess concessionality for loans with maturity of at least 15 years, and six-month average CIRRs for loans with short maturity; the OECD uses six-month average CIRRs. - In some Fund arrangements the minimum grant element is higher than 35 percent. - The Board of Directors of IDA endorsed adopting the same method as the Fund for defining concessionality in the context of IDA’s new policy on nonconcessional borrowing in grant-eligible and MDRI-recipient countries. ### Practice, flexibility, and examples of non-zero ceilings (Boxes 4 and 5) - In practice, limits on nonconcessional borrowing have been applied flexibly according to observed country performance and ability to manage external financing. - Non-zero ceilings have been included in PRGF arrangements and PSIs for reasons such as: - Financing specific large-scale projects, sometimes involving co-financing. - Supporting a gradual shift from concessional to market-based finance for countries near “blend” status. - Financial constraints (insufficient concessional resources), a sound debt situation, and appropriate governance structures. - Examples of non-zero ceilings and exceptions (illustrative cases from PRGF/PSI practice): - Funding of specific priority projects: Grenada (limited bilateral financing post-hurricanes); Uganda (hydroelectric power); Guyana (sugar sector productivity); Sri Lanka (children’s hospital, bridges, rural development). - Preparing for graduation to market-based finance: Cape Verde (initial project-related exceptions later broadened); Albania, Georgia, Pakistan; Vietnam (pilot bond placement). - Debt management and debt sustainability prospects: Bangladesh and Cape Verde exceptions based on prudent debt management; Azerbaijan accepted modest nonconcessional contracting given low debt burden and expected oil/gas sector development. - Empirical evidence and operational guidance: - Non-zero ceilings have been justified when there is a sound debt situation and capacity to manage debt. - Among current PRGF arrangements and PSIs as of end-August, some programs include non-zero ceilings and some include concessionality requirements above standard levels; waivers have been granted in select cases where projects differed from initial specifications or credit letters required adjustments. *Source: Box 3 and related boxes in the provided IMF document.* ### 27. IDA’s recently approved policy on nonconcessional borrowing in grant-eligible ### 27. IDA’s recently approved policy on nonconcessional borrowing in grant-eligible ### Policy summary and immediate implications - IDA’s recently approved policy extends the notion of minimum concessionality (and the monitoring of nonconcessional borrowing) to all grant-eligible and MDRI-recipient countries. - IDA will examine, case by case, instances of nonconcessional external borrowing by these countries. - Where such borrowing is judged to be unwarranted under the new policy, IDA may propose the application of disincentive measures, such as a volume reduction or hardening of terms. - Whenever action in an individual country is proposed, management will return to the Board of IDA. ### Rationale for presumption in favor of concessional finance - The presumption remains that concessional flows are the most appropriate source of external finance for LICs. - HIPC Initiative and MDRI relief have significantly lowered debt ratios in beneficiary countries, but other economic circumstances remain unchanged, including generally weak project and debt-management capacities. - Many MDG-related expenses (for example, in health and education) do not immediately generate the cash flows required to service commercial debt. - A minimum concessionality requirement can help borrowers obtain more suitable credit terms by raising awareness among lenders of their financial vulnerabilities. ### Exceptions: case-by-case flexibility and assessment criteria - The presumption in favor of concessional finance should be applied flexibly, allowing exceptions on a case-by-case basis; Bank and Fund staffs will discuss exceptions to avoid inconsistencies. - Elements to be taken into account when considering exceptions: - Debt sustainability: - The DSF should be the primary means of assessing the impact of alternative financing strategies and recommending the minimum concessionality for new lending. - Countries that are close to, or over, the relevant debt burden thresholds should consider nonconcessional external finance only in very exceptional circumstances. - There should be a presumption that the recommended minimum grant element would increase with the risk of debt distress. - Availability of concessional resources and quality of the investment: - Borrowing on nonconcessional terms may be justified for projects with high expected risk-adjusted rates of return that would otherwise not be undertaken, provided the overall expenditure program is well-designed. - LICs should exhaust all avenues of access to concessional resources before considering nonconcessional borrowing. - In Fund-supported program contexts, multilaterals and bilaterals have sometimes increased concessionality by combining loans with grants; care should be taken to avoid complex packages designed to circumvent the minimum grant element (hidden fees, non-transparent pricing, in-kind grants, other side deals). - Countries with weak governance and poor debt management capacity should generally avoid highly structured deals, including collateralized loans. - Overall policy environment and susceptibility to shocks: - Projects with potentially high returns may underperform in distorted or unstable policy contexts or economies subject to exogenous shocks. - Policies affecting public investment efficiency, public expenditure and debt management capacity should figure prominently in assessments. - The economy’s ability to absorb shocks and the government’s capacity to handle them should be important considerations. - Note on measurement challenges: - "Defining and measuring the concessionality of such loans may be particularly difficult. Resource-rich LICs may represent a distinct challenge, as many are already accumulating large amounts of nonconcessional debt, backed, implicitly or explicitly, by future export receipts. Aid recipients should also be aware that borrowing on nonconcessional terms may reduce their access to concessional resources, particularly under IDA’s policy on nonconcessional borrowing in grant-eligible and post-MDRI countries." ### DSF enhancements and vulnerability analysis - DSAs could discuss more explicitly the vulnerabilities created by an increase in nonconcessional external debt. - DSAs include a stress test assuming financing under less concessional terms and show explicitly the grant element of new borrowing. - Where the grant element is found to fall markedly, DSAs could include a discussion of the reasons for this decline and its impact on debt-distress risks. ### Taking private external creditors into account: risks and policy actions - Increased private sector capital flows offer opportunities but create new vulnerabilities: - Short-term private capital flows could expose LICs to abrupt reversals in market sentiment, complicating exchange rate and monetary management. - Balance sheet problems may arise if foreign investment in domestic paper crowds out domestic banks, causing them to lend to higher risk projects, possibly including unhedged foreign currency loans; currency, maturity, or interest rate mismatches may migrate risks across sectors and create contingent liabilities for the sovereign. - The outlook for medium-term debt sustainability may weaken when liabilities are collateralized with future export receipts. - The scale of risks depends on capital account openness, exchange rate regime, currency denomination of debt, and soundness of financial intermediaries and policy institutions. - Policy actions where private external creditors become significant: - Improve debt-monitoring capacity. - Strengthen assessment of reserve adequacy. - Improve quality of debt-management institutions. - Strengthen banking supervision and prudential regulation prior to capital account liberalization (sequencing of reforms is important). - Note: "The case for substituting domestic financing with nonconcessional external finance requires scrutiny... the benefits of such a substitution should be balanced against the risk of a sudden drying up of external sources or a reversal of flows, exchange rate risks, and the more general benefits of developing domestic debt markets through sovereign issuance." ### Additional indicators for vulnerability analysis (Table 2 highlights) - Where private capital inflows become significant, additional indicators (subject to data availability) could better capture: - (i) Risks to sovereign liquidity from debt composition, including maturity structure and nonresident holdings of domestically issued debt. - (ii) External liquidity and rollover risks, and the adequacy of reserve cover—may need to be increased given the possibility of reversals in market sentiment. - (iii) Weaknesses in the financial sector that may give rise to contingent liabilities for the sovereign. - Selected indicators from Table 2 (as presented): - Current DSF indicators and additional indicators for: - Public sector stock imbalances (solvency risk): NPV of public sector debt-to-GDP (public sector revenue)9; NPV of external public sector debt-to-GDP (exports)9; NPV of foreign-currency denominated public sector debt-to-GDP9; NPV of contingent liabilities (not included in public sector debt)9; Public sector debt-to-GDP ratio9; Of which: External9; Of which: Foreign currency denominated9; Of which: Foreign currency linked9; Of which: Indexed to the CPI9; Primary deficit that stabilizes public sector debt-to-GDP9. - External sector stock imbalances (solvency risk): NPV of external debt-to-GDP (exports)9; External debt-to-GDP9; Non-interest external current account deficit that stabilizes external debt-to-GDP9. - Public sector flow imbalances (liquidity, rollover risks): Public sector debt service-to-revenue1/9; External public debt service-to-exports9; Public sector gross financing need (in percent of GDP)2/9; Short-term public debt-to-total debt (at remaining maturity)3/9; Domestic public debt held by nonresidents-to-GDP9. - External sector flow imbalances (external liquidity, rollover risks): External debt service-to-exports (revenue)9; External gross financing need (billions of U.S. dollars)4/9; Gross official reserves-to-short-term external debt (at remaining maturity)5/9; Extended reserve cover6/9; Gross official reserves-to-broad money (M2)9; Foreign currency deposits-to-foreign assets of the banking system9. - Financial system soundness: Regulatory capital-to-risk-weighed assets9; Nonperforming loans-to-total loans (gross and net of provisions)9; Claims on the Government and Central Bank-to-total banking sector claims9; Private sector credit growth9; Foreign currency loans-to-total loans9; Foreign currency deposits-to-total banking sector deposits9; Share of foreign currency deposits held by nonresidents9. - Table source: IMF. - Definitions and notes in table footnotes (examples preserved exactly): - 1/ The sum of interest and amortization of medium- and long-term debt. - 2/ Defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period. - 3/ Amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period. - 4/ Defined as the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of short-term debt at the end of the last period. - 5/ External short-term debt includes amortization of medium- and long-term debt plus stock of short-term debt at the end of the last period. - 6/ Gross official reserves in percent of the current account deficit adjusted for net FDI inflows plus total external amortization due plus the stock of short-term debt at the end of the last period plus foreign currency deposits in the banking system. ### Better integration of domestic debt in the DSF: evidence and challenges - Current status and empirical findings: - The DSF’s capacity to detect early debt vulnerabilities would be strengthened by better integration of domestic debt in DSAs. - Domestic debt is substantial in many LICs but is not formally incorporated in debt distress thresholds. - An update review found that in a sample of 33 joint Fund-Bank DSAs, 24 included a public debt DSA; in all but one case, the risk of debt distress classification coincided with the one that would have been derived from an assessment of external debt and debt-service indicators only. - A preliminary empirical analysis found that domestic debt (as a percentage of GDP) had an estimated effect on the likelihood of external debt distress similar in magnitude to the effect of external debt relative to GDP. - The inclusion of domestic debt in the regression explaining the likelihood of external debt distress increased the explanatory power of the model from 21 percent to 27 percent. - Behavioral evidence: - Analyses of domestic debt behavior before episodes of external debt distress show domestic and external debt have tended to grow rapidly relative to GDP in the two years immediately prior to the onset of external debt crises; afterwards, domestic debt tends to decline while external debt surges. - Conceptual and practical challenges in integrating domestic debt: - External and domestic debt are qualitatively different—governments often resort to seignorage or financial repression rather than default on domestic debt. - Domestic debt serves monetary policy, exchange rate management, and domestic financial market development in addition to budget financing. - Financial terms differ: domestic debt generally has shorter maturities, higher nominal interest rates, and is denominated in domestic currency—exposing different risks than low-interest, long-term external debt. - Data coverage and quality for domestic debt differ across countries; inclusion in classification may create adverse incentives for transparent recording of domestic debt. - Implementation issues for linking IDA grant-share decisions to domestic debt: - Explicitly linking risk classification for grant-share decisions to domestic debt ratios raises issues—for example, increased issuance of domestic debt could trigger higher risk classifications and thus higher external grants, potentially weakening incentives for domestic revenue mobilization. - Practical approaches (not simply adding domestic to external thresholds): - Domestic debt can be taken into account in assessing risk of debt distress and designing borrowing strategies. Illustrative cases: - External public debt > indicative thresholds while domestic debt is low: strategy should seek to reduce external debt gradually while keeping domestic debt in check, provided domestic debt cost is not excessive. - External public debt well below thresholds while domestic debt is high: shifting from domestic to external debt (on concessional terms) could reduce present value of total debt and market risks, assuming feasible. - Both external and domestic debt too high: the pace of reduction for each depends on relative costs, maturity-structure risks, and the government’s rollover capacity. *From: IDA’s recently approved policy on nonconcessional borrowing in grant-eligible and MDRI-recipient countries (paragraphs 27–40).* ### 41. Staffs see scope for integrating more systematically domestic debt considerations ### 41. Staffs see scope for integrating more systematically domestic debt considerations ### Integrating domestic debt into LIC DSAs - All LIC DSAs should include a public debt DSA; external and public debt DSAs need to be produced simultaneously and in a consistent manner because they complement each other in assessing a country’s debt sustainability. - Domestic debt should receive heightened attention where domestic debt has an above-average weight or has increased rapidly in recent years. - Higher levels of domestic debt warrant closer scrutiny, tempered by country-specific factors including macroeconomic performance and debt management capacity. - Staff teams should consider the circumstances under which domestic debt was accumulated (e.g., domestic financing of budgetary spending, assumption of contingent liabilities, sterilization operations) and note constraints due to insufficient information. - The public debt DSA should systematically indicate whether the baseline primary balance is consistent with debt sustainability and whether it is realistic in view of historical experience. - Additional indicators of domestic debt-related vulnerabilities—particularly relating to the maturity of domestic debt—could be added to the public debt DSA template when the requisite information is available. - The DSA should explicitly flag situations where inclusion of domestic debt in overall debt and debt-service prospects would lead to a different classification than consideration of external debt and debt service alone. Such situations are expected to be rare because domestic debt constitutes only about 20 percent of total public debt in the typical LIC; if a difference emerges it should be explicitly acknowledged to enable IDA and other multilateral donors to base grant allocation decisions on a risk assessment unbiased by moral hazard concerns. ### Data and capacity challenges - Incorporating domestic debt into some DSAs poses a data challenge; improving the quality of domestic debt reporting will be particularly challenging. - In cases where domestic debt is significant but data quality is deficient, DSAs must signal clearly that results depend on assumptions. - Improved debt reporting is a key objective of ongoing efforts to build debt management capacity in LICs. ### Strengthening links from DSAs to policy advice and conditionality - The DSF should be used widely by borrowers and creditors; the link between DSA results and policy advice—and where relevant, program conditionality—could be tightened. - A higher risk of debt distress should generally be associated with a lower recommended increase (or a higher decrease) in the NPV of external debt; but countryspecific circumstances advise against a mechanistic link. - There should be a presumption that the recommended minimum grant element will increase with the risk of debt distress, and the recommended volume of new debt (including concessional debt) will decrease. - A shift to a higher risk category should trigger a comprehensive reassessment of Bank and Fund staffs’ recommendations on the appropriate debt accumulation strategy. - In the Fund, DSA results should be taken more closely into account for program design and conditionality; Fund Board calls include using conditionality related to the NPV of external debt and more systematic use of limits on the overall fiscal deficit (including grants) where debt sustainability is a concern. - Minimum concessionality requirements exceeding 35 percent should continue to be used when needed. - The easing of limits on nonconcessional external finance for countries graduating from concessional financing should be subject to the authorities’ track record and DSA results. - In a Fund-supported program context, sub-ceilings on nonconcessional external debt could be adjusted upward throughout the program period based on the member’s debt management capacity and other criteria. - The DSF could provide a platform to assess alternative financing mixes and scaling up scenarios and their implications for external and public debt sustainability. - For LICs with no Fund-supported program, Boards would discuss staffs’ advice on appropriate borrowing strategy in the context of Article IV consultations and Country Assistance Strategies (CASs). - In countries with increased creditworthiness, IDA and Fund staffs would collaborate closely with authorities on debt strategies and capacity-building issues. ### DSA use by borrowers: medium-term debt strategies (MTDS) and debt management capacity - Regular DSAs should become part of sound policy design and pave the way for country-owned MTDSs that address vulnerabilities uncovered in DSAs. - An MTDS should ensure borrowing that: (i) is consistent with the country’s development plans and macroeconomic program; (ii) is sustainable; and (iii) minimizes borrowing costs over the medium to long term, consistent with a prudent degree of risk. - An MTDS should be closely linked to the medium-term fiscal framework and strengthen operational debt management capacity. - Preconditions and elements of an MTDS: - capability to monitor existing debt-service obligations; - contracting of new debt subject to oversight and an agreed macroeconomic framework; - linkage to a full-fledged medium-term fiscal framework with prudent revenue projections and expenditures consistent with the PRS; - recognition of cost and risk tradeoffs in setting sustainable borrowing limits; - addressing terms of new borrowing (mix of fixed vs. variable rate) and mix between domestic and external debt (local currency vs. foreign currency); - regular updates, integration into government decision making, and full ownership by relevant government institutions. - Operational challenges: - debt management offices in many LICs lack adequate capacity to monitor, record, and manage debt and new resource flows; - key debt management challenges in HIPCs include: (i) need for comprehensive institutional and legal frameworks; (ii) need for greater and more effective coordination across units; (iii) lack of public/parliamentary oversight and limited transparency/reporting; (iv) recruitment and retention of staff and resource constraints; and (v) limited political support. - First-step capacity priorities: - strengthen monitoring of a broad definition of public debt (central government liabilities, public enterprises, local authorities, publicly guaranteed debt); - provide debt-management units with a clear operational mandate and accountability arrangements; - recruit appropriately skilled staff; consider establishing an investors relations office. - Technical assistance (TA) needs: - current TA often focuses on "needs identification" or limited aspects of debt management and on providing debt management software without guaranteeing high quality data; - systematic approaches to develop debt management functions and operationalize MTDSs are needed; - TA should move beyond training "debt recorders" to building comprehensive debt management capacity and sensitizing senior policy makers to interlinkages between debt management, monetary and fiscal policies, and financial market development. - IDA and donor coordination: - IDA proposes developing a diagnostic tool and reporting framework to assess debt management capacity in LICs, establish partnerships to assess capacity and identify needs, guide reforms and TA, and monitor performance over time; - the proposed approach should be embedded in country programs to ensure client ownership, donor coordination, and continuous tracking; resource implications are significant and may require additional funding. - Implementation timeline and ownership: - having an MTDS in all LICs is a medium-term goal; more advanced LICs could have an MTDS over the medium term. - Fund- or IDA-supported programs should include a detailed plan for developing an MTDS or significant progress during the program period; progress could, on a case-by-case basis, be an element of Fund or Bank conditionality while respecting government ownership. - Short-term measures: - more intensive use of the DSF by country authorities can pave the way to a homegrown MTDS; - authorities should be involved more closely in DSA preparation and DSA results should be discussed systematically at a high level to ensure decision maker involvement; - DSAs (and eventually MTDSs) could serve as a basis for discussions with creditors and donors in consultative group (CG) meetings. *Source: IMF staff paper excerpt (section 41–56).* ### 57. The DSF, and ultimately an MTDS, can also be a useful tool to inform and guide ### _110606 - 57. The DSF, and ultimately an MTDS, can also be a useful tool to inform and guide ### Use of the DSF by creditors and borrowers - DSAs can be used to disseminate concerns about risks to debt sustainability and in some cases guide recommendations on the appropriate level of concessionality in new borrowing. - Broad acceptance by all creditors of the results of DSAs would contribute to enhance creditor coordination and minimize the risks of crises. - The use of the DSF by creditors is expanding but still limited: - Actively used by a few multilateral creditors and donors; much smaller extent by export credit agencies (ECAs) and commercial creditors. - Early creditor feedback indicates they value the informational and analytical content of DSAs despite limited use. - Use of the DSF and its results is an individual choice for each creditor: - The DSF has no institutional or contractual basis and does not seek to bind creditors around a given course of action (e.g., overall lending envelope, degree of concessionality, or investment priority). - Main objective: allow creditors and borrowers to make informed decisions about preferred financing strategy. - Ultimate responsibility for borrowing decisions rests with borrowing governments; governments must understand DSAs and use them to define borrowing strategy. - Broadening creditor awareness of debt sustainability concepts and Bank-Fund assessments can facilitate creditor coordination through shared understanding of the impact of individual lending decisions on a debtor’s overall debt outlook. ### Outreach and engagement with creditors - Staffs have intensified outreach on the DSF with traditional official lenders, including ECAs: - Attendance at meetings of the export credit group of the OECD, of European ECAs, and of the Paris Club to discuss implications of the DSF for ECA lending in a post-MDRI context. - Continued contacts with multilateral development banks to foster their more active use of the DSF. - ECAs and creditor awareness: - Contacted creditors were generally aware of risks of excessive debt buildup in LICs. - Many ECAs acknowledged that officially-supported lending to LICs, while a small part of total portfolio, can be large relative to recipients’ budgets; increasing nonconcessional lending to LICs could put debt sustainability at risk. - DSAs could inform ECAs’ country risk analysis and provisioning decisions; some ECAs developing “responsible lending” practices that take DSAs into account. - An informal group of 16 ECAs from OECD countries established to develop their own framework; expected to present a proposal at the OECD export credit group meeting in November 2006, with non-OECD countries invited as observers. - Broader public access and tools: - Interest in increased and easier access to conclusions and underlying assumptions of joint Bank-Fund DSAs. - DSAs will shortly be easy to locate on dedicated pages in the Bank and Fund websites. - A grant element calculator is available on the IDA website to facilitate calculation of concessionality for IDA’s policy on nonconcessional borrowing. - Information on concessionality and a concessionality calculator developed by Fund staff will soon be posted on the Fund’s website. - Posting of a given DSA remains subject to consent of the authorities. - Merit in allowing web access to templates and fostering more regular exchanges between Bank/Fund staffs and other creditors; possible web summary table of LIC DSAs, dates, and links where authorities consent. - Outreach to emerging creditors: - Planned further outreach; emerging creditors generally not represented in donor-coordination organizations (OECD, Paris Club), creating gaps in information on amounts and terms of their support. - Outreach should aim to improve information on emerging creditors’ lending activities. ### Information, reporting, and data gaps - Current comprehensive source of loan-by-loan data: World Bank’s Debtor Reporting System (DRS). - Approximately half of LICs expected to report public external debt data to the DRS do not submit at all or have moderate to major problems with submissions. - Efforts underway to strengthen adherence to quarterly and annual reporting. - Annual data obtained with a lag and coverage uneven; need to complement with detailed creditor records. - Collaborative reporting efforts: - IMF and World Bank staffs, together with OECD, BIS, and Berne Union staffs, trying to develop reporting mechanisms to measure official lending to LICs to validate and supplement DRS data. - Potential integration into web-based Joint External Debt Hub (JEDH), though would not cover financing from emerging and private creditors not members of OECD or Berne Union. - Outreach to emerging creditors should aim to improve available information on their lending. ### Refining the debt-distress ratings - Boards asked staffs to consider refinements to existing debt-distress risk ratings, including subdividing the moderate risk category: - Of 21 DSAs completed in time for the review and that had given a risk rating, nine (43 percent) had received a moderate risk rating. - Concern whether moderate risk category should be split to allow more nuanced risk assessment and whether classifications allow sufficient precision for IDA and other lenders to tailor grants. - MDRI impact and risk incidence: - Implementation of the MDRI, among other factors, has reduced incidence of moderate risk ratings. - Main DSF implementation change: provision of MDRI stock debt relief to 20 countries, with more expected to follow. - Footnote: 22 countries have actually received MDRI relief from the Fund (20 HIPCs, plus Cambodia and Tajikistan). - Six MDRI recipients still receive IDA grants: Ethiopia, Guyana, Malawi, Nicaragua, Niger, and Rwanda. - Effect: reduced risk in many cases; some countries (Benin, Cameroon, Uganda and Zambia) moved from IDA-grant recipients to receiving 100 percent loans from IDA. - Recommendation on risk categories: - Revising risk category definitions appears unnecessary at this point. - Recent review found existing DSF guidelines being applied appropriately. - Increasing number of categories would require refining guidelines and could overstate precision of 20-year forecasts, and increase frequency of grant-share alterations, adding administrative burden. - CPIA volatility concern and proposed mitigation: - CPIA fluctuations (rather than secular change) can translate into undue volatility in IDA grant share. - Instances where temporary CPIA changes led to temporary performance category changes. - Recommendation: use a three-year moving average CPIA score to determine performance category. - Basing performance categories on a three-year moving average CPIA, with the same two CPIA cutoff values between categories, will smooth out undue fluctuations in grant share. - CPIA cutoff values: 3.25 is the cutoff between weak and medium performance; 3.75 is the cutoff between medium and strong performance. - Staffs recommend allowing the DSF to build a longer track record before revisiting risk categories. - Clearance and review functions in Bank and Fund must continue to ensure guidelines applied appropriately and consistently. - IDA will look to Bank Economic Policy and Debt Department staff to execute a standardized approach and ensure moderate risk ratings do not over-proliferate. ### Resource costs and capacity building - TA to help governments develop capacity and prepare MTDSs will entail large resource costs: - Substantial, multi-year, multi-institution TA effort required given weak capacity in most LICs to manage existing debt. - Proposed evolutionary approach: short developmental phase at headquarters, initial mission to assess institutional/operational arrangements, consultation to set priorities, followed by focused missions; substantial capacity building engagement in some cases, collaboration with other agencies and private sector, and contracting of technical assistance where appropriate. - Preliminary estimates suggest this could require, on average, 1-1.5 Fund staff-years, as well as significant recourse to external experts and additional travel costs. - Bank staff and travel costs over the next three years are estimated at about US$6 million. - Such effort would require major reallocation of existing resources away from current activities. - Footnote clarifies 1-1.5 Fund staff-years would cover: (i) cost of developing MTDS, templates, capacity building frameworks; (ii) outreach activities and collaboration with other agencies, and internal staff dissemination; (iii) backstopping including review work. Does not factor costs associated with direct delivery of capacity building activities. - Outreach resource implications: - Expanding outreach on the DSF requires resources but to a much smaller extent. - Fund and Bank staff participation in ECA meetings and outreach to emerging creditors. - Fund: additional travel costs could be covered from Fund-wide budgetary contingency for implementation of Medium-Term Strategy. - Bank: costs would need additional budget allocations for relevant departments. - Other proposals (designing more solid baseline scenarios, accounting for domestic debt more systematically) have staff resource implications but could be covered within existing budget. ### Conclusions and issues for discussion (key proposals and questions) - Paper proposes practical guidelines to enhance rigor and quality of DSAs and effectiveness of the DSF given challenges from debt relief and new lenders. - Key staff proposals to improve quality and rigor of DSAs: - Guidelines to design more solid baseline macroeconomic and growth scenarios. - Reinforcement of precautionary features already in the DSF, including active use of historical or other alternative scenarios. - Where debt buildup expected to be sudden and rapid, DSF will call for robust justification of expected growth dividend. - Concessional flows remain most appropriate external finance for LICs; case-by-case consideration of nonconcessional finance should explicitly take into account: (i) impact on debt sustainability; (ii) availability of concessional resources; (iii) overall strength of policies and institutions including public expenditure program quality; (iv) quality of investment to be financed. - Increasing interest of private external creditors in LIC sovereign debt requires careful monitoring; additional analyses focusing on short-term debt-related vulnerabilities to be used more systematically with DSF. - All LIC DSAs should include a public debt DSA, produced simultaneously and consistently with external DSA; special attention where domestic debt has above-average weight or increased rapidly. - Effectiveness of DSF depends on broader use by debtors and creditors: - Borrowers: develop own MTDS to support development objectives and MDGs while containing debt distress risks; renewed efforts to build capacity in public debt management. - Creditors: further outreach needed; strengthen link between DSA results and policy advice. - No need to revise debt distress categories now; use three-year moving average CPIA score to avoid undue volatility in IDA grant share. - Resource implication: TA to provide capacity building for MTDS development would be substantial and require reduction in current activities given budget constraints. - Questions posed for Directors: - Is the DSF well suited to assess and monitor debt and risk of debt distress but in need of strengthened application due to debt relief and new lenders? - Would improving DSAs as proposed allow satisfactory case-by-case approach to debt accumulation, more careful use of nonconcessional financing, and more systematic consideration of vulnerabilities related to private creditors and domestic debt? - Is outreach needed to foster use of DSAs by creditors and debtors, including capacity building to help debtors develop MTDSs? - Is refinement of debt distress ratings unwarranted now, but should a three-year moving average CPIA score be introduced to avoid undue volatility in IDA grant allocation? ### Appendix 1: Domestic debt database — availability and coverage - Motivation: - Data on public domestic debt in LICs has been quite limited; Fund and Bank staffs collaborated to compile a joint domestic debt database to fill the gap. - Coverage and data features: - Domestic debt stock data includes 66 countries for period 1998-2004, though for most countries time series cover 1995-2004. - Longer time series data exist for 30 countries covering 1980-2004. - Public sector debt coverage captures as broad a definition of the public sector as possible. - Definition of gross public domestic debt consistent with coverage at country reporting level, but excludes contingent liabilities, central bank advances to central government, and central bank debt. - Variable coverage: - Domestic debt as a share of total debt analyzed for 66 LICs. - Domestic interest (as percentage of revenues and of total interest) available for 65 countries. - Real interest rates coverage: 64 countries. - Domestic debt maturity: coverage for 44 countries and 384 annual observations. *Source: Excerpt from IMF/World Bank staff paper on the Debt Sustainability Framework (DSF) and Medium-Term Debt Strategies (MTDS).* ### 81. A good starting point is to consider the magnitude of LICs’ domestic debt ### A good starting point is to consider the magnitude of LICs’ domestic debt relative to GDP during the period 1995-2004 ### Magnitude and distribution of domestic debt in LICs (1995–2004) - Mean domestic debt (percent of GDP): 18.72 - Median domestic debt (percent of GDP): 15.0 - Standard deviation (percent of GDP): 16.5 - 1/3 Percentile (percent of GDP): 9.8 - 2/3 Percentile (percent of GDP): 20.7 - Max (percent of GDP): 80.9 - Min (percent of GDP): 0.8 - Number of Observations (for % of GDP column): 627 - Number of Countries (for % of GDP column): 66 - Two-thirds of the countries analyzed have average domestic debts below 21 percent of GDP. - Domestic debt represents about one-fifth of LICs total public debt in the period under analysis. - Median domestic debt as percent of total public debt: about 17 percent. - Two-thirds of countries have domestic debt that is less than a quarter of total public debt. ### Cost, maturity, and interest burden of domestic debt - Typical LIC paid, on average, about 8 percent of public revenues to cover the domestic interest bill. - This domestic interest bill represented more than 40 percent of total interest. - Short-term domestic debt (percentage of total domestic debt) — sample statistics: - Mean: 67.2 - Median: 85.3 - 1/3 Percentile: 47.2 - 2/3 Percentile: 100.0 - Standard Deviation: 37.2 - Max: 100.0 - Min: 10.0 - Number of Observations: 384 - Number of Countries: 44 - Ex-post real annual interest rate on domestic debt (annual percent) — sample statistics: - Mean: 3.2 - Median: 3.1 - 1/3 Percentile: 1.9 - 2/3 Percentile: 5.0 - Standard Deviation: 5.9 - Max: 19.8 - Min: -17.9 - Number of Observations: 579 - Number of Countries: 64 - Comment in source: “The higher cost of domestic debt might reflect an appropriate insurance premium against the exchange rate risk.” ### HIPC status, CPIA ratings, and domestic debt - Distribution of the domestic-debt-to-GDP ratio is similar for HIPCs and non-HIPCs. - Within HIPCs: - Those which have reached the completion point have higher domestic debt. - Pre-decision point HIPCs show lower levels of domestic debt. - Countries with higher CPIA ratings have higher domestic debt (counts shown in Table 3 by domestic debt bands: <10% of GDP, >10%–20%, >20% of GDP). ### Historical trend evidence (longer series) - For 17 countries with uninterrupted data from 1982-2001: - Mean domestic debt to GDP ratio: 22 percent in 1982 and 21 percent in 2001. - Median domestic debt to GDP ratio: rose from 11 percent in 1982 to 21 percent in 2001. - External debt for the same sample showed a more marked rise over the same period. ### Joint Bank-Fund DSAs and treatment of domestic debt - Between April 2005 and early June 2006: 33 joint DSAs published, of which only 24 included a public debt DSA. - Of these 33 joint DSAs, 30 corresponded to countries included in the domestic debt database used in this appendix. - Some countries with low domestic debt (<5 percent of GDP for 1995-2004) did not include a public debt DSA (examples: Benin, Central African Republic, Tajikistan). - Some countries with domestic debt burdens above 7 percent of GDP in 2004 did not include sustainability analysis of total public debt (examples: Lesotho, Niger, Rwanda, Tanzania). - Table 4 summary (counts): - Without Public (DSA): 3 4 0 7 (distributed across domestic debt bands) - With Public (DSA): 8 6 9 23 - Grand Total: 11 10 9 30 ### Cases where domestic debt is large despite low/moderate assessed external debt risk - Twelve countries at low or moderate risk of debt distress are toward the upper end of the domestic debt distribution. - Country examples and metrics (period averages or 2004 observations as reported): - Sierra Leone: domestic debt above 30 percent of GDP; slightly less than 20 percent of total public debt; domestic interest about 30 percent of public revenues and two thirds of total interest; assessed at moderate risk of debt distress. - Ethiopia (domestic debt excluding public enterprises): above 30 percent of GDP; about 30 percent of total public debt; domestic interest bill >50 percent of total interest but only 4 percent of government revenues; real domestic interest rates were negative in 2004; assessed at moderate risk. - Papua New Guinea: domestic debt 23 percent of GDP; about 40 percent of total public debt; interest on domestic debt about 7 percent of total revenues in 2004 and 65 percent of total interest; assessed at moderate risk. - Cameroon: domestic debt close to 20 percent of GDP and >30 percent of total public debt; domestic interest 35 percent of total interest and 2 percent of revenues; assessed at low risk. ### Preliminary econometric analysis: role of domestic debt in external debt distress - Sample and data limits: - Domestic debt data for regressions come from low- and middle-income countries for 1980–2005. - Data cover 30 countries; 18 had per-capita income below US$1,000 (in 2004 terms) in the last year reported; 13 were PRGF and IDA eligible as of end-2004. - Original DSF analysis used 167 country-year observations; restricted sample with comparable domestic debt data reduces to 73 observations. - Consequences of the restricted sample: lower precision of estimation and a different composition of countries/years. - Summary statistics (Table 7) — larger vs smaller sample: - GDP per capita (US$): Larger sample Mean 1,646; Standard Deviation 1,448. Smaller sample Mean 976; Standard Deviation 853. - NPV of external debt to GDP (%): Larger sample Mean 28.2; Standard Deviation 18.6. Smaller sample Mean 32.4; Standard Deviation 20.1. - NPV of external debt to exports (%): Larger sample Mean 132.3; Standard Deviation 140.5. Smaller sample Mean 153.8; Standard Deviation 144.4. - External debt service to exports (%): Larger sample Mean 21.0; Standard Deviation 18.3. Smaller sample Mean 21.5; Standard Deviation 17.0. - Domestic debt to GDP (%): Larger sample: .. ; Smaller sample Mean 14.9; Standard Deviation 14.0. - The restricted dataset contains a higher proportion of low-income countries: 62 percent of the smaller sample vs 43 percent of the larger sample have per capita income below US$1,000. - Domestic debt in the restricted sample is approximately one-third of total debt (consistent with other patterns reported). - Probit estimation results (Table 8) — marginal effects on probability of external debt distress: - Specifications I–IX with sample sizes: Specification I: n=167; II: n=73; III: n=73; IV: n=167; V: n=73; VI: n=73; VII: n=167; VIII: n=73; IX: n=73. - External debt to exports marginal effects: - I: 0.336* (0.076) - II: 0.605** (0.171) - III: 0.489** (0.185) - IV: 0.247** (0.083) - V: 0.578** (0.177) - VI: 0.468** (0.185) - VII: 0.0945 (0.094) - VIII: 0.445** (0.184) - IX: 0.391** (0.192) - Domestic debt to exports marginal effects (reported in columns that include it): - III: 0.342 (0.229) - VI: 0.396 (0.245) - IX: 0.299 (0.253) - Note: coefficients on domestic debt are not statistically significant at conventional levels in these specifications. - External debt service to exports marginal effects (included in VII–IX): - VII: 3.81** (0.95) - VIII: 1.93 (1.26) - IX: 1.512 (1.376) - CPIA marginal effects (where included): - IV: -.468** (0.149) - V: -.0591 (0.263) - VI: 0.0823 (0.285) - VII: -.591** (0.163) - VIII: -.00753 (0.267) - IX: 0.0818 (0.282) - Growth (lagged) marginal effects (where included): - VII: -6.80** (2.31) - VIII: -3.12 (4.48) - IX: -4.39 (4.85) - IV: -5.03* (2.63) - V: -3.19 (4.65) - VI: -3.58 (4.97) - Pseudo R2 values reported: - I: 0.113 - II: 0.273 - III: 0.308 - IV: 0.218 - V: 0.280 - VI: 0.320 - VII: 0.340 - VIII: 0.316 - IX: 0.338 - Statistical significance notation: - ** Indicates statistical significance at the 5-percent level. - * Indicates statistical significance at the 10-percent level. - Key econometric conclusions reported: - Domestic debt matters for the risk of external default in the regressions, but the coefficient on domestic debt is not statistically significant in these specifications; the point estimate is positive and of similar magnitude to the effect of external debt in the restricted sample. - The sensitivity of the likelihood of debt distress to external debt to exports is considerably higher in the smaller sample (compare columns I and II). - CPIA’s significance declines in the smaller sample — an effect attributed to sample composition rather than the inclusion of domestic debt. - In the larger dataset, external debt service drove out the debt-to-exports ratio (compare columns I and VII); in the smaller dataset debt-to-exports retains significance even when debt service is included (compare II and VIII). - Overall, including domestic debt in the analysis reduces sample size and precision; results are preliminary and should be interpreted cautiously. *Source: Bank and Fund staffs (extracted from the IMF appendix text)._ ### 93. A more appropriate analysis of debt distress extended to domestic debt uses ### _110606 - 93. A more appropriate analysis of debt distress extended to domestic debt uses ### Debt distress analysis using debt-to-GDP ratios - Replaces debt burden ratios as a proportion of exports (used previously) with debt-to-GDP ratios to better capture the effects of domestic debt. - Table 9 (preferred specifications) shows coefficients on the domestic debt measure (columns III, VI, IX) are significant in all specifications when using GDP as the denominator. - Conclusion: the lack of significance of domestic debt in the export-denominator specifications (Table 8) was mainly due to an inappropriate denominator for domestic debt analysis. ### Empirical results (Table 9 — marginal effects on probability of external debt distress) - Sample sizes: 167 (columns I, IV, VII), 73 (columns II, V, VIII), 73 (columns III, VI, IX). - External debt to GDP marginal effects (with standard errors): - Column I: 2.35** (0.60) - Column II: 3.05** (0.93) - Column III: 2.50** (0.94) - Column IV: 2.20** (0.64) - Column V: 2.76** (0.93) - Column VI: 2.25** (0.95) - Column VII: 1.37* (0.72) - Column VIII: 2.80** (1.09) - Column IX: 2.46** (1.08) - Domestic debt to GDP marginal effects (columns III, VI, IX): - Column III: 2.97** (1.44) - Column VI: 2.69* (1.42) - Column IX: 2.78* (1.43) - External debt service to GDP (reported in some specifications): - 8.81** (3.84) - -0.492 (6.127) - -2.66 (6.45) - CPIA marginal effects (selected): - -.613** (0.155) - -0.321 (0.257) - -0.186 (0.272) - -.744** (0.171) - -0.315 (0.267) - -0.146 (0.289) - Growth marginal effects (selected): - -6.72** (2.36) - -4.16 (4.14) - -4.47 (4.42) - -5.68** (2.48) - -4.17 (4.13) - -4.62 (4.40) - Pseudo R2 by column: - Column I: 0.091 - Column II: 0.177 - Column III: 0.247 - Column IV: 0.238 - Column V: 0.214 - Column VI: 0.269 - Column VII: 0.267 - Column VIII: 0.214 - Column IX: 0.271 - Significance notation: - **Indicates statistical significance at the 5-percent level. - *Indicates statistical significance at the 10-percent level. ### Interpretation of Table 9 results - Using debt-to-GDP ratios, the effect of domestic debt on the risk of external debt distress is robust and similar in magnitude to external debt. - In columns I-III (simple specifications with only debt stocks), the restricted sample shows a stronger external debt effect than the larger sample, but the difference is less marked than in the export-denominator analysis. - When GDP is the denominator, the effect of domestic debt on the likelihood of debt distress is slightly larger than that of external debt; the difference is not statistically significant. - Including CPIA and controlling for shocks does not change the finding that domestic debt has a robust effect (compare columns V and VI). - External debt service explains debt distress in the larger dataset (column VII) but not in the restricted dataset (columns VIII and IX); inclusion of external debt service does not reduce the robust effect of domestic debt (compare columns VI and IX). ### Behavior of debt around episodes of external debt distress (Tables 10 and 11) - Table 10: Annual average changes in public debt (percent of GDP), mean, median, number of observations - 2 years before debt distress: - Mean: Domestic +2.7, External +3.9 - Median: Domestic +0.0, External +4.3 - No. of observations: 27 Domestic, 27 External - 2 years into debt distress: - Mean: Domestic -1.1, External +11.7 - Median: Domestic +0.6, External +4.0 - No. of observations: 32 Domestic, 32 External - 2 years before normal episode: - Mean: Domestic +0.1, External +0.9 - Median: Domestic -0.1, External +0.5 - No. of observations: 101 Domestic, 101 External - 2 years into normal episode: - Mean: Domestic +0.8, External +1.9 - Median: Domestic +0.3, External +1.4 - No. of observations: 129 Domestic, 129 External - Key patterns (Table 10 interpretation): - Both domestic and external debt increase sharply in the two years prior to debt distress: about 3 percent and 4 percent of GDP per year on average respectively. - After onset of debt distress: - Domestic debt declines on average by about one percentage point of GDP per year. - External debt increases by ten percentage points of GDP per year on average. - Table 11: Annual average changes in public debt (percent of GDP) during episodes - During distress episodes: - Mean: Domestic +0.7, External +4.7 - Median: Domestic +0.1, External +2.0 - No. of observations: 89 Domestic, 89 External - During normal episodes: - Mean: Domestic +0.6, External +1.7 - Median: Domestic +0.0, External +0.9 - No. of observations: 317 Domestic, 317 External - Table 11 interpretation: - Domestic debt grows at about the same rate during normal and distress episodes. - External debt grows at a mean rate of nearly 5 percent per year (median 2 percent) during debt distress, versus a mean rate of less than 2 percent (median less than one percent) during normal episodes. ### Interpretation and possible explanations for post-distress patterns - Domestic debt is not a close substitute for external debt: - No evidence of substitution from external to domestic debt prior to external default or distress. - Once debt distress occurs, domestic debt does not generally serve as an outlet for government financing needs; instead, external debt tends to be mobilized to address short-term liquidity needs. - Possible explanations for rising external debt after distress: - If distress is defined by a Paris Club rescheduling or by IMF financial support, an accompanying IMF program may preclude large domestic borrowing. - Depreciation or devaluation may drive up the external debt ratio. - New lending by official creditors to alleviate liquidity problems may increase external debt to GDP. - Note (footnote 62): The switch into external debt following an event of debt distress may reduce the future absorptive capacity of the local market, with possible negative implications for the composition of domestic debt. ### DSF, pace of new borrowing, and detection of potential problems - Empirical exercise: applying existing real allocations of main MDB lending (allowing for nominal inflation of 2 percent per year), standard lending terms, no grants from IDA/African Development Fund/IDB, and a conservative 4 percent export growth rate. - Resulting simple simulations identify four countries whose ratios would breach the threshold within ten years under these assumptions: Rwanda, Ethiopia, Burkina Faso, and Nicaragua. - Post-MDRI risk ratings: Rwanda (red-light, receiving only grants from IDA and African Development Fund), Ethiopia (yellow-light), Nicaragua (yellow-light), Burkina Faso (green-light post-MDRI; its projection depends on higher assumed export growth in its DSA). - Five important characteristics of the DSF as implemented: - (a) Proactive – 20-year forecasts of debt burdens used to determine financing mix offered by largest creditors (IDA and African Development Fund). - (b) Self-regulating – stress tests automatically calibrated to historical economic performance (GDP growth, export growth, FDI, financing terms, etc.). - (c) Operational – risk rating has consequences for lending decisions; both IDA and the African Development Bank base grant allocations on DSF findings. - (d) Regular – DSA updated every year to address incipient problems from pace of new borrowing or updated forecasts. - (e) Self-correcting – DSAs explain main assumptions underlying projections and how they drive projected debt ratios and risk ratings, allowing modulation of assumptions over time. - Cautionary message: significant increases in new borrowing by LICs from other creditors, particularly at or near market interest rates, could jeopardize debt sustainability relatively rapidly. ### Rates of return and the link between debt-financed investment and growth - Aggregate production-function estimates imply average rates of return in the range 20-30 percent for both aid- and domestically-financed investments (Dalgaard and Hansen (2005)). - Implication: debt-financed investments would, on average, more than pay for themselves, but averages may not apply in particular country cases. - Efficiency of public investment depends on overall economic environment and policy framework; indicators such as the CPIA governance rating and PEFA public expenditure management assessments provide information on likely investment efficiency. - Composition of public expenditure matters for likely growth impact; some projects can raise national income, revenues, and/or exports within the 20-year DSF horizon, while others may target non-poverty MDGs. - Differences across sectors and countries: - Canning and Bennathan (2000): highest rates of return to infrastructure are in countries with low infrastructure relative to human and physical capital and low construction costs; rate of return on infrastructure capital is roughly equal to non-infrastructure capital; rapidly diminishing returns for each type. - Public investment can generate productivity spillovers and crowding-in of private investment, but evidence is mixed: - Firm-level surveys and studies (Eiffert and others (2005)) show power outages reduce TFP, indicating infrastructure affects private productivity. - However, public investment is not systematically a strong predictor of incidence or duration of growth accelerations (see Box 1). - Structural and macroeconomic absorptive capacity constraints remain important determinants of whether debt-financed investment will generate growth. *Source: _110606 - 93. A more appropriate analysis of debt distress extended to domestic debt uses* ### 108. Measures of the overall policy environment may provide some indication of ### _110606 - 108. Measures of the overall policy environment may provide some indication of ### Absorptive capacity and returns to public investment - Aggregate evidence suggests diminishing returns to public investment when public investment reaches, on average, 9.5 percent of GDP (Isham and Kaufman, 1999). - Firm-level evidence can differ: Kraay and Raddatz (2005) find some evidence of moderate increasing returns to scale at the plant level but scant evidence of substantial increasing returns to scale external to the firm. - The appropriate rate of public investment depends on evolving absorptive capacity—both stock and flow—and on complementary investments in managerial capacity, human capital, governance, and public expenditure management. ### Investment efficiency, implementation, and governance - Empirical findings indicate investment efficiency tends to decline with investment volume because of flow capacity constraints. - Pritchett (1997) suggests that in developing regions—East Asia excepted—only ½ to ¾ of investment expenditures are transformed into productive capital. - Measures that may inform the scope for useful scaling up: - Completion or implementation rates of public investment projects. - Measures of public expenditure management and governance. - Sectoral balance of expenditures to identify where ineffective scaling up risks are greatest. - Examples of measured inefficiencies: - Herrera and Pang (2005) estimate inefficiencies in the health and education sectors in the range of 35-50 percent. - Efficiency scores are negatively correlated with the size of public expenditure, the share of the wage bill in total public budget, and the proportion of the service that is publicly financed. - Gupta, Verhoeven, and Tiongson (2001) find some evidence that the returns to public spending on health are higher in poor countries than elsewhere. ### Macroeconomic constraints: Dutch disease and financial crowding out - Dutch disease: - Theory and evidence are inconclusive about whether scaling up aid induces Dutch disease; short-run effects claimed include real exchange rate appreciation and loss in competitiveness. - Appreciation and sectoral contraction in tradables need not be pathological if they free resources for critical aid-financed investments; long-run productivity gains from those investments can reverse initial competitiveness losses. - Empirical studies are mixed: some find aid inflows affect exchange rates and lead to overvaluation (Rajan and Subramanian, 2006); others find effects on the real exchange rate are small and statistically insignificant (Bulir and Lane, 2002). - A nuanced case-by-case assessment of Dutch disease risk is necessary, using indicators of competitiveness, effectiveness of aid-financed investments, productivity in tradable and non-tradable sectors, and growth of manufactured exports. Firm-level investment climate surveys can indicate whether real wages are a binding constraint on export performance versus factors such as infrastructure shortages. - Financial crowding out: - Establishing the presence of financial crowding out is challenging. - Indicators that may signal crowding out risk or scope for channeling resources to private investment include: the share of domestic debt in GDP, levels of real interest rates, and rates of private investment. - Conversely, excess liquidity in the banking system may indicate that other factors (e.g., property rights) are limiting private investment. - IMF (2005) notes difficulty in establishing crowding out because credit markets rarely clear through interest rate changes alone. ### Aggregate evidence on growth impact and scaling up - Empirical evidence on the aggregate net contribution of public investment to growth—and on the roles of returns, absorptive capacity, and macro constraints—is ambiguous. - Some studies find, on average, a positive net contribution of public investment to growth, but robustness and causality are uncertain; even when statistically significant, estimated growth impacts tend to be relatively small (Calderon and Servén, 2004). - Clemens, Radelet and Bhavnani (2004) find significant growth effects of aid directed toward growth-enhancing investments. - Key point: factors determining the appropriate rate of public investment evolve over time and depend on policy environment and complementary investments, including investments that increase absorptive capacity itself. ### Stylized facts on growth accelerations (Box 1) - Maintaining a high level of positive growth for a sustained period is difficult; there is a tendency for regression in growth rates following a boom. - Countries with low initial growth rates are more likely to improve than to remain at low growth; countries with high initial growth rates are more likely to experience lower growth subsequently than to maintain or improve strong performance. - The most stable growth rates are those in the middle; very weak or very strong growth rates are less likely to persist. - Example from historical data (47 low-income countries, five-year periods 1971–2003): a country with an average growth between 0 and 2.5 percent over the past five years could expect to have a growth rate above 2.5 percent with a 25 percent probability over the next five years. - Literature on growth accelerations indicates that the likelihood an acceleration can be initiated and sustained is correlated with: - Ex-ante improvements in inflation, the exchange rate, private investment, and the perception of corruption (associated with the start of longer growth accelerations). - Africa-specific evidence: economic liberalization and political transitions predict accelerations; higher debt burdens correlate negatively with the probability of sustained accelerations. - Manufactured exports benefit from a competitive real exchange rate and trade liberalization and are linked to sustained growth accelerations. - While overall investment predicts growth in some contexts, public investment is less clearly a determinant of growth accelerations and does not appear to have been critical to most documented acceleration episodes. - Overall assessment: it is difficult to explain or predict most growth accelerations or their duration; comprehensive policy reform does not clearly precede most accelerations. This suggests caution in making optimistic growth forecasts in scaling up scenarios. ### Policy-relevant indicators and diagnostics suggested by the analysis - Assess structural absorptive capacity before and during scaling up: - Share of public investment in GDP (watch for levels around 9.5 percent as a potential marker of diminishing returns in aggregate studies). - Completion/implementation rates of public investment projects. - Measures of public expenditure management, governance, and sectoral efficiency. - Monitor macroeconomic and financial signals to manage risks: - Real exchange rate and competitiveness indicators, manufactured export growth, and productivity in tradable vs non-tradable sectors (to assess Dutch disease risks). - Share of domestic debt in GDP, real interest rates, private investment rates, and banking system excess liquidity (to assess financial crowding out or constraints on private investment). - Prioritize complementary investments that expand absorptive capacity: - Managerial capacity, human capital, governance, and public expenditure management to raise flow absorptive capacity and sustain returns to public investment. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_110606.pdf* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_110606.pdf_