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The Debt Sustainability Framework to Become More Flexible for Low-Income Countries

Interview with Carlos Braga, Director PREM Economic Policy and Debt

bragaWhat is the Debt Sustainability Framework and why was it reviewed by the Bank and the Fund?

The Bank-Fund Debt Sustainability Framework (DSF) is a standardized framework for analyzing debt-related vulnerabilities in low-income countries (LICs). It aims to help countries monitor their debt burden and take early preventive action; to provide guidance to creditors in ensuring that their lending decisions are consistent with countries’ development goals; and to improve the Bank and Fund’s assessments and policy advice.

This review was in response to a call by the G20 and the IMFC to make the DSF more flexible. The framework has been criticized by some as being pro-cyclical and unduly constraining low-income countries’ capacity to borrow. Accordingly, it was argued that this was limiting LICs’ development and growth potential and trapping them in a “low debt-low growth” vicious cycle.

It is also worth noting that the DSF, introduced in 2005, was last reviewed in 2006, and a reconsideration of some aspects of the framework was timely.

What is new about this paper?

This paper looks at ways of making the framework more flexible, so as to ensure that countries are not subject to excessively conservative borrowing policies, without compromising on the integrity of the tool.

It is important to understand that the DSF is a tool aimed at assessing a country’s debt sustainability; metaphorically, it is like a “thermometer” used to take a patient’s temperature. Therefore, while revising the DSF, efforts were made to improve the quality of assessment, without jeopardizing the reliability and accuracy of the tool.

The revised version of the DSF allows for greater flexibility in conducting a country’s debt sustainability analysis (DSA) by undertaking a more in-depth country specific assessment of the following:

-      the way remittances are taken into account in DSAs (as a measure to gauge a country’s repayment capacity);

-      the way external SOE debt is taken into account (and its impact on a country’s overall debt situation);

-      the way public investment programs are accounted for (especially, the growth dividend from public investment programs and their impact on debt sustainability).

In addition, there are a few operational issues that the paper also looks into and makes recommendations on, including:

-      how changes in a country’s policy and institutional assessment (CPIA) score should be treated to avoid large fluctuations in the risk of debt distress ratings when these changes breach policy thresholds;

-      the discount rate used to calculate the PV of debt;

-      revised content of the DSAs, with a special focus on explicitly including the views of country authorities;

-      the frequency of doing DSAs.

 

How do the decisions affect low-income countries?

The implications of these changes will vary depending on country-specific circumstances. No country will be adversely affected, but for some countries the additional flexibility may translate into more borrowing space.

One can predict, however, that the proposed operational changes will have these effects:

-      There will be less volatility in countries’ risk ratings as breaches of the CPIA thresholds will occur less often than in the pre-existing framework;

-      Ownership will be enhanced as country authorities will have an opportunity to explicitly convey their views in their respective DSAs;

-      Over the medium term, there will be lesser demand on country resources as comprehensive DSAs will be undertaken every three years (instead of the current annual cycle).

 

What are the main recommendations?

On the analytical front, the paper recommends undertaking more in-depth country specific analyses in three areas: (1) how remittances may affect a country’s repayment capacity; (2) how SOE debt may affect a country’s debt situation; and (3) how public investment programs account for future growth.

On the operational front, the recommendations are: (1) to reduce the volatility in a country’s risk assessment by constraining the way that minor changes in CPIA ratings around relevant boundaries affect debt risk ratings; (2) to implement the existing rule governing changes in the discount rate (which implies that the discount rate used in the DSAs will be reduced from 5 to 4 percent);[1] (3) to better reflect the views of country authorities in DSAs; and (4) to reduce the frequency of DSAs from an annual cycle to a three year cycle (although this will not come into effect till the crisis is over).

How do you ensure DSAs do not lead to excessive borrowings?

The DSF is an analytical tool aimed at assessing a country’s debt sustainability and guiding borrowing decisions of country authorities and lending decisions of creditors. Despite the DSAs, excessive borrowing may or may not result depending on how borrowers and lenders integrate the output of the DSAs into their decisions. The possibility of excessive borrowing depends on whether or not lenders and borrowers act responsibly after the assessment has been done.

What is the operational impact of the DSF on country borrowings?

The impact of the DSF on country borrowing from IDA is two-fold. First, the DSF impacts the loan/grant composition of IDA financing. Second, through its interaction with the Non-concessional Borrowing Policy (NCBP), the DSF can have an impact on the volume and terms of IDA financing.

On the loan/grant composition, under IDA 15 a country’s risk of debt distress emerging under the DSF is the only criterion to determine grant eligibility. Countries rated under the DSF as in debt distress or at high risk receive 100 percent of their allocations on a grant basis, those at moderate risk receive 50 percent of their allocations on a grant basis, and those at low risk receive 100 percent of their allocations on a credit basis.

On the NCBP, this is a two-pronged policy involving creditor outreach as well as measures aimed at borrowers to reduce the risk of over-borrowing. The second prong of the policy involves IDA responses (reductions in volumes or hardening of IDA lending terms) to episodes of non-concessional-borrowing. The NCBP, however, is not a blanket restriction on non-concessional borrowing. The policy fully acknowledges that, under certain circumstances, non-concessional loans can be part of a financing mix that helps promote economic growth and that is consistent with debt sustainability.  In that regard, waivers to the policy can be considered based on country-specific and loan-specific considerations. Long-term debt sustainability, as defined under the DSF, is one of the country-specific factors to be considered in deciding whether or not a waiver under the NCBP should be granted.

How will the new process help achieve the MDGs?

To the extent that the changes will create more borrowing space for countries – i.e., the extent to which countries were indeed constrained by the DSF – the proposed amendments to the framework will allow countries to invest more and/or spend more in social programs and/or relevant public infrastructure and, as a result, foster the achievement of the MDGs.

How will the decisions be made operational?

Bank and Fund staffs are currently working on updating the Staff Guidance Note on the application of the DSF. This revision, which should be ready by the end of this year, seeks to make the recommendations operational. It will be widely disseminated so that starting next (calendar) year, new DSAs will incorporate the approved changes.

 



[1] The rules of the DSF require the discount rate to be changed only when the U.S.

dollar CIRR (six-month average) diverges from the discount rate by at least 100 basis points for a continuous period of at least six months. When this occurs, the magnitude of the change in the discount rate is required to be 100 basis points.




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