Debt Sustainability and Fiscal Risk Analysis

1. Debt Sustainability andFiscal Risk Analysis Using the LIC Templates PFAM Course April 24, 2007 Mark Roland Thomas, PRMED mthomas1@worldbank.org

2. Outline • Introduction • The External Template • The Fiscal Template • Operational Factors • Beyond the LIC DSF

3. Introduction Debt sustainability concepts and the Bank

4. When is Debt Sustainable? • Liquidity: can the country pay today? • The answer depends on what “can” is • Solvency: is the country likely to be able to pay at all points in future? • The answer depends on the current debt • It also depend on current economic policies • And it also depends on broader institutional strength • Any solvency problem must eventually manifest itself as a liquidity problem • Analyze vulnerability: identify relevant risk concepts • In LICs, it is important to account for loan terms • Present value, concessionality, grant element

5. The Joint (Bank-Fund) DSF • An operational approach to debt sustainability in LICs • External • Fiscal • A DSA is a 20-year forecast of debt burden indicators under baseline assumptions and stress tests • Conducted jointly by IMF and WB teams but the tool can be used by authorities, others • DSA forecasts, combined with policy specific debt thresholds, lead to a risk rating • Used by IDA: 0/50/100 grant rule • Joint LIC-DSF analysis is a core element of WPAs

6. DSA Output

7. The DSF: what it is and isn’t • The DSF is part of our due diligence as a responsible creditor • It tells us whether current debt levels and policies pose a risk of debt distress • If they do, we move towards grants • The DSF is not a needs assessment • The DSF is not a binding framework on the borrower • The DSF is not imposed on other creditors

8. Timeline • April 05: DSF adopted; first joint Bank-Fund DSAs • March 06: 1st Board Review • Confirmed design and asked for 2nd paper addressing: • Pace of new borrowing post debt relief • Domestic debt • Moderate risk category • November 06: 2nd Board Review • Reported to EPSB, November 29 • April 07: Staff guidelines and web publication of DSAs • Improved framework for collaboration with IMF • June 07: Full rollout of DSA-based approach to IDA grant allocation • FY08: DSF mainstreamed in budgets and WPAs and sent stand-alone for information to the Board of IDA

9. The External Template

10. External DSA • Focus on external public debt • Private debt is a consideration but not an integral part of the analysis • Low levels in LICs and data constraints • External DSA is built on relatively rich empirical underpinnings • Kraay and Nehru (WBER, 2007) • IDA bases decisions on the external picture • Moral hazard concerns

11. External debt: definitions

12. Institutional strength and quality of policies Poor CPIA<3.25 Medium 3.25<CPIA<3.75 Strong CPIA>3.75 Debt service-to-exports 15 20 25 Debt service-to-revenue 25 30 35 NPV of debt-to-GDP 30 40 50 NPV of debt-to-exports 100 150 200 NPV of debt-to-revenue 200 250 300 Indicative External Debt Thresholds

13. External Template: Structure Inputs Input External • Historic values and projections of macroeconomic variables: • Current account balance • XGNF • FDI • GDP • Exchange rate Inp_Out_Debt • Debt service projections on the stock of debt at the base year • Levels and terms of projected new borrowing Outputs SR_Table_Baseline • Projected debt burden indicators: NPV/GDP, NPV/X, DS/X • Decomposition of debt dynamics into its driving forces SR_Table_Stress • Projected debt burden indicators under stress test Risk of debt distress Relevant indicative thresholds Other considerations • Domestic debt • Remittances

14. Evolution of External Debt

15. Endogenous variables Nominal GDP Identified Debt creating flows Nominal Interest Rate Debt Stock Variables at historical levels Real GDP growth GDP Deflator Non-Interest CA Net FDI Unchanged Variables Exports Imports Exchange Rate Standardized Risk Analysis • Stress tests and alternative scenarios • Alternatives: cost of finance and historical • Stress: GDP growth, export growth, inflation, net non-debt creating flows, combination, exchange rate • Trade-off: comparability and transparency with specificity and realism

16. Risk Ratings • Low Risk • Policy dependent indicative thresholds not breached under baseline or stress tests • Moderate Risk • Thresholds breached only under stress tests • If only one threshold, briefly, there is room for debate • High Risk • Baseline breaches thresholds, although no existing payment difficulties • In Debt Distress • Either, debt service thresholds persistently or significantly breached… • Or, significant existing arrears • NB: the risk rating takes into account all scenarios, baseline and alternatives, plus country knowledge • IDA grants response should not affect risk rating

17. The Fiscal Template

18. Fiscal Analysis • Adds public domestic debt • Fiscal deficit becomes the key driver • Long-run government budget constraint • Nuances when considering domestic debt • Term structure: domestic is shorter term • Domestic market interest rates • Inflation and indexation • Concentration and financial repression?

19. Domestic Debt (PPG) • Obligations to domestic (resident) creditors • Usually refers to debt payable in domestic currency, although the actual payment may be indexed to inflation or a foreign currency • In LICs, domestic debt usually refers to debt of the central government • Domestic debt may also include wage and supplier arrears

20. Contingent Liabilities

21. Fiscal Template: Structure Inputs Input Fiscal • Historic values and projections of macroeconomic variables: • Public sector debt data • Fiscal variables • Privatization Receipts • Recognition of implicit contingent liabilities • Financing assumptions Outputs Table_Baseline • Projected debt burden indicators: NPV/GDP, NPV/X, DS/X • Decomposition of debt dynamics into its driving forces Table_Stress • Projected debt burden indicators under stress test Revise risk of debt distress?

22. Evolution of Public Debt

23. Illustration Domestic Debt Dynamics Identified Factors Primary balance Endogenous debt dynamics Change in real interest rate Real GDP growth Changes in prices and exchange rates

24. Operational Factors Board Reviews and Staff Guidance

25. Direct Responses to the Board’s Requests in a “DSF2” Paper • The Pace of New Borrowing • A 5 percent of GDP in-a-year caution flag • Domestic Debt • Public Sector DSA requirement • Possibility of “splitting the risk rating” • Risk Ratings • Use of a three-year moving average to set the indicative debt burden thresholds • No change in the moderate risk category

26. Economic Projections in DSAs • The battle against optimism • Active use of the historical scenario • Referral to past DSAs and their projections • “High-investment low-growth” check • Particularly under caution flag • Rigor in financing assumptions as well as growth and exports

27. The New Landscape • Nonconcessional borrowing by LICs is a reality • Including MRDI recipients • Realism about financial flows is needed in DSAs • Need not imply endorsement of borrowing plans • Active modeling can signal costs and risks • Other vulnerability indicators may be brought in where private credit is large • List of indicators is suggestive only • Economical approach recommended

28. Other Institutions • IMF • Despite some breakdowns, overall collaboration has been good • Joint work commences prior to briefing paper stage • Bank participation in IMF mission is encouraged • IMF: early agreement on timing and full file sharing • WB: early, full participation and prompt review and clearance • Guidelines provide more detailed step-by-step • Main RDBs • Suggested approach sent to RDBs at working level • Inputs based on preliminary tables and charts • Attendance at meetings at government invitation • Bank responsible for sharing final document

29. The Role of PRMED • Support • Staff training (e.g., hub training events) • Online materials and guidance notes • Ad hoc advisory services • Regional priority DSAs • Review and clearance • Clearance is in conjunction with Regional PREM director • Country interpretation versus DSF-wide concerns • See the Guidance Note • Price setting for FRM • Submission to Board • R&D • Domestic debt • Risk ratings vis-à-vis outcomes • Creditor outreach including database maintenance • Borrower training

30. Staff Guidelines • Definitions and departures from previous practice • Design of macroeconomic scenarios • Treatment of domestic and private external debt • Description of responsibilities and timeline • Review process • HIPCs • Model outline

31. Beyond the DSF Fiscal Sustainability in MICs

32. Tailored Middle-Income Analysis • MIC features: • Greater variety of debt instruments • But concessionality and grant element less germane (no need to use present value) • Emerging markets’ participation in international capital markets • Market risks in addition to exogenous shocks • Shorter time horizon • More, higher-quality data • Option for modeling covariance, monte-carlo simulation, value-at-risk analysis

33. Thank You Questions…