Debt Sustainability andDebt Sustainability andFiscal Risk AnalysisFiscal Risk Analysis

Using the LIC TemplatesUsing the LIC Templates

PFAM CoursePFAM Course

April 24, 2007April 24, 2007

Mark Roland Thomas, PRMEDmthomas1@worldbank.org

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OutlineOutline

1.1. IntroductionIntroduction

2.2. The External TemplateThe External Template

3.3. The Fiscal TemplateThe Fiscal Template

4.4. Operational FactorsOperational Factors

5.5. Beyond the LIC DSFBeyond the LIC DSF

IntroductionIntroduction

Debt sustainability concepts Debt sustainability concepts and the Bankand the Bank

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When is Debt Sustainable?When is Debt Sustainable? LiquidityLiquidity: can the country pay today?: can the country pay today?

– The answer depends on what “can” isThe answer depends on what “can” is SolvencySolvency: is the country likely to be able to : is the country likely to be able to

pay at all points in future?pay at all points in future?– The answer depends on the current debtThe answer depends on the current debt– It also depend on current economic policiesIt also depend on current economic policies– And it also depends on broader institutional And it also depends on broader institutional

strengthstrength Any solvency problem must eventually Any solvency problem must eventually

manifest itself as a liquidity problemmanifest itself as a liquidity problem– Analyze vulnerability: identify relevant risk conceptsAnalyze vulnerability: identify relevant risk concepts– In LICs, it is important to account for loan termsIn LICs, it is important to account for loan terms

Present value, concessionality, grant elementPresent value, concessionality, grant element

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The Joint (Bank-Fund) DSFThe Joint (Bank-Fund) DSF An operational approach to debt sustainability in An operational approach to debt sustainability in

LICsLICs– ExternalExternal– FiscalFiscal

A DSA is a 20-year forecast of debt burden A DSA is a 20-year forecast of debt burden indicators under baseline assumptions and stress indicators under baseline assumptions and stress teststests– Conducted jointly by IMF and WB teams but the tool can Conducted jointly by IMF and WB teams but the tool can

be used by authorities, othersbe used by authorities, others DSA forecasts, combined with policy specific debt DSA forecasts, combined with policy specific debt

thresholds, lead to a thresholds, lead to a risk ratingrisk rating– Used by IDA: 0/50/100 grant ruleUsed by IDA: 0/50/100 grant rule– Joint LIC-DSF analysis is a core element of WPAsJoint LIC-DSF analysis is a core element of WPAs

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DSA OutputDSA Output

NPV of debt-to-GDP ratio (%)

0

10

20

30

40

50

60

70

2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

Baseline

Historical scenario

Most extreme stress test

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The DSF: what it is and isn’tThe DSF: what it is and isn’t

The DSF is part of our due diligence as a The DSF is part of our due diligence as a responsible creditorresponsible creditor

It tells us whether current debt levels and It tells us whether current debt levels and policies pose a risk of debt distresspolicies pose a risk of debt distress

If they do, we move towards grantsIf they do, we move towards grants

The DSF is not a needs assessmentThe DSF is not a needs assessment

The DSF is not a binding framework on the The DSF is not a binding framework on the borrowerborrower

The DSF is not imposed on other creditorsThe DSF is not imposed on other creditors

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TimelineTimeline April 05: DSF adopted; first joint Bank-Fund DSAsApril 05: DSF adopted; first joint Bank-Fund DSAs March 06: 1March 06: 1stst Board Review Board Review

– Confirmed design and asked for 2Confirmed design and asked for 2ndnd paper addressing: paper addressing: Pace of new borrowing post debt reliefPace of new borrowing post debt relief Domestic debtDomestic debt Moderate risk categoryModerate risk category

November 06: 2November 06: 2ndnd Board Review Board Review– Reported to EPSB, November 29Reported to EPSB, November 29

April 07: Staff guidelines and web publication of April 07: Staff guidelines and web publication of DSAsDSAs– Improved framework for collaboration with IMFImproved framework for collaboration with IMF

June 07: Full rollout of DSA-based approach to IDA June 07: Full rollout of DSA-based approach to IDA grant allocationgrant allocation

FY08: DSF mainstreamed in budgets and WPAs and FY08: DSF mainstreamed in budgets and WPAs and sent stand-alone for information to the Board of IDAsent stand-alone for information to the Board of IDA

The External The External TemplateTemplate

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External DSAExternal DSA

Focus on external public debtFocus on external public debt– Private debt is a consideration but not an Private debt is a consideration but not an

integral part of the analysisintegral part of the analysis Low levels in LICs and data constraintsLow levels in LICs and data constraints

External DSA is built on relatively rich External DSA is built on relatively rich empirical underpinningsempirical underpinnings– Kraay and Nehru (WBER, 2007)Kraay and Nehru (WBER, 2007)

IDA bases decisions on the external IDA bases decisions on the external picturepicture– Moral hazard concernsMoral hazard concerns

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External debt: definitionsExternal debt: definitions

Gross Total External Debt

Public and PubliclyGuaranteed

PPG

Private Non Guaranteed

PNG

Short-term(Public + Private)

Central GovernmentLocal GovernmentPublic Enterprises

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Indicative External Debt Indicative External Debt ThresholdsThresholds

Institutional strength and quality of policies

PoorCPIA<3.25

Medium3.25<CPIA<3.75

StrongCPIA>3.75

Debt service-to-exports

Debt service-to-revenue

NPV of debt-to-GDP

NPV of debt-to-exports

NPV of debt-to-revenue

30 40 50

100 150 200

200 250 300

15 20 25

25 30 35

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External Template: External Template: StructureStructure

InputsInputs

Input ExternalInput External Historic values and Historic values and

projections of projections of macroeconomic variables:macroeconomic variables:

– Current account balanceCurrent account balance– XGNFXGNF– FDIFDI– GDPGDP– Exchange rateExchange rate

Inp_Out_DebtInp_Out_Debt Debt service projections Debt service projections

on the stock of debt at on the stock of debt at the base yearthe base year

Levels and terms of Levels and terms of projected new borrowingprojected new borrowing

OutputsOutputs

SR_Table_BaselineSR_Table_Baseline Projected debt burden Projected debt burden

indicators: NPV/GDP, NPV/X, indicators: NPV/GDP, NPV/X, DS/XDS/X

Decomposition of debt dynamics Decomposition of debt dynamics into its driving forcesinto its driving forces

SR_Table_StressSR_Table_Stress Projected debt burden indicators Projected debt burden indicators

under stress testunder stress test

Relevant indicative Relevant indicative thresholdsthresholds

Other considerationsOther considerations Domestic debtDomestic debt RemittancesRemittances

Risk of debt Risk of debt distressdistress

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Evolution of External DebtEvolution of External Debt

Evolution of DEBT/GDP

Identified factors Residual

Current account deficit

Net FDIEndogenous debt

dynamics

Change in nominal interest rate

Real GDP growthChanges in prices and exchange rates

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Standardized Risk AnalysisStandardized Risk Analysis

Stress tests and alternative scenariosStress tests and alternative scenarios– Alternatives: cost of finance and historicalAlternatives: cost of finance and historical– Stress: GDP growth, export growth, inflation, Stress: GDP growth, export growth, inflation,

net non-debt creating flows, combination, net non-debt creating flows, combination, exchange rateexchange rate

– Trade-off: comparability and transparency with Trade-off: comparability and transparency with specificity and realismspecificity and realism

Variables at historical levels

Real GDP growthGDP Deflator

Non-Interest CANet FDI

Endogenous variablesNominal GDP

Identified Debt creating flowsNominal Interest Rate

Debt Stock

Unchanged VariablesExportsImports

Exchange Rate

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Risk RatingsRisk Ratings1.1. Low RiskLow Risk

– Policy dependent indicative thresholds not breached under Policy dependent indicative thresholds not breached under baseline or stress testsbaseline or stress tests

2.2. Moderate RiskModerate Risk– Thresholds breached only under stress testsThresholds breached only under stress tests– If only one threshold, briefly, there is room for debateIf only one threshold, briefly, there is room for debate

3.3. High RiskHigh Risk– Baseline breaches thresholds, although no existing payment Baseline breaches thresholds, although no existing payment

difficultiesdifficulties4.4. In Debt DistressIn Debt Distress

– Either, debt service thresholds persistently or significantly Either, debt service thresholds persistently or significantly breached…breached…

– Or, significant existing arrearsOr, significant existing arrears NB: the risk rating takes into account all scenarios, NB: the risk rating takes into account all scenarios,

baseline and alternatives, plus country knowledgebaseline and alternatives, plus country knowledge IDA grants response should not affect risk ratingIDA grants response should not affect risk rating

The Fiscal TemplateThe Fiscal Template

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Fiscal AnalysisFiscal Analysis

Adds public domestic debtAdds public domestic debt Fiscal deficit becomes the key driverFiscal deficit becomes the key driver

– Long-run government budget constraintLong-run government budget constraint Nuances when considering domestic Nuances when considering domestic

debtdebt– Term structure: domestic is shorter termTerm structure: domestic is shorter term– Domestic market interest ratesDomestic market interest rates– Inflation and indexationInflation and indexation– Concentration and financial repression?Concentration and financial repression?

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Domestic Debt (PPG)Domestic Debt (PPG)

Obligations to domestic (resident) Obligations to domestic (resident) creditorscreditors

Usually refers to debt payable in domestic Usually refers to debt payable in domestic currency, although the actual payment currency, although the actual payment may be indexed to inflation or a foreign may be indexed to inflation or a foreign currencycurrency

In LICs, domestic debt usually refers to In LICs, domestic debt usually refers to debt of the central governmentdebt of the central government

Domestic debt may also include wage and Domestic debt may also include wage and supplier arrearssupplier arrears

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Contingent LiabilitiesContingent Liabilities

ExplicitExplicit Guarantees for borrowing and obligations of sub-national Guarantees for borrowing and obligations of sub-national governments and public or private entitiesgovernments and public or private entitiesUmbrella guarantees for various loans (e.g. agriculture Umbrella guarantees for various loans (e.g. agriculture loans, small business loans)loans, small business loans)State insurance schemes (e.g. crop insurance, flood State insurance schemes (e.g. crop insurance, flood insurance)insurance)

ImplicitImplicit Defaults of sub-national governments and public or Defaults of sub-national governments and public or private entities on non-guaranteed debt and other private entities on non-guaranteed debt and other obligationsobligationsLiability clean-up in entities being privatizedLiability clean-up in entities being privatizedBank failuresBank failuresFailures of non-guaranteed pension funds or other social Failures of non-guaranteed pension funds or other social security fundssecurity funds

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Fiscal Template: StructureFiscal Template: Structure

InputsInputs

Input FiscalInput Fiscal Historic values and Historic values and

projections of projections of macroeconomic macroeconomic variables:variables:– Public sector debt Public sector debt

datadata– Fiscal variablesFiscal variables– Privatization Privatization

ReceiptsReceipts– Recognition of Recognition of

implicit contingent implicit contingent liabilities liabilities

– Financing Financing assumptionsassumptions

OutputsOutputsTable_BaselineTable_Baseline Projected debt burden Projected debt burden

indicators: NPV/GDP, indicators: NPV/GDP, NPV/X, DS/XNPV/X, DS/X

Decomposition of debt Decomposition of debt dynamics into its driving dynamics into its driving forcesforces

Table_StressTable_Stress Projected debt burden Projected debt burden

indicators under stress indicators under stress testtest

Revise risk of Revise risk of debt debt distress?distress?

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Evolution of Public DebtEvolution of Public Debt

Domestic debt dynamics

Identified factors Residual

Primary Balance Additional FactorsEndogenous debt

dynamics

Change in nominal interest rate

Real GDP growthChanges in prices

and exchange rates

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IllustrationIllustration

Domestic Debt Dynamics

Identified Factors

Primary balance

Endogenous debt dynamics

Changes in prices and

exchange rates

Change in real interest rate

Real GDP growth

Operational FactorsOperational Factors

Board Reviews and Staff Board Reviews and Staff GuidanceGuidance

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Direct Responses to the Direct Responses to the Board’s Requests in a “DSF2” Board’s Requests in a “DSF2”

PaperPaper1.1. The Pace of New BorrowingThe Pace of New Borrowing

– A 5 percent of GDP in-a-year caution flagA 5 percent of GDP in-a-year caution flag

2.2. Domestic DebtDomestic Debt– Public Sector DSA requirementPublic Sector DSA requirement– Possibility of “splitting the risk rating”Possibility of “splitting the risk rating”

3.3. Risk RatingsRisk Ratings– Use of a three-year moving average to set Use of a three-year moving average to set

the indicative debt burden thresholdsthe indicative debt burden thresholds– No change in the moderate risk categoryNo change in the moderate risk category

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Economic Projections in Economic Projections in DSAsDSAs

The battle against optimismThe battle against optimism– Active use of the historical scenarioActive use of the historical scenario– Referral to past DSAs and their Referral to past DSAs and their

projectionsprojections– ““High-investment low-growth” checkHigh-investment low-growth” check

Particularly under caution flagParticularly under caution flag

– Rigor in financing assumptions as well Rigor in financing assumptions as well as growth and exportsas growth and exports

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The New LandscapeThe New Landscape

Nonconcessional borrowing by LICs is a realityNonconcessional borrowing by LICs is a reality– Including MRDI recipientsIncluding MRDI recipients

Realism about financial flows is needed in Realism about financial flows is needed in DSAsDSAs– Need not imply endorsement of borrowing plansNeed not imply endorsement of borrowing plans

Active modeling can signal costs and risksActive modeling can signal costs and risks Other vulnerability indicators may be brought Other vulnerability indicators may be brought

in where private credit is largein where private credit is large– List of indicators is suggestive onlyList of indicators is suggestive only– Economical approach recommendedEconomical approach recommended

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Other InstitutionsOther Institutions IMFIMF

– Despite some breakdowns, overall collaboration has Despite some breakdowns, overall collaboration has been goodbeen good

– Joint work commences prior to briefing paper stageJoint work commences prior to briefing paper stage– Bank participation in IMF mission is encouragedBank participation in IMF mission is encouraged– IMF: early agreement on timing and full file sharingIMF: early agreement on timing and full file sharing– WB: early, full participation and prompt review and WB: early, full participation and prompt review and

clearanceclearance– Guidelines provide more detailed step-by-stepGuidelines provide more detailed step-by-step

Main RDBsMain RDBs– Suggested approach sent to RDBs at working levelSuggested approach sent to RDBs at working level

Inputs based on preliminary tables and chartsInputs based on preliminary tables and charts Attendance at meetings at government invitationAttendance at meetings at government invitation Bank responsible for sharing final documentBank responsible for sharing final document

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The Role of PRMEDThe Role of PRMED SupportSupport

– Staff training (e.g., hub training events)Staff training (e.g., hub training events)– Online materials and guidance notesOnline materials and guidance notes– Ad hoc advisory servicesAd hoc advisory services– Regional priority DSAsRegional priority DSAs

Review and clearanceReview and clearance– Clearance is in conjunction with Regional PREM directorClearance is in conjunction with Regional PREM director– Country interpretation versus DSF-wide concernsCountry interpretation versus DSF-wide concerns– See the Guidance NoteSee the Guidance Note– Price setting for FRMPrice setting for FRM– Submission to BoardSubmission to Board

R&DR&D– Domestic debtDomestic debt– Risk ratings vis-à-vis outcomesRisk ratings vis-à-vis outcomes

Creditor outreach including database maintenanceCreditor outreach including database maintenance Borrower trainingBorrower training

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Staff GuidelinesStaff Guidelines

Definitions and departures from previous Definitions and departures from previous practicepractice

Design of macroeconomic scenariosDesign of macroeconomic scenarios Treatment of domestic and private Treatment of domestic and private

external debtexternal debt Description of responsibilities and timelineDescription of responsibilities and timeline Review processReview process HIPCsHIPCs Model outlineModel outline

Beyond the DSFBeyond the DSF

Fiscal Sustainability in MICsFiscal Sustainability in MICs

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Tailored Middle-Income Tailored Middle-Income AnalysisAnalysis

MIC features:MIC features:– Greater variety of debt instrumentsGreater variety of debt instruments

But concessionality and grant element less germane But concessionality and grant element less germane (no need to use present value)(no need to use present value)

– Emerging markets’ participation in Emerging markets’ participation in international capital marketsinternational capital markets Market risks in addition to exogenous shocksMarket risks in addition to exogenous shocks Shorter time horizonShorter time horizon

– More, higher-quality dataMore, higher-quality data Option for modeling covariance, monte-carlo Option for modeling covariance, monte-carlo

simulation, value-at-risk analysissimulation, value-at-risk analysis

Thank YouThank You

Questions…Questions…