The distressing Debt Sustainability Framework of the IMF and World Bank

The buildings with the logos of three of South Africa's biggest banks, ABSA, Standard Bank and First National Bank (FNB) are seen against the city skyline in Cape Town, South Africa, August 30, 2017. Picture taken August 30, 2017. REUTERS/Mike Hutchings - RC199A8F64C0

This week, the IMF and the World Bank will roll out their 2017 Low-Income Country Debt Sustainability Framework (LIC DSF). What should the DSF look like to be relevant for low-income developing countries (LIDCs) in Africa (listed in Annex Table 1 of the IMF’s March 2018 LIDC debt paper)? That’s a question I take on in my critique, where I conclude that the 2017 DSF is obsolete instead of the “significant overhaul” that is claimed.

Starting from scratch

The centerpiece should be a thorough analysis of public debt given the entrenched deterioration noted in the March 2018 LIDC debt paper. This would mean quantifying variables that drive debt relative to GDP: primary fiscal deficits and the interest rate-growth differential, as well as exchange rate risks, since over half of the debt is denominated in foreign currency. In addition, the contingent liabilities of banks and state-owned enterprises need to be factored in.

The next step would assess the composition and quality of government spending, the integrity of fiscal institutions and the public investment needed in infrastructure and human capital to meet the Sustainable Development Goals. The latter is bound to clash with debt sustainability even in the best-governed African LIDCs like Kenya and Rwanda.

One would then use simple macroeconomic accounting to establish that unsustainable public finances typically spill over into current account deficits, external debt, and foreign exchange reserves. These latter variables should be treated as symptoms of poorly managed public finances, where the fundamental problem lies.

The focus on public debt and its dynamics is dictated by the exigencies confronting African LIDCs and the donor community today:

  • The need to reconcile debt sustainability and development in a situation where Official Development Assistance (ODA) is dwindling (see the March 2018 LIDC paper and the 2017 Report of the High Level Panel on reinvigorating African development finance) while public debt problems are intensifying and growth is slowing down. What matters is the sustainability of long-run growth and development for which debt sustainability is a necessary condition, not an end in itself.
  • The need to reconsider the framework for ODA, including its pricing and allocation. There is considerable scope for this considering first that the market is increasingly defining the marginal borrowing cost for African LIDCs. And second, that concessionality after the HIPC-MDRI debt write off has led neither to sustainable public debt nor a solid foundation for long-run growth. Simply put, concessionality cannot offset the factors driving the deterioration in public debt dynamics noted in Felino and Pinto 2017 and the IMF’s March 2018 LIDC debt paper: weak public finance management systems, misuse of public resources, growth slowdowns, and currency collapses linked to economic and political risks. This calls for a tougher policy dialogue and a higher bar for access to ODA with the goal of igniting a race to the top instead of subsidizing weak policies and institutions.

The 2017 Bank-Fund Framework

This is what 2017 Low-Income Country Debt Sustainability Framework (LIC DSF) does:

  • It retains the focus on PPG (public and publicly guaranteed) external debt of the original 2004-2005 framework. The framework identifies external debt distress episodes based on arrears or commercial debt restructuring. It runs a probit model to estimate the probability of distress, with explanatory variables that include a debt burden indicator (such as the ratio of the present value of PPG external debt to GDP or exports), the country’s growth rate, world growth rate, foreign exchange reserves and the Country Policy and Institutional Assessment (CPIA) rating.
  • Next, countries are classified as weak, medium or strong based on a composite of the CPIA and these variables, except for the debt burden indicator itself. Cutoff probabilities of debt distress that balance Type I (missed crises) with Type II (false alarms) errors are picked. The probit regression is inverted to get thresholds for each debt burden indicator for each country group, based on evenly spaced percentiles for the country composite indicator.
  • The next step is to graft domestic public debt onto the thresholds for the present value of PPG external debt to get thresholds for total public debt. This is defined not as nominal public debt, but as the present value of PPG external debt plus nominal domestic debt.
  • The final step is to come up with a rule for the level of debt distress by comparing the actual debt burden indicator with the thresholds derived for each country group.

What’s wrong with the 2017 LIC DSF?

First, the 2017 LIC DSF ignores the fact that unsustainable public finances are typically the fundamental cause of debt distress: indicators of public debt dynamics, such as primary fiscal deficits and the interest rate-growth differential (r-g), are completely absent in the probit model. Also missing are market signals on default and devaluation risks, such as Eurobond spreads or interest rates on local debt in excess of inflation targets, or credit ratings, that are relevant given the big shift to market debt.

Second, the focus on the present value of debt is outdated. Not only does this obfuscate debt dynamics because it makes (r-g) hard to interpret, it is inconsistently applied. Only concessional external debt is discounted, at an arbitrary discount rate of 5 percent; market debt, including Eurobonds and domestic debt, is taken at face value because it typically carries interest higher than 5 percent. Today, nominal debt makes more sense because of the profusion of different types of public debt—official concessional, market domestic debt, Eurobonds, and non-concessional bilateral loans—at different interest rates. It is their weighted average that is relevant for debt dynamics.

Third, there is no provision for the constant tussle between debt sustainability and development in economies that need huge investments in infrastructure and human capital, for them to grow and create jobs for their burgeoning youth populations—and reduce the instability from insecurity and mass migration.

It is clear from the 2017 Report of the High Level Panel on reinvigorating African development finance  that imaginative ways will need to be found to reconcile debt sustainability and development by using shrinking ODA better and taking on board the growing heterogeneity among African LIDCs. The debt sustainability problems in Ghana and Mozambique, for example, are due to misuse of public resources and weak fiscal institutions. In contrast, Ethiopia, Kenya and Rwanda face the prospects of unsustainable public debt and current account deficits because of big investments in infrastructure. The 2017 DSF doesn’t distinguish between the two.

An Illustration from Ethiopia

This January, the IMF and World Bank downgraded Ethiopia to high risk of external debt distress because one liquidity indicator—the ratio of PPG external debt service to exports—went above its threshold. This effectively shuts off Ethiopia’s access to non-concessional loans.

IMF Country Report No. 18/18 shows clearly that Ethiopia’s current account deficits (CAD) are driven by high fiscal deficits. In 2016-17, the trade deficit was 16.1 percent of GDP of which 13.1 percentage points was on account of the public sector deficit; less than a fifth was because of private borrowing. Net private transfers—mainly remittances—were 6.9 percent of GDP while official transfers were 1.8 percent. This meant that the “public” component of the current account balance was minus 11.3 percent of GDP, partially offset by the private component of plus 3.8 percent of GDP. If Ethiopia is at risk of external debt distress, the cause is its public finances—driven (mainly) by large infrastructure investments. But all the debt sustainability analysis (DSA) says is that public debt is below its threshold and does not “flag additional risks”.

A logical alternative would start with Ethiopia’s public debt dynamics, which superficially look good: the public debt-to-GDP ratio fell from 61 percent in 2014-15 to 54 percent in 2016-17 in spite of primary deficits of about 6 percent of GDP. But this was because of highly negative real interest rates, the result of financial repression and currency overvaluation, as shown in my critique. So the questions the Bank and IMF should be encouraging the Ethiopians to ask are:

  • What would public debt dynamics look like without financial repression and currency overvaluation, which at present distort the private savings and investment choices?
  • Will Ethiopia’s massive infrastructure investments actually spur future growth and taxes and ensure fiscal solvency?
  • What international liquidity pressures are being caused by the spillovers from the fiscal deficits into external deficits?

The 2017 DSF would address only the third question. A more relevant DSA would start with nominal public debt-to-GDP dynamics while treating current account deficits, external debt and foreign exchange reserves as symptoms of public finance spillovers. It would analyze recent history in depth, with a short projection period to spotlight urgent policy reforms. This would minimize the temptation to build in excessively optimistic reform and growth scenarios, which—based on the IMF’s own studies, see for example the March 2018 LIDC debt paper and Mooney and de Soyres 2017—seldom materialize. Finally, by facilitating collaboration among governments, multilateral finance institutions and bilateral donors, such a framework would help to reconcile Africa’s debt sustainability concerns with its sizeable development needs.