Low-income countries (LICs) face significant challenges in meeting their development objectives, including the Sustainable Development Goals (SDGs), while at the same time ensuring that their external debt remains sustainable. In April 2005, the Executive Boards of the Fund and the Bank endorsed a joint framework for debt sustainability assessments (DSAs) in low-income countries. The aim of the DSF is to guide borrowing decisions of low-income countries in a way that matches their need for funds with their current and prospective ability to service debt, tailored to their specific circumstances.
Debt is a key component of long-term financing for sustainable development and structural transformation. The most important criterion for the long-term sustainability of debt obligations is that borrowing serves the purpose of increasing productive investment significantly with regard to the average interest rate and maturity of the debt stock. If this condition is met, increases in domestic income and export earnings are expected to cover the servicing of outstanding debt obligations. A second key criterion concerns the contractual conditions of (re-) financing such debt. The more closely lending conditionalities are aligned with the objective of mobilizing debt finance for structural transformation in developing countries, the higher the chances the debt can be serviced promptly.
External indebtedness poses important challenges for developing countries, particularly in a context of floating exchange rate systems, open capital accounts and fast integration into international financial markets. The historical position of developing countries as debtors in foreign currency has been a recurrent source of vulnerability to external shocks, for example during a commodity price slump. This is because the servicing of external debt obligations ultimately requires generating sufficient export earnings (or other forms of income). At the same time, exchange rate volatility is likely to affect the value of debt owed externally and that of export earnings in opposite directions. Thus, a depreciation of the local currency against hard currencies may result in increased export earnings (provided that the fall in the dollar price of local exports is compensated by a commensurate increase in export volumes),) but will automatically imply an increase in the value of foreign-currency denominated debt obligations in local currency.
Against a backdrop of insufficient international public finance flows and limited access to concessional resources,1 developing economies have increasingly raised development finance on commercial terms in international financial markets. They have also opened their domestic financial markets to non-resident investors, and they have allowed their citizens and firms to borrow and invest abroad. While increased access to international financial markets can help capital-scarce countries to quickly raise much-needed funds, it also exposes them to higher risk profiles of debt contracts, i.e. shorter maturities and more volatile financing costs, as well as to sudden reversals of private capital inflows. In conjunction with other exogenous shocks, such as natural disasters, pandemics or episodes of political instability, external debt burdens deemed sustainable by international creditors can quickly become unsustainable.
To build a more sustainable, inclusive and resilient global economy that works for all, we must also reform the international financial architecture with rules that are inclusive, effective and fair. Our inability to address debt challenges in many countries speaks to the glaring inequities that continue to characterize our global economic order.
As well as addressing the weaknesses of the Common Framework for Debt Treatment, we must urgently work toward a more comprehensive solution to sovereign debt challenges. The United Nations can provide a neutral and inclusive venue to bring together all countries, major creditors, debtors and other relevant stakeholders to discuss how to reform the international debt architecture. The 2022 Financing for Sustainable Development Report provides the basis for such discussions.
Halfway into the implementation of the 2030 Agenda, the world is at a watershed. The COVID-19 pandemic has caused a severe setback to the achievement of the Sustainable Development Goals (SDGs). The military conflict in Ukraine and heightened geopolitical risks are threatening the global recovery and pushing the most vulnerable further behind. The international community must join forces to prevent further suffering and loss. We must work together to mobilize all resources needed to secure a path to recovery and sustainable development for all.
The 2022 Financing for Sustainable Development Report identifies a “great finance divide” as a main driver of the divergent recovery. Developed countries were able to borrow record sums at ultra-low interest rates to support their people and economies, but the pandemic response and investment in recovery of poor countries was limited by fiscal constraints.
To overcome this “finance divide” and enhance developing countries’ access to financing for recovery and productive and sustainable investment is key in this time.
ASSIST DEVELOPING COUNTRIES IN ATTAINING DEBT SUSTAINABILITY
If the change in policy is infeasible for social or political reasons, or because of prohibitive economic costs (such as the efficiency or growth costs associated with cutting essential government spending or raising already high taxes), debt is unsustainable.
Economic growth must be inclusive to provide sustainable jobs and promote equality.
Enhanced transparency and a more complete information ecosystem will strengthen the ability of countries to manage risks and use resources well and in line with sustainable development.
Three key messages emerge:
Financing gaps and rising debt risks must be urgently addressed. All sources of finance need to be mobilized, and resources must be spent well. With limited options to raise additional domestic resources in the current moment, the international community must meet ODA commitments, support long-term sustainable finance, and address rising debt risks, including by strengthening and expanding the Common Framework for debt treatment beyond DSSI and working towards a more comprehensive solution to address sovereign debt challenges.
All financing flows must be aligned with sustainable development to support a greener, more inclusive, and resilient recovery. To account for the interlinkages between the social, environmental, and economic dimensions of development—highlighted again by the pandemic—fiscal policies must address inequalities and support a just transition to a low-carbon world. Policy actions can include more progressive tax systems and stronger social protection, the pricing of carbon emissions and investment in sustainable and resilient infrastructure. Policymakers should also promote credible norms and consistent reporting standards for
sustainable private investment products.
Enhanced transparency and a more complete information ecosystem will strengthen the ability of countries to manage risks and use resources well and in line with sustainable development. Better quality data is needed to: enable monitoring and accountability; support private and public sector planning and management; and strengthen financial integrity. Higher quality and more complete information can also make sovereign debt markets more efficient.
Sovereign debt is unsustainable if it cannot be repaid without altering the contractual terms of the debt or rendering them irrelevant, via default, restructuring, or hyperinflation. Fiscal policy is unsustainable if preventing such an event requires a change in (fiscal) policy. If the required policy change is feasible, debt is sustainable although status-quo policies are not. If the change in policy is infeasible for social or political reasons, or because of prohibitive economic costs (such as the efficiency or growth costs associated with cutting essential government spending or raising already high taxes), debt is unsustainable.
The World Bank Group and the IMF work with low-income countries to produce regular Debt Sustainability Analyses, which are structured examinations of developing country debt based on the Debt Sustainability Framework. Both institutions use this framework to guide the borrowing decisions of low-income countries in a way that balances their financing needs with their ability to repay—both in the present and in the future.
This area of work has three goals:
Ensure that countries that have received debt relief are on a sustainable development track.
Allow creditors to better anticipate future risks and tailor their financing terms accordingly.
Help client countries balance their needs for funds with the ability to repay their debts.
The Debt Sustainability Framework (DSF) is the main tool for multilateral institutions and other creditors to assess risks to debt sustainability in Lower-Income Countries (LICs). The framework classifies countries based on their assessed debt-carrying capacity, estimates threshold levels for selected debt burden indicators, evaluates baseline projections and stress test scenarios relative to these thresholds, and then combines indicative rules and staff judgment to assign risk ratings of debt distress. First introduced in 2005, the LIC DSF has been subject to a comprehensive review every 5 years. The most recently revised LIC DSF became operational in 2018.
Under the DSF, debt sustainability analyses (DSAs) must be conducted regularly.
These consist of:
(i) an analysis of a country’s projected debt burden over the next 10 years, and its vulnerability to economic and policy shocks, based on baseline and stress test scenarios;
(ii) an assessment of the risk of external and overall public debt distress, based on indicative debt burden thresholds and benchmark, respectively, that depend on the country’s macroeconomic framework and other country-specific information.
Assessing debt to avoid risks
The DSF analyzes both external and public sector debt. The framework focuses on the present value (PV) of debt obligations for comparability, as terms extended to LICs vary considerably and many are concessional. A 5-percent discount rate has been used since 2013 to calculate the PV of external debt.
Countries with different policy and institutional strengths, macroeconomic performance, and buffers to absorb shocks, have different abilities to handle debt. The DSF, therefore, classifies countries into one of three debt-carrying capacity categories (strong, medium, and weak), using a composite indicator, which draws on the country’s historical performance and outlook for real growth, international reserves coverage, remittance inflows, and the state of the global environment, in addition to the World Bank's Country Policy and Institutional Assessment (CPIA) index. Different indicative thresholds for debt burdens are used depending on the country’s debt-carrying capacity.
Thresholds corresponding to strong performers are highest, indicating that countries with good macroeconomic performance and policies, can generally handle greater debt accumulation.
To assess debt sustainability both risk signals from the framework and judgement are used. Risk signals are derived by comparing debt burden indicators with the indicative thresholds above, over a projection period.
There are four ratings for the risk of external public debt distress:
low risk, if none of the debt burden indicators breach their respective thresholds under the baseline and stress tests;
moderate risk, if none of the debt burden indicators breach their thresholds under the baseline scenario, but at least one indicator breaches its threshold under the stress tests;
high risk, if any of the external debt burden indicators breaches its threshold under the baseline scenario, but the country does not currently face any repayment difficulties; or
in debt distress, when the country is already experiencing difficulties in servicing its debt, as evidenced, for example, by the existence of arrears, ongoing or impending debt restructuring, or indications of a high probability of a future debt distress event (e.g., debt and debt service indicators show large near-term breaches, or significant or sustained breach of thresholds).
In addition to the risk ratings signaled by the framework, the use of judgment may be needed to arrive at a final risk rating. In particular, judgment can help assess the gravity of threshold breaches, and country-specific factors that are not fully accounted for in the framework.
To flag countries with significant public domestic debt, the framework also provides a signal for the overall risk of public debt distress, which is based on joint information from the four external debt burden indicators, plus the indicator for the PV of public debt-to-GDP ratio.
Integrating debt issues into policy advice
The DSF has enabled the IMF and the World Bank to integrate debt issues more effectively into their analysis and policy advice. It has also allowed comparability across countries.
The DSF is important for the IMF’s assessment of macroeconomic stability, the long-term sustainability of fiscal policy, and overall debt sustainability. Furthermore, debt sustainability assessments are taken into account to determine access to IMF financing, as well as for the design of debt limits in Fund-supported programs, while the World Bank uses it to determine the share of grants and loans in its assistance to each LIC and to design non-concessional borrowing limits.
The effectiveness of the DSF in preventing excessive debt accumulation hinges on its broad use by borrowers and creditors. LICs are encouraged to use the DSF or a similar framework as a first step toward developing medium-term debt strategies. Creditors are encouraged to incorporate debt sustainability assessments into their lending decisions. In this way, the framework should help LICs raise the finance they need to meet the Sustainable Development Goals (SDGs), including through grants when the ability to service debt is limited.
Key reforms that took effect in July 2018 include:
(i) moving away from relying exclusively on the CPIA to classify countries’ debt-carrying capacity, and instead using a composite measure based on a set of economic variables;
(ii) introducing realism tools to scrutinize baseline projections;
(iii) re-calibrating standardized stress tests while adding tailored scenario stress tests on contingent liabilities, natural disasters, commodity prices shock, and market-financing shock; and
(iv) providing a richer characterization of debt vulnerabilities (including those from domestic debt and market financing) and better discrimination across countries within the moderate risk category.