Debt Sustainability Model
It is a way of systematically examining the debt viability of a developing nation based on the Debt Sustainability Framework.
What is the Debt Sustainability Model?
The debt sustainability analysis (also referred to as the debt sustainability model) systematically examines a developing nation's debt viability based on the Debt Sustainability Framework.
It is used primarily by the World Bank and the International Monetary Fund (IMF) to assess the effects of lending and borrowing decisions in low-income and developing countries.
The model is essential when determining the amount of financing a country needs and the ability of the country to repay borrowed funds.
A country's public debt carrying capacity is the maximum amount of debt beyond which its income or growth cannot increase. McKinny (2004) noted that a government's debt-carrying ability measures how much it can reasonably borrow.
Debt is good for economic growth, but it can also be harmful, depending on its level of accumulation and management. Since different levels of public debt have varying effects, a tolerable level of public debt is necessary for economic growth.
A rising public debt, low investment, and non-inclusive economic growth will negatively affect change. Besides the impact of debt on economic growth and carrying capacity, concern also exists about how debt affects economic growth.
Understanding the Debt Sustainability Model
The World Bank and the IMF devised the model to ensure debt sustainability within countries. These two international organizations assist developing nations in preserving the sustainability of their economies.
As part of its mission to assist low-income countries, the World Bank provides grants and loans to finance capital projects.
To support sustainable economic growth and reduce poverty, the IMF is also focused on facilitating global monetary cooperation, managing financial stability, and facilitating international trade.
Debt sustainability is based on the following three pillars or goals:
- Countries that borrow funds must have a sustainable development plan before lending funds.
- This will allow lenders to anticipate and measure potential risks and tailor the financing terms accordingly.
- The purpose of this program is to assist low-income countries in managing their debt repayments and their need for additional financing.
The World Bank publishes periodic debt sustainability reports for many low-income countries.
Among the risk factors highlighted in these reports are:
- The risk associated with external debt distress.
- The risk associated with overall debt distress.
These reports include several components, such as a base scenario determined from a series of macroeconomic forecasts and projections that consider the policy intentions of the federal and state governments.
It is assumed that parameters and presumptions have been defined clearly. Sensitivity testing is also applied, which provides an upper limit or confidence level on the probability of each of the probabilistic scenarios that might be possible depending on several changing factors. These include:
- Variables that affect policy
- Decisions regarding macroeconomic developments
- Cost of financing
Importance of the Debt Sustainability Model
It is well known that a market-based economy depends on growth to sustain itself. Therefore, the development of an economy is generally measured by the gross domestic product (GDP), which measures the value of goods and services produced in that country.
Even though almost every economy in the modern world is based on markets, some countries are disadvantaged and less advanced than others.
Developing low-income countries require funding and assistance from developed countries and international institutions for the global economy to grow continuously.
A debt sustainability model allows lenders of funds to understand the risk profiles of the countries they are lending to.
Investors who can improve their evaluation of return expectations or potential losses will better understand the risks of such countries.
Types of Debt Sustainability Models
Debt sustainability is not intended to represent or act as a rigid structure or model. On the contrary, it should be viewed as something essential in assessing national circumstances.
There are a variety of underlying factors that affect every country, including the political climate and the track record of its policies. A generalized description of two types of frameworks that the IMF implements are as follows:
1. Market-Access Debt Sustainability Model
A framework for debt sustainability based on market-access methodology is applied to developed and emerging market economies. Emerging market economies are countries that have ready access to global capital markets.
As part of its debt sustainability analysis, the Fund distinguishes between market-access countries (MACs), which have significant access to international capital markets, and low-income countries (LICs), which meet their external financing needs essentially through concessional resources.
2. Low-Income Country Debt Sustainability Model
Low-income economies can take advantage of the framework of debt sustainability. However, these economies face significant challenges in meeting their development goals.
Due to the uncertainty of their risk and return profiles for investors, these countries are the target countries of the debt sustainability model.
Given the economic, political, and social uncertainty that low-income economies face, it is challenging to forecast borrower payments for low-income countries.
3. Sovereign Debt Sustainability
The sustainability of sovereign debt is more difficult to measure than corporate debt. If you consider a corporation as an example, insolvency is when the value of the company's liabilities outweighs its assets. On the other hand, measuring a sovereign's balance sheet is much more complicated.
In essence, the concept is similar to how corporations measure debt sustainability in the context of financial obligations. For a sovereign country to be able to pay off its debts in the long run, it need to generate surpluses in the future.
However, there is a significant difference in that the potential surpluses that will come to a sovereign in the future are much more uncertain than they were in the past, which makes it significantly more challenging to measure solvency.
To gauge the sustainability of sovereign debt, it is vitally essential to make forward-looking estimates.
Due to this reason, the debt sustainability model is critically important for determining the future state of a developing economy based on factors that were observed in the past or can be observed presently.
Debt Sustainability Analysis (DSA)
Using the Debt Sustainability Framework, the World Bank Group and the IMF conduct regular Debt Sustainability Analyses for low-income countries.
Both institutions use this framework to guide the borrowing decisions of low-income countries to balance their borrowing needs and future repayment capacity.
The three objectives for this area of work are:
1. Achieve sustainable development for countries that have received debt relief.
2. Provide creditors with a better understanding of future risks and allow them to modify their financing terms accordingly.
3. Ensure that client countries can repay their debts while balancing their need for funds.
Macroeconomic policy advice issued by the IMF, both in the context of IMF-supported programs and in surveillance, is based on an assessment of a country's ability to meet its policy objectives and service its debt without unduly adjustments, which could otherwise compromise its stability.
The IMF developed a formal framework for conducting public and external debt sustainability analyses (DSAs) to detect, prevent, and resolve potential crises. This framework was implemented in 2002.
Objectives and Framework
The three objectives of the framework are as follows:
- First, evaluate the existing debt situation, its maturity structure, whether fixed or floating interest rates are applied, and who holds the debt.
- Identify the need for compromises in the debt structure or policy framework early enough so that policy adjustments can be made before problems arise with payments.
- Consider alternative debt-stabilizing policies when such difficulties arise or are about to wake.
The framework has two complementary components:
- The analysis of the sustainability of total public debt
- The study of total external debt.
Each component includes a baseline scenario derived from macroeconomic projections, expressing the government's intended policies and significant assumptions and parameters.
An analysis of the debt dynamics under various assumptions such as policy variables, macroeconomic developments, financing costs, and sensitivity tests is applied to the baseline scenario.
Indicators of debt under baseline and stress scenarios are used to determine whether a country is vulnerable to a payment crisis.
Nevertheless, DSAs should not be interpreted mechanistically or rigidly. In assessing their results, relevant country-specific factors such as debt, previous performance, and experiences must be considered.
Therefore, two types of frameworks have been designed:
- Those for market-access countries
- Those tailored for low-income countries.
In both cases, the frameworks have been continually modified to increase discipline in the analysis and respond to changing economic and financial market conditions.
Debt Sustainability Framework (DSF)
Multilateral institutions and other creditors use the Debt Sustainability Framework (DSF) to assess risks associated with debt sustainability in lower-income countries.
The framework classifies countries based on their assessed debt-carrier capacity. In addition, it estimates threshold levels for selected debt burden indicators, evaluates baseline projections and stress test scenarios relative to these thresholds, and assigns risk ratings based on indicative rules and staff judgment.
LIC DSF was introduced in 2005 and has been reviewed every five years. The most recent revision came into effect in 2018.
DSF Requirement
By supporting low-income countries to achieve their development goals, the LIC DSF aims to minimize the risks of debt distress. A debt crisis is costly to debtors, creditors, and the international monetary and financial system.
Debt vulnerabilities in LICs have increased over the last few years. Several countries have seen a rise in the risk of debt distress since 2013, and over two-fifths of these countries are facing significant debt problems.
Generally, debt sustainability analyses should be performed at least once every calendar year.
Both the IMF's surveillance (Article IV) and lending (IMF program) must be accompanied by a DSA. The World Bank also requires DSAs for IDA credit-grant allocation.
LIC DSF
Under the LIC DSF, low-income countries with significant long-maturity debt could receive loans at substantially lower rates (concessional debt) or funds from the World Bank's International Development Association (IDA).
A low-income country can graduate from the concessional debt sustainability analysis and get into the Debt Sustainability Analysis for Market Access over time.
MAC countries are defined as developing countries when their per capita income level exceeds a specified threshold for a specified period or when they can access international markets on a sustained and substantial basis.
When it comes to borrowing and lending decisions, DSAs play a critical role.
DSA as Decision-Making Tool in Distress Situations
A country's (or its government's) public finances must be analyzed before financial assistance is granted.
Loaning money to a country when its debt is unsustainable is unlikely to improve the situation and may lead to losses for the lender. Additionally, the ESM and IMF are bound by legal obligations.
There is no mandate for either of them to lend to a country that cannot pay its debt. In a crisis, the critical question is how to define sustainability.
According to the most common definition, the debt to GDP ratio should reach a predetermined level without requiring unrealistic primary surpluses.
In terms of the latter, there is some consensus that a surplus of 3 % of GDP over a long period would be a reasonable goal.
The IMF perspective and its DSA framework
The IMF uses its DSA framework worldwide; thus, the 'standard' case for the analysis is a country with its central bank and national currency. In addition, IMF interventions are triggered by the balance of payment crises, according to its mandate.
The fiscal stress experienced in these countries differs from that observed in the euro area, although some similarities can be found.
Public debt is denominated in foreign currencies in many developing and emerging economies.
It is not possible in most of these countries to finance a large public debt in local currency due to their underdeveloped financial markets. This is why most IMF programs deal with countries with modest public debt but contract in foreign currency (usually the USD).
While member states of the euro area typically have high public debt, they have no control over the currency they use to denominate that debt, just like countries where debt is denominated in foreign currencies.
In general, the improvements aim to create a framework better suited for advanced economies as this helps incorporate a more risk-based (fiscal and financial) approach.
Fiscal policy sustainability is at the heart of the IMF DSA. If the government cannot service its debt, fiscal policy will not be sustainable. Two conditions can lead to this.
- Without policy change and the current primary balance, debt-to-GDP cannot be stabilized.
- It is not politically or economically feasible to adjust the prior balance to stabilize the debt-to-GDP ratio.
IMF's Debt Sustainability Analysis Framework
Over the last few years, the Commission's framework for assessing debt sustainability has changed considerably. Currently, the Commission publishes an annual Debt Sustainability Monitor (DSM).
Essentially, this is the annual update to the 3-year cycle of the Fiscal Sustainability Report (FSR), a reimbursable report on fiscal sustainability.
In the FSR, Member States' fiscal sustainability challenges are evaluated based on a comprehensive horizontal framework that integrates debt sustainability analysis (DSA) and fiscal sustainability indicators and identifies challenges across several time horizons (short, medium, and long-term).
Those EU countries that are not undergoing macroeconomic adjustment are assessed this way. In its DSA, the Commission distinguishes between three different time horizons and several sets of indicators.
Whenever a country is deemed 'vulnerable,' an enhanced DSA is needed. In other words, a DSA must be written, and ad hoc sensitivity tests must be conducted.
- If a country's composite indicator of short-term fiscal stress risk is higher than the threshold or the fiscal subindex is higher than the threshold.
- The country's current and/or forecasted gross public debt exceeds 90% of GDP.
- Gross public debt as a percentage of GDP is currently at or above 5% or projected.
- The country's gross financing requirements equal to or exceed 15% of GDP.
- Like the IMF, the European Commission prepares both deterministic and stochastic public debt projections; however, the time horizon is more extended, ten rather than five years.
Public investment and debt sustainability
As a result of fiscal austerity, public investment tends to suffer. This is because it's easier to cut spending that doesn't have a direct effect today than it is, for example, to cut transfers.
To proceed with decisions about public investment, there should be a separation of powers.
Public investments should proceed until the risk-adjusted social rate of return on the investment is equal to the government's real borrowing rate over the project's life, regardless of whether they are financed through debt.
The impact of public investments on debt sustainability largely depends on whether the government can reap the benefits directly or indirectly.
Most public investment projects have either no or lower financial returns than the market rate, even with high social returns.
The public sector typically carries out these investments because they have lower returns than the market. This impacts the sustainability of public debt.
Based on these considerations, a clear conclusion can be drawn. From the point of view of debt sustainability, a public investment that yields no financial returns for the government has the same adverse effect as government consumption.
Even though public investment is essential, the proposition that it should be funded by debt is incorrect: it may affect the sustainability of debt, so part of it may need to be financed by taxes.
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