What is the LIC DSF?
The joint IMF-World Bank Debt Sustainability Framework for Low-Income Countries (LIC DSF) is a tool for assessing debt vulnerabilities that guides borrowing and lending decisions.
The LIC DSF is the cornerstone of the international community’s assessment of debt-related risks in LICs, with important operational implications for stakeholders.
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.
Why do we need the LIC DSF?
The objective of the LIC DSF is to support efforts by low-income countries to achieve their development goals, while minimizing their risk of experiencing debt distress. Debt crises are costly to debtors, creditors, and the international monetary and financial system.
In recent years, debt vulnerabilities in LICs have risen. Since 2013, many countries have witnessed an increased risk of debt distress and over two-fifths of these countries are facing significant debt challenges.
A full debt sustainability analysis (DSA) should generally be produced at least once every calendar year.
For the IMF, both surveillance (Article IV) and lending (IMF program) should be accompanied by a DSA. For the World Bank, an annually produced DSA is required to determine the IDA credit-grant allocation. See the “Guidance Note” for more information.
Who should use the LIC DSF?
The LIC DSF applies to low-income countries that have substantially long-maturity debt with terms that are below market terms (concessional debt), or to countries that are eligible for the World Bank’s International Development Association (IDA) grants.
A low-income country may eventually graduate from the concessional debt sustainability analysis and migrate to the Debt Sustainability Analysis for Market-Access Countries (MAC DSA) when its per capita income level exceeds certain threshold for a specified period or when it has the capacity to access international markets on a durable and substantial basis.
DSAs play a critical role in guiding borrowing and lending decisions.
How does the LIC DSF template work?
The LIC DSF template, an Excel-based tool, analyzes scenarios based on user inputs. These inputs are in turn based on a comprehensive macroeconomic framework consisting of historical data and interrelated projections of key macroeconomic variables, often referred to as the baseline scenario. Also important is a financing strategy consistent with the macroeconomic framework (discussed in station 2).
The template automatically applies a series of shocks, or stress tests, to gauge the sensitivity of the debt burden indicators to changes in the baseline scenario. All the debt burden indicators are based on Public and Publicly Guaranteed (PPG) debt and the solvency indicators are in Present Value (PV) terms.
The LIC DSF template classifies countries based on their debt-carrying capacity (see station 4 for explanations). It also compares countries' debt indicators under the baseline and stress scenarios to the relevant thresholds. Risk signals from the template, referred to
as mechanical risk signals, are combined with judgement to determine the risk ratings of external and overall public debt distress.
External and Public DSA
The LIC DSF has two components: an external DSA and a public DSA. For each DSA, the framework generates a mechanical risk signal by comparing the relevant debt indicators with the thresholds. The final risk rating is determined by the combination of the mechanical signals and judgement. Judgement is used to account for other factors that inform the risk rating, but may not be fully captured under the model.
The external DSA covers total external debt in the economy owed by both the public sector and the private sector. Within the external DSA, the mechanical external risk signal is derived from the debt indicators associated with the public external debt. The final external risk rating can be different from the mechanical signal after applying judgement, which is used to assess whether private external debt, public domestic debt, market financing vulnerabilities, or other factors not captured in the model may have fiscal implication and affect the risk rating.
The public DSA covers total public sector debt, composed of both external and domestic debt. The mechanical overall risk of total public debt is derived from the mechanical external risk signal plus the total public sector debt (both external and domestic) signal. The final overall risk of public debt distress can be also different from mechanical signals through judgement.
The LIC DSF coverage excludes private domestic debt. It is shown for expositional purposes.
To sum up: the LIC DSF
INTRODUCES a composite indicator of debt-carrying capacity
VALIDATES the realism of the underlying assumptions
PRODUCES multiple stress scenarios tailored to country-specific risks
OFFERS enhanced guidance on judgement to determine the risk rating of debt distress
This process is illustrated by the diagram below. Yellow text indicates new features of the LIC DSF that came into effect in 2018.
Takeaways for Station 1
- The LIC DSF is a widely used framework that produces public and external DSAs to assess debt vulnerabilities.
- DSAs are typically produced at least once a year to help guide borrowing and lending decisions and assess the risk of debt distress.
- The LIC DSF is applicable to countries that can borrow concessionally. For example, they can borrow with public debt maturities spanning several decades and on borrowing terms that are better than the average market terms.
- Every DSA is based on a coherent set of economic policy assumptions over a long projection period, which are subjected to many stress tests.
- The final risk of debt distress rating is based on how a set of indicators compares to thresholds that were based on each country’s debt-carrying capacity and factors in additional judgement based on country-specific circumstances.