Public Information Notice No. 03/111

Public Information Notice: IMF Discusses Applications of and Methodological Refinements to Assessments of Sustainability

September 5, 2003

On July 2, 2003, the Executive Board of the International Monetary Fund (IMF) discussed the application of the framework for assessing fiscal and external sustainability and proposed methodological refinements to the framework, based on a paper (Sustainability Assessments - Review of Application and Methodological Refinements, June 10, 2003) prepared by IMF staff.¹

Background

In June 2002, as part of the Fund's efforts at crisis prevention and resolution, the Executive Board endorsed a new framework for assessing the sustainability of countries' public and external debt (PIN No. 02/69, 7/11/2002). Such assessments underpin the Fund's policy advice in both program and surveillance contexts. The new framework was intended to bring a greater degree of consistency and discipline to sustainability analyses, including by laying bare the basis on which projections are made and subjecting them systematically to sensitivity tests.

At the time of that Board discussion, it was understood that the approach represented work in progress, and that modifications and enhancements might be introduced to each of these elements in light of experience. Directors thus asked staff to review the application of the framework after one year, and also identified a number of issues warranting further examination, including whether baseline projections are overly-optimistic, whether the sensitivity tests are calibrated appropriately, and whether it is feasible to establish threshold values or "danger zones" for the debt ratio, taking account of liquidity or roll-over risk. Directors also asked staff to explore ways in which the debt sustainability analysis could be linked more closely to assessments of financial sector vulnerability, in particular, the possible contingent liabilities arising from financial sector restructuring.

In this paper, the staff addresses these issues raised by the Directors, reporting on preliminary experience with use of the framework, and proposing some enhancements in light of that experience. The paper enhances the current framework by incorporating four basic features: (i) a convenient format for laying out the baseline projection; (ii) a method for calculating the "95 percent" probabilistic bound around that baseline; (iii) a framework for articulating alternative scenarios; and (iv), a means for tracking gross financing needs. To facilitate better analysis of key relevant parameters, the modified framework also allows graphical representation of the two most extreme sensitivity tests along with the baseline (and their respective gross financing needs), and computation of debt-stabilizing primary balances.

This approach will continue to be applied to most countries, including those with significant access to international financial markets and those requesting use of the IMF's general resources.

Executive Board Assessment

Executive Directors welcomed the opportunity to discuss the application of the framework for assessing external and fiscal sustainability, introduced in June 2002. They noted that realistic and credible assessments of sustainability are a necessary basis for effective Fund surveillance and informed decisions on the use of Fund resources. As part of surveillance, debt sustainability analyses inform the Fund's advice on appropriate policy adjustments and on crisis prevention. In connection with the use of Fund resources, they help determine judgments on the design of the program and the financing to underpin the program.

Directors noted that debt sustainability depends upon a confluence of factors, including macroeconomic developments, political and social constraints on adjustment, and the availability and cost of private and official financing. They underscored that no single summary statistic can be used to make definitive judgments about debt sustainability, and that the appropriate role of the framework is to provide analytical input to such judgments. Debt dynamics should be viewed against a variety of indicators—including the level, structure and characteristics of the debt; the plausibility that the primary surplus required to stabilize the debt dynamics can be infinitely sustained; and the possible rollover risk arising from gross financing needs. The importance of a good understanding of market views and sound debt management strategies was also highlighted in this connection.

Directors noted that debt sustainability assessments based on the standard framework have been introduced progressively over the past year, and are now routinely presented in connection with requests for use of Fund resources under the GRA and for Article IV consultations for countries with significant market access. Several Directors stressed that it will remain important to apply the framework across the membership going forward. Directors agreed that sustainability assessments have, on the whole, contributed to more realistic projections of the debt dynamics, including by laying bare the assumptions upon which projections are based. A number of Directors also noted that the sensitivity tests in the standard template have been useful in illustrating how the debt dynamics could evolve under extreme circumstances, but at the same time emphasized the need for caution in interpreting these scenarios, given their extreme nature. Some Directors suggested that, in some cases, it would be desirable to model in greater detail the impact of the structure of debt and interest rates on the debt dynamics.

While welcoming the promising start with the introduction of the sustainability framework, Directors nevertheless agreed that there is scope for improvement. In particular, they highlighted that debt sustainability assessments are still insufficiently integrated with the rest of the staff's analysis and its policy discussions with country authorities, and that experience thus far points to an over-optimistic bias in baseline projections. Directors agreed that projections should instead be centered, balancing upside and downside risks. Directors stressed the need for sustainability assessments to inform the staff's overall analysis of the country's fiscal and other macroeconomic policies. The assessments should be a starting point in examining the risks to sustainability, which in many cases will need to be followed up with further analysis focused on issues particularly relevant to individual countries. Directors also underscored that the assessment of debt sustainability provides a valuable tool for staff to focus discussions with the authorities on medium-term developments and the associated risks, and they called on staff to build on best practice in this area.

Against this backdrop, Directors generally welcomed the proposed modifications and enhancements intended to facilitate interpretation of the debt sustainability analysis and its integration in staff reports. In particular, Directors supported the use of alternative, country-specific scenarios that highlight the main vulnerabilities to the baseline projection and against which contingency corrective measures might be contemplated. They saw the inclusion of no policy-change scenarios as a useful tool to help assess the realism of baseline projections. Directors recognized that alternative scenarios will need to be developed selectively, depending on the characteristics of the country's debt dynamics. Most Directors also welcomed the analytical work by the staff providing a basis for further analysis of potential debt dynamics and the probability of debt crises. A number of Directors, however, cautioned against the use of debt thresholds which, they believed, could invite erroneous interpretations and risk becoming self-fulfilling. Some Directors highlighted the importance of incorporating an analysis of the country's intended policy response, reflecting consultations with the authorities, in arriving at judgments about vulnerabilities.

Directors observed that contingent liabilities, in particular those associated with the potential costs of financial sector restructuring costs, have often been a source of increases in public indebtedness. They welcomed the staff's analytical work on possible approaches to estimating contingent liabilities, while recognizing the inherent difficulties of quantifying such liabilities and emphasizing the need for a flexible, case-by-case approach tailored to country-specific circumstances. They encouraged country authorities to provide relevant information to help refine such estimates, in the context of FSAP missions and Article IV consultations. At the same time, however, a number of Directors cautioned that estimates of implicit contingent liabilities would remain highly judgmental, given that it is inherently impossible to specify the precise circumstances under which these might become liabilities of the government. The inclusion of implicit liabilities in sustainability assessments would thus raise complex issues, including possible moral hazard problems. It will therefore be important to proceed with great care in this area.

On the application of the standard framework, Directors stressed that the intention should be to promote best practices, and not to impose a rigid or mechanistic approach. While in all cases the staff's debt sustainability assessments should meet the standards of the agreed framework, they urged staff to complement the template by exploring alternative frameworks and methodologies when these may be more appropriate to country specific circumstances, including for countries with relatively stable macroeconomic environments, and whose debt dynamics are subject mostly to slow-moving demographic or other influences. In this connection, some Directors encouraged the use of the probabilistic approach outlined in the staff paper, in cases where the relevant data are available.

Given the central importance of debt sustainability assessments for the Fund's overall policy advice, Directors agreed that debt sustainability assessments should become an integral part of the analysis underlying the staff report. Most Directors agreed that the standard publication and deletions policy should apply to these assessments, although some Directors would, in view of the potential sensitivity of DSA findings, have preferred to retain the current approach, under which appendices presenting the results of these exercises may be omitted from the published report without requiring explicit justification in each case on the grounds of market sensitivity.

In supporting the proposed enhancements to the debt sustainability framework, Directors noted that further improvements may need to be considered in light of future experience. The staff was also encouraged to continue its efforts to improve the assessment of investor sentiment in a particular country context—a factor that is also key to the discussions with country authorities of their debt management strategies. Directors highlighted the potential resource implications of the enhanced sustainability assessments while noting, in this context, that the staff does not expect these to be significant. They underscored the importance of continued efforts to ensure technical understanding of the framework by markets and country authorities, and of engaging the latter fully in discussing the sustainability assessments. This will be key to promoting country ownership of the policy response prompted by sustainability assessments. A few Directors noted that, in some cases, technical assistance would be necessary for authorities to benefit fully from the debt sustainability analysis and to take ownership of the appropriate policy response. Directors looked forward to further discussions of debt sustainability assessments and reviewing progress with their implementation in the context of future work.