Policy Research Working Paper 10602 Making the Low-Income Country Debt Sustainability Framework Fit for Purpose Indermit Gill Brian Pinto Development Economics Vice Presidency Office of the Chief Economist and Senior Vice President November 2023 Policy Research Working Paper 10602 Abstract The World Bank and the International Monetary Fund use Country Debt Sustainability Framework. Third, causality the Low-Income Country Debt Sustainability Framework to in the framework countries flows from fiscal deficits to assess the sustainability of sovereign debt in about 75 low- current account deficits rather than the other way around, and middle-income developing countries. It is overdue for and the public component constitutes the lion’s share of a review, and this paper recommends that it be replaced for total external debt. To focus on external debt distress in three reasons. First, it was designed when official conces- these circumstances is tantamount to tackling the symp- sional external debt was virtually synonymous with public tom—accumulated current-account deficits—instead of debt. Over the past decade, however, the marginal cost the fundamental cause: fiscal deficits, or the gap between of borrowing for Low-Income Country Debt Sustainabil- government investment and saving. The experiences of ity Framework countries has been defined increasingly by Ethiopia, Ghana and Zambia illustrate the arguments. The domestic and external debt markets. This has rendered the paper recommends a framework based on nominal public framework largely obsolete. Second, the framework focuses debt and its dynamics, supplemented with a thorough anal- mainly on external debt, but development outcomes in ysis of international liquidity. Discarding the Low-Income the framework countries are more closely related to overall Country Debt Sustainability Framework could well be dis- public debt. The mission of the World Bank—and, increas- ruptive in the short run. However, the alternative would ingly, the International Monetary Fund—is to improve be worse: retaining an obsolete framework that has failed growth, stability and living standards. So public debt to anticipate public debt crises and is poorly aligned with ought to be the principal focus of the revised Low-Income the Sustainable Development Goals. This paper is a product of the Office of the Chief Economist and Senior Vice President, Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// www.worldbank.org/prwp. The authors may be contacted at igill@worldbank.org and bpinto1954@gmail.com. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team Making the Low-Income Country Debt Sustainability Framework Fit for Purpose Indermit Gill and Brian Pinto1 1 Indermit Gill is Chief Economist, and Brian Pinto is Consultant, both at the World Bank. We thank Luca Bandiera, Aart Kray, Sandeep Mahajan for serving as discussants during a seminar at the World Bank on May 31, 2023, and Adam Lerrick for helpful comments on an early draft. We also benefited from discussions with Norman Loayza. The views herein are entirely our own and should not be attributed to the World Bank or its Executive Board. 1. Introduction We examine the ‘why’ and ‘how’ of reforming the Low-Income Country Debt Sustainability Framework (henceforth LIC DSF), the analytical construct used by the World Bank Group and the International Monetary Fund for assessing debt sustainability in about 75 low- and middle-income developing countries. The LIC DSF also plays a crucial role in informing non-concessional borrowing limits in the Bank and Fund, and in aid allocation through IDA’s Performance-Based Allocation System (PBAS). The LIC DSF was reviewed in 2017 to secure a better understanding of new debt vulnerabilities in the rapidly changing financing landscape for LIC DSF countries. But its overwhelming focus on debt distress in relation to public and publicly guaranteed (PPG) external debt and its present value (PV) were kept intact—four of the five distress indicators pertain to PPG external debt. This single fact has rendered the LIC DSF largely obsolete. When it was originally implemented around 2005, private external debt was virtually nonexistent and public debt was more or less synonymous with PPG external debt. The latter in turn coincided with concessional external borrowing from official creditors because commercial public borrowing was minuscule, justifying the focus on PPG external debt and its PV. However, the public sector in many LIC DSF countries has now had access to commercial borrowing from the international and domestic capital markets for several years. As a result, the marginal cost of borrowing has been increasingly determined by the market or by new lenders like China, not by the traditional official creditors. Even the poorer countries, which do not issue bonds internationally, borrow domestically in local currency on commercial terms. In addition to the changed financing landscape, there are two other reasons for replacing the current LIC DSF. First, it is not well-aligned with the Sustainable Development Goals (SDGs). Development outcomes are related to overall public debt, not just to the PPG external debt, in two respects: (i) via the quality, quantity and composition of public spending and how it is financed, whether by taxes, (external/ domestic) debt or inflation; and (ii) the need to avoid public debt crises that set progress back for years, because of the absence of a well-functioning arrangement for sovereign debt restructuring. The second reason is macroeconomic logic. In most LIC DSF countries, the fiscal or public sector deficit is the main determinant of the current account deficit, which in turn is the main determinant of external debt dynamics. The fiscal deficit is the main determinant of public debt dynamics. With fiscal imbalances spilling over into CADs, public debt dynamics drive external debt dynamics, not the other way around. The ‘why’ of reform, then, is straightforward: The changed financing landscape, macroeconomic logic, and the need for a debt sustainability framework that is better aligned with the SDGs all call for an overhaul of the LIC DSF. On the ‘how’, we argue for a shift in focus to nominal public debt (as opposed to its present value) and its dynamics based on the standard framework of the ratio of the primary fiscal deficit-to-GDP (pd) and the difference between the real interest rate and the real growth rate of GDP (r-g). Such an approach provides clear warnings about potential crises, something the LIC DSF has not done well, by alerting us when the ratio of public debt to GDP is on an unsustainable course. For example, if a LIC DSF country’s government debt-to-GDP ratio (d) is 40 percent with pd at 5 percent and (r-g) at 5 percentage points, this tells us that d will grow by at least 7 percentage points a year and hence the debt dynamics are unsustainable. 2 This does not guarantee that the debt level will become unsustainable or that a crisis will result, but cautions that both are distinct possibilities in the absence of decisive corrective action. In the current financial landscape, this point is critical: the LIC DSF needs to provide timely warning about an 2 For the technically minded, the equation giving the path of d in continuous time is ̇ = + ( − ). 2 impending crisis based on an assessment of public debt dynamics because prevention is far less costly than cure. The numbers in the paragraph are based on data from the debt sustainability analysis (DSA) for Zambia in IMF (2015), which rated Zambia at moderate risk of external debt distress but overall public debt dynamics as sustainable. Recasting the data to focus on d, pd and (r-g), ADF Lab (2016) described public debt dynamics as “definitely unsustainable”, confirmed by market signals: the secondary market yield on Zambia’s 10-year 8.625 percent Eurobond issued in April 2014 was close to 16% at that time. Experience also shows that the seeds of crises get sown over several years, notwithstanding the image of a sharp discontinuity that a debt default may convey. This makes early warning essential. With the debt structure of LIC DSF countries now resembling that in emerging market countries (EMs), the examination of public debt dynamics needs to be complemented with a thorough analysis of international liquidity (foreign exchange reserve adequacy), an assessment of market signals on devaluation and default risks, and the monitoring of risks from private sector balance sheets. We illustrate the obsolescence of the LIC DSF and the desirable direction of reform with the experiences of Ghana, Ethiopia and Zambia, which are now in public debt crises. In addition, a growing number of LIC DSF countries have been grappling with a big deterioration in public debt sustainability that predates the COVID-19 pandemic, but which has been poorly anticipated by the LIC DSF. The next section shows that the LIC DSF is a specific analytical framework that was appropriate in the pre-HIPC-MDRI and immediate post-HIPC-MDRI eras. A specific framework risks becoming obsolete when the purpose for which it was designed no longer applies. In principle, the solution is to scrap the framework and adopt a new one. In practice, the framework may get entrenched in a bigger context institutionally, resulting in the framework outliving its original purpose. To paraphrase John Maynard Keynes, the problem may lie not in developing a new framework, but in escaping the old one. Getting rid of the current LIC DSF will be neither simple nor costless. But sticking with it is costlier, because it helps neither with assessing debt sustainability nor in supporting economic development. The rest of the paper is organized as follows. Section 2 provides a brief history of the LIC DSF. Section 3 discusses its obsolescence and sketches out an alternative with desirable properties. Section 4 discusses the 2017 revision of the LIC DSF, while section 5 argues it fell far short of the “significant overhaul” that was claimed. Section 6 demonstrates that one needs to give primacy to public debt and its dynamics even if one is simply an external creditor who does not care about development. Section 7 appraises the LIC DSF templates for the external and public sector DSAs. It illustrates the idea that debt sustainability should not be an end in itself but a platform for development with the experience of Ethiopia. It also discusses Zambia where a high level of private external debt was “discovered” in 2017 and concludes that the Zambian case only reinforces the need for a new LIC DSF. Section 8 concludes with a summary of recommendations. 2. A Brief History of the LIC DSF The LIC DSF was introduced in April 2005 to carry out public and external debt sustainability analyses in LICs. This was the same year in which the Multilateral Debt Relief Initiative (MDRI) was adopted, under which the IMF, IDA, the African Development Fund (AfDF) and Inter-American Development Bank (IADB) agreed to write off 100 percent of their claims on countries that had reached or would eventually reach completion point under the enhanced Initiative for Heavily Indebted Poor Countries (HIPC). 3 The IMF’s website, updated after the 2017 revision of the LIC DSF (IMF 2017), notes that the goal of the LIC 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.” It defines the twin challenges of LICs as “meeting their development objectives, including the Sustainable Development Goals (SDGs), while at the same time ensuring that their external debt remains sustainable.” 3 This raises two questions: First, who are the main borrowers in LIC DSF countries and, second, what is the connection between borrowed resources and the SDGs? The answer is that the government and state corporations are the main borrowers and that the connection to development is through public spending on human development—education, health, and social welfare—and infrastructure with the goals of poverty reduction and private sector led growth. Since the public sector is the main borrower and the objective is economic development, the main variable should be public debt and not external debt. External debt is the stock of borrowings from non-residents and is mainly the integral of past current account deficits. 4 Before HIPC-MDRI and soon after it, the public sector in LICs borrowed almost exclusively from official creditors, multilateral and bilateral, with little domestic borrowing. So it made sense to focus on external debt sustainability, especially as the private sector was unlikely to borrow externally—something that remains largely true today (Zambia, discussed below, is an exception). Thus, external and public debt were more or less synonymous, with the bulk of the external debt owed to official creditors. But this started changing dramatically well before 2017, which the IMF website acknowledges. It notes that the 2017 revision was to “ensure that the DSF remains appropriate for the rapidly changing financing landscape facing LICs and to further improve the insights provided into debt vulnerabilities”. Yet, the website persists: “Given the central role of official creditors and donors in providing new development resources to these countries, the framework simultaneously provides guidance for their lending and grant-allocation decisions to ensure that resources to LICs are provided on terms that are consistent with their long-term debt sustainability and progress towards achieving the SDGs.” The website further notes: “Given that concessionality is an important element in financing LICs, the debt concept used in the template focuses on the present value (PV) of debt.” Concessionality is important because LIC DSF countries are poor with insufficient domestic saving, necessitating external funds to enable critical investments at home. Borrowing from official sources means savings relative to the market, justifying the use of the PV of debt. Calculating the level of concessionality of debt, or its “grant element”, is a way of recognizing the efforts of official donors. But this “financing landscape” began changing well 2017, with borrowing by the public sector from both external and domestic markets growing in importance. Markets began increasingly to define the marginal cost of borrowing for LIC DSF countries. Problems with the Discount Rate The profusion of borrowing sources at different interest rates and in different currencies for the government and large state-owned enterprises has implications for the choice of discount rate used to compute the PV of external debt. In 2004, when the LIC DSF was being launched, the discount rate 3 The quotes are from the IMF’s LIC DSF website https://www.imf.org/external/pubs/ft/dsa/lic.htm. Italics added. 4 Factors such as FDI, a non-debt financing source, and valuation changes result in the change in external debt being less (FDI) or more than the current account deficit CAD. 4 varied by currency, and was based on the OECD’s CIRRs (commercial interest reference rates). 5 In 2004, a six-month moving average of the US dollar CIRR was used to calculate the PV of debt while grant elements were determined by using currency-specific CIRRs plus a mark-up. But with interest rates in advanced economies falling to historically low levels after the Great Recession, the PV of debt tended to be inflated, compressing borrowing space. The LIC DSF discount rate (DR) dropped to 3%, pushing up the PV of debt and restricting new borrowing. Large discrepancies arose between the DR for calculating the PV of debt and grant element calculations because of the variation in CIRRs across currencies. These developments prompted a change in the discount rate in 2013. A 10-year average of the 10-year USD CIRR was adopted both for calculating the PV of debt and its grant element. The then-average CIRR plus a margin of 1.15% implied a rate of 5.26%, which was rounded down to 5%. This would be used for all debt related calculations irrespective of currency. This rate has stayed in force ever since and is, coincidentally, the DR used at the inception of the LIC DSF in 2004. Summing up, in the pre- and immediate post-HIPC-MDRI era, the LIC DSF was fit for purpose because external debt was both concessional—because it was predominantly from official sources—and virtually synonymous with total public debt. Focusing on the PV of external debt made sense, even though the choice of an appropriate DR presented difficult conceptual and computational problems (to which we return below). But the debt configuration changed rapidly after HIPC-MDRI. 3. The Obsolescence of the 2005 LIC DSF In 2007 Ghana became the first beneficiary of HIPC-MDRI to issue a Eurobond, marking the start of the obsolescence of the LIC DSF. HIPC-MDRI cut Ghana’s government debt from 78 percent of GDP in 2005 to 42 percent in 2006. In September 2007, the government issued a 10-year $750 million Eurobond— about 5 percent of Ghana’s GDP—at an interest rate of 8.5 percent. The Eurobond issue seemed logical. The IMF’s April 2008 Regional Outlook for Africa applauded Ghana for a “...gradual, well sequenced opening” of the capital account following “...considerable debt reduction from HIPC and MDRI debt relief” (IMF 2008). Ghana's IDA Resource Allocation Index of 4.0 for 2007 was well above the average of 3.3 for all IDA borrowers for that year (the IDA Resource Allocation Index runs from a low of 1 to a high of 6 and is an important input into how much money LICs receive from IDA). It had also discovered oil, with revenues expected to start in 2011. The Eurobond could have been seen as borrowing against these revenues in line with the Permanent Income Hypothesis, which posits that consumption should be determined not by current income but by the present value of lifetime income. In the Ghanaian government’s case, the latter would be increased by the oil discovery. But then things went wrong. First, political realities reared their head. The 2008 elections contributed to the fiscal deficit ballooning to 14.5 percent of GDP in 2008 from 9 percent the previous year, while the current account deficit shot up to 19 percent of GDP from 12 percent. Second, it was not clear how the proceeds from the 2007 Eurobond and from the privatization of Ghana Telecom, a total of over 10 percent of GDP, had been spent. Third, the debt reduction via HIPC-MDRI was rapidly reversed and the situation became even worse when arrears and contingent liabilities from state-owned enterprises were included. A June 2010 IMF report expected public debt to peak at 65 percent of GDP at end-2010, an increase of 20 percentage points of GDP in four years. Not included in the calculations were “domestic 5 The CIRRs are linked to secondary market yields on advanced economy (AE) government bonds and constitute the minimum interest rates to be charged on fixed-interest rate export credits; floating rates have different rules. 5 expenditure arrears projected at 5 percent of GDP and state-owned enterprise (SOE) liabilities to banks from past underpricing of energy products amounting to about 6 percentage points of GDP” (IMF 2010). Eventually, the 2010 public debt-to-GDP ratio came in at just 41 percent instead of the projected 65 percent because Ghana revised its GDP upwards by 70 percent. This alone would have lowered debt from 65 percent to 38 percent of GDP. Then Ghana’s real GDP increased by close to 14 percent in 2011 as oil production came on stream. This too should have contributed to the containment of the government’s debt-to-GDP ratio. But the recalculated government debt-to-GDP ratio rose from 34 percent of GDP in 2008 to 45 percent in 2011. Thus, one-off factors like the upward GDP revision and new oil production raised GDP and reined in the debt ratio, obscuring the effects of poor fiscal policy and public spending composition. In 2011, Ghana passed the Petroleum Revenue Management Act, which established a "strong legal framework for the collection, allocation, and management of petroleum revenue in a transparent and accountable manner”. The IMF program allowed Ghana to increase its stock of non-concessional borrowing ceiling from $800 million to $3.4 billion to accommodate a loan agreement negotiated with the China Development Bank. But the IMF also said that a stronger framework for prioritizing public investments would be needed, and the public sector wage bill had to be kept under control (IMF 2012). In 2013, 2014 and 2015, Ghana issued three more Eurobonds for $1 billion each. By the end of 2015, its public debt had risen to an estimated 78% of GDP, compared with 41% at end-2011. Public debt dynamics were clearly unsustainable with real interest rates much higher than real growth rates. The primary surplus needed to stabilize the debt-to-GDP ratio in 2015 was over 7% of GDP compared to an actual primary deficit that had already been lowered from more than 3% of GDP in 2014 to a tiny surplus of 0.1% of GDP in 2015. The additional fiscal effort was both huge and unlikely to occur. Against this background, the DSA in IMF Country Report 16/16, January 2016 (IMF 2016) assessed Ghana at high risk of debt distress because two of the PPG external debt burden indicators exceeded their policy-based thresholds in the baseline scenario: the PV of PPG external debt exceeded 40% of GDP and PPG external debt service exceeded 20% of revenue. The DSA devoted two paragraphs to public debt sustainability, reproduced below: “8. Strong fiscal adjustments and an adequate financing package should be able to bring Ghana’s total public debt back to a sustainable path ... Fiscal adjustment has been gradually reducing fiscal dominance, including less reliance on central bank’s financing. As confidence in economic policy improves, and accordingly the exchange rate and inflation stabilize, borrowing conditions on the domestic market– which accounts for a large share of financing – would also gradually improve. The relevant debt indicators are expected to improve with PV of public debt declining to around 40 percent of GDP by the end of the projection period. 9. PV of debt-to-GDP ratio would breach the public debt benchmark as a result of the lowering of the policy-dependent threshold in the initial years. The public debt benchmark was also lowered by the changes in CPIA, leading to breaches of the threshold in the baseline. Though all indicators show sustainable paths under the baseline scenario, they could be on an explosive path under the historical and the most extreme shock scenario (with abrupt real exchange rate depreciation).” Paragraph 8 above from the 2016 DSA mentions the PV of public debt declining to 40 percent of GDP by the end of the projection period, that is, by 2035, or some 20 years later. Paragraph 9 asserts that the PV of debt-to-GDP ratio would breach the public debt benchmark. In general, the tone is sanguine, with sustainable paths in the baseline scenario even though the public debt benchmark is breached. 6 Developing an Alternative to the Current LIC DSF We consider an alternative approach to assessing debt sustainability using the same data as in IMF (2016) based on giving nominal public debt-to-GDP and its dynamics primacy over the PV of PPG external debt-to-GDP. We do five exercises: • First, we demonstrate that current account deficits are driven mainly by the public sector or fiscal deficit, depending upon the coverage. If this is the case, then it is reasonable to assume that public debt dynamics, which are driven by fiscal deficits, exchange rates and GDP growth, spill over into external debt dynamics. This would be particularly true if the bulk of external debt is accounted for by PPG debt. • Second, we go back to the basics on the PV of debt and what this means conceptually as public borrowing sources expand to include commercial borrowing from sources such as domestic Treasury Bills (T-bills) and Eurobonds, with the share of official, concessional financing diminishing. We look at the PV of public debt versus nominal public debt. • Third, we examine nominal public debt and its dynamics in conjunction with market signals, drawing sharply different conclusions about sustainability from those in IMF (2016) using the same data. • Fourth, we stress the need for an adequate analysis of international liquidity based on the measures used for EMs. • Finally, we look at the early warning in IMF (2016) versus the alternative presented here. Links between Fiscal and Current Account Deficits Table 1 presents data on fiscal and current account deficits as well as nominal external debt and its PPG share for the years 2013-15. Table 1: Ghana’s Fiscal and Current Account Deficits 2013-15 (% of GDP unless otherwise noted) 2013 2014 (Est.) 2015 (Prog.) 1. Fiscal deficit 10.5 10.2 7.2 2. Current account deficit 11.9 9.6 8.2 3. Nominal external debt 35.2 48.5 56.0 4. PPG share (% of 3.) 87.2 88.5 92.9 Source: Lines 1 and 2 are from Table 1, p.25, of IMF (2016), while 3 and 4 are from the external DSA table. The table shows that the current account deficit (CAD)—which equals the fiscal deficit plus the gap between private investment and saving—is substantially accounted for by the fiscal deficit. Hence, it is not a surprise that PPG external debt accounts for the bulk of total nominal external debt. For LICs, the idea that the CAD is largely explained by the fiscal deficit is not surprising because it is usually difficult for the domestic private sector to borrow from abroad, either because lenders consider it too risky or because of legal restrictions (once again, Zambia is an exception). In this case, the private sector is restricted to borrowing at home and could be “crowded out” even in this space by the government if large deficits push up real interest rates or if banks are statutorily required to hold government securities. 7 Since the fiscal deficit is the outcome of spending and revenue decisions by the government, it can be thought of as causing the CAD. The government is constrained by the need for balance in its intertemporal budget constraint and the need to avoid disruptive debt crises. Not surprisingly, corrective policies for unsustainable CADs center around changes in fiscal and exchange rate policy. A reasonable conclusion from Table 1 is that current account deficits and hence the dynamics of external debt in Ghana are driven by fiscal deficits and the dynamics of public (government) debt. Thus, shifting attention from external to public debt would amount to focusing on the fundamental cause— public debt—instead of the symptom—external debt—that is the central concern of the LIC DSF. Present Value (PV) of Debt versus Nominal Debt While IMF (2016) does not contain a table showing the composition of Ghana’s government debt by creditor, either in the main text or in the DSA annex, it is a safe bet that much of the government’s debt was owed to private, commercial creditors. This means that the marginal cost of borrowing was determined by the market, not the official sector. This poses a problem. If governments are borrowing from different sources, which interest rate does one choose as the discount rate for calculating the PV of debt? Indeed, what is the rationale for calculating a PV when much of the debt is non-concessional? Most LICs today borrow at the margin from commercial sources. Even Chad and Zambia, two of the countries that have applied for debt treatment under the Common Framework, have significant commercial debt—Chad from Glencore and Zambia from several Eurobond issues. Many LICs have loans from China or from commercial banks. And local currency debt is significant and typically at market rates. This has rendered the 5% DR arbitrary. If a country gets official USD loans at 2% but the market rate is 12% on a Eurobond of equivalent maturity, then the extent of concessionality is captured by the 10 percentage-point difference, and a 2% loan should be discounted at 12% to obtain its PV, not at 5%. Apart from the arbitrary choice of the discount rate, another problem is that the LIC DSF discounts official concessional debt to obtain its PV but takes market debt at face value. This asymmetry has no analytical justification. The simplest solution is to eliminate the use of the PV of debt and use nominal public debt-to-GDP instead in debt sustainability assessments. This will make public debt dynamics transparent, based on the standard parameters, pd and (r-g). As shown below, it will also provide more reliable early warning. If even more persuasion is needed that the PV of debt for sustainability analysis is an outmoded concept, revisiting the original 2004 LIC DSF paper (International Monetary Fund and International Development Association 2004) is useful. Essentially, the PV of debt as a concept linked to a reliance on predominantly official financing is inseparable from the need for a separate LIC DSF: if one goes, so should the other, as paragraph 12 from IMF and IDA (2004) demonstrates (boldface added): "The concept of debt sustainability in low-income countries is different from that in middle- income countries that rely primarily on private financing. While low-income countries are a diverse group—ranging from poor countries with weak policy records and histories of war and civil strife to relatively advanced economies that have some access to private capital inflows and are on the verge of becoming emerging markets—most countries in this group rely predominantly on official financing. As a result, the sustainability of their debt—i.e., the condition that this debt can be serviced without resort to exceptional financing or a major future correction in the balance of income and expenditure—is largely de-linked from the sentiments of the market, as embodied in spreads on market interest rates. Indeed, to the extent that donors and creditors base the allocation of new aid flows on the implied net 8 transfers to recipient countries—effectively providing more gross transfers to those countries with higher debt-service payments—debt sustainability is a particularly blurred concept in these countries. Debt can be serviced for long periods, or suddenly become unsustainable, depending on the willingness of official creditors and donors to provide positive net transfers through concessional loans and grants." We recognize an important qualification. Discounting remains of crucial importance for two purposes: 1. Discounting concessional loans from donors to calculate their grant element. 2. Assessing fair burden sharing across creditors when a country defaults and the net present value of debt is being reduced, in line with the ‘comparability of treatment’ principle. But in the assessment of debt sustainability which, by its nature, attempts to provide early warning and is aimed at crisis prevention rather than debt restructuring, discounting only obscures the picture, as we shall demonstrate. In the case of debt restructuring, the choice of an appropriate discount rate remains a complex topic (see, for example, Kozack (2005) and Lazard (2022)). Nominal Public Debt and Its Dynamics, Plus Market Signals Table 2 presents data on Ghana’s nominal public (government) debt levels and the variables determining its dynamics during 2013-15 using the data available in IMF (2016). Table 2: Ghana’s Public Debt Dynamics 2013-15 2013 2014 2015 (estimate) 1. Public Debt (% of GDP) d 56.7 70.7 77.9 2. Foreign currency share (%) 54.1 60.0 67.0 3. Primary deficit (% of GDP) pd 5.6 3.3 -0.1 4. Real interest rate r (%) 6.0 19.3 8.1 5. Real growth rate g (%) 7.3 4.0 3.0 Source: Table 2 in the DSA annex in IMF (2016). Real interest rates computed by authors based on Annex 1. Table 2 gives the ratio of public debt to GDP and the standard variables that describes its expected path: pd, r and g. The real interest, r, shown is a composite of the interest rates on local currency (cedi) and foreign currency (fx) debt. It includes the capital gain or loss on fx debt resulting from currency depreciation/appreciation. Hence, there is no separate real exchange rate effect as in the LIC DSF. Thus, r is the equivalent of the real interest rate that would prevail in a single-currency environment. Box 1 uses a numerical example to illustrate exactly what this means, while Annex 1 derives the formula for r using information already available in the LIC DSF. Box 1: Public Debt Dynamics in LIC DSF Countries: What does (r-g) mean in a multicurrency context? When the government borrows only in local currency, (r-g) is easy to understand. For example, in continuous time, the trajectory of the government or public debt-to-GDP ratio d is given by (a) ̇ = + ( − ). In this case, if d exceeds some market-determined threshold (as signaled by interest rates and bond spreads), pd>0 and r>g, the debt trajectory will be considered to be on an explosive path absent decisive reform to raise primary 9 surpluses and bring r down; in the short-run, such fiscal consolidation is likely to hurt g, but the improved macroeconomic climate will give private sector investment and growth a boost over the medium run. (We rule out default and inflating away local currency debt.) Most EM and LIC DSF country governments borrow both in local currency, typically at market terms, and in foreign exchange, say, the US dollar ($) at concessional and market terms. In order to apply the framework embodied in equation (a) above, one would need to mimic a single-currency environment. The challenge is presented by $ borrowing, as illustrated with a numerical example: Time 0 Time 1 $100 $104 1. Exchange rate (local currency per $) 1.0 1.1 2. Local currency-equivalent debt 100 114.4 3. Interest payment in $ 4.0 4. Interest payment in local currency 4.4 The government borrows $100 at time 0 at $ =4% per period. The exchange rate (local currency price of $) at time 0 is 1.0 but depreciates to 1.1 by time 1. As a result, the interest due of $4 becomes 4.4 in local currency terms, shown in lines 3 and 4 of the table. This 4.4 will show up in the fiscal balance. But the impact on the government’s balance sheet is much bigger, as shown in line 2 at Time 1. The effective interest rate is 14.4%, of which 4.4 will show up in the fiscal accounts and the remaining 10 on the balance sheet and in the headline debt number. In other words, the true local currency equivalent interest rate of $ borrowing is 14.4%. Formally, if x denotes the − end-year exchange rate expressed as local currency per $ and � = −1, its growth rate or the rate of −1 depreciation, then the local currency equivalent of $ =4% is given by $ (1 + � = 0.04 X1.1+0.1=0.044 + � ) + 0.10=0.144=14.4%. This is simply ex post interest rate parity. Now suppose the government had also borrowed 200 in local currency at time 0 at 7%. Then its accounts would show interest payments of (4.4+14)=18.4 in local currency units. The LIC DSF calculates the effective interest rate i as interest payments divided by the local currency-equivalent debt stock at the end of the previous period, giving i=18.4/300 = 6.13%, which can be converted into real terms using the GDP deflator. This interest rate of 6.13 = (2/3)x7 + (1/3)X4.4, where 2/3 and 1/3 are the respective weights of local currency and dollar debt at the end of the previous period. What about the balance of 10, the capital loss on $ debt? This goes into the exchange rate contribution to the change in the headline debt number in the LIC DSF template, and is given by (currency depreciation x share of $ debt in total debt at the end of the previous period x total debt at the end of the previous period) = 0.1X(1/3)x300=10. However, to mimic a single-currency environment for assessing debt sustainability based on (r-g), this capital loss needs to be merged with the interest payment of 18.4 to give a composite nominal interest rate of (18.4+10)/300 = 9.47%. This can in turn be written as a weighted average of the interest rates on local currency and $ debt as 9.47 = (2/3)x7 + (1/3)x14.4, and the real equivalents can be obtained by deflating 9.47, 7 and 14.4 by the GDP deflator. For example, if inflation measured by the GDP deflator were 6%, then the composite real interest rate r = (1.0947/1.06) – 1 = 3.27%. This r captures the impact of currency depreciation on the $ component of debt and is the r that should be used for (r-g). It is useful to break it down into its local currency and $ components, 0.94% and 7.92% respectively, to gauge what is driving r, in this case $ debt, clearly. There are two advantages to merging the capital loss on foreign currency debt with its interest cost. First, it gives a more accurate picture of the cost of $ borrowing. For example, if the government were to simply compare 7% on local currency debt with 4.4% on $ debt, it might wrongly conclude that dollars are cheaper to borrow. Based on the second author’s conversations with investment banks in Ghana in early 2017, this was the argument they used to persuade the Government to issue $-denominated debt in the domestic market. Second, it enables a clear picture of debt dynamics by amalgamating currency depreciation with the interest rate, making it comparable to r in a single-currency environment. In contrast, there is little insight to be gained analytically or for borrowing purposes by treating currency depreciation as a separate effect. 10 Suppose the elaborate tables and graphs of the LIC DSF did not exist and all we had were Table 2 and market signals on Ghana’s perceived credit standing. The first telling observation would be the more than 20 percentage points of GDP increase in public debt with a rising share of $ debt in just two years. Second, we would see a big drop in the primary fiscal deficit-to-GDP ratio, pd, indicating a commendable fiscal effort but also raising the question of how sustainable it is, given political economy and the quality of fiscal institutions. Third, we would see that r is highly volatile and high. It jumps from 6% in 2013 to 19% in 2014 and one might guess that the high share of $ debt has something to do with this. Indeed, the public DSA table in IMF (2016) indicates that the real exchange rate depreciated by 26% in 2014. Fourth, real GDP growth, g, is on a downward trend, with (r-g) swinging from negative to highly positive. A safe bet is that economists acquainted with debt crises in EMs would be alarmed by the results in Table 2. It depicts the public debt-to-GDP ratio, d, on an explosive path with d far above levels at which major crises occurred in EMs (for example, the Russian Federation 1998, Argentina 2001). In keeping with the quote above from IMF and IDA (2004) that Ghana’s debt sustainability cannot be “de-linked from the sentiments of the market, as embodied in spreads on market interest rates,” let’s take a look at market signals prevalent at the time. The secondary market yields on Ghana's Eurobonds were above 15% in January 2016, signaling high default risk. Its credit rating had been lowered by Moody’s from B2 to B3 (equivalent to B-, six levels below investment grade) in March 2015, with a negative outlook. The combination of Ghana’s debt fundamentals with market signals should have triggered urgency for a draconian fiscal consolidation on the argument that preventing a debt crisis is less costly than curing an economy after one. To be fair, IMF (2016) and the related LIC DSF took pains to note Ghana’s financing challenges given bond spreads and the global macroeconomic environment. But this was not reflected in any sense of urgency about remedying the situation, as evidenced by the two paragraphs devoted to public debt sustainability reproduced above. Instead, attention focused on debt burden indicators related to the PV of PPG external debt and PV of public debt. Indeed, the public sector DSA in IMF (2016) relied on a continued rise in primary surpluses, and a return to r