By W.A. Wijewardena –

Aseni, the whiz kid of economics has come across a report by the Nobel Laureate Joseph E. Stiglitz and former Argentinian Economy Minister Martin Guzmán critiquing IMF’s Debt Sustainability Analysis, known as DSA[1]. This report has been prepared by them for the faith, development, and advocacy group Jubilee-USA Network and the USA branch of the German foundation, Friedrich Ebert Stiftung, for submission to IMF to enable it to consider how its standard DSA should be revised. Aseni has found that it is a technical subject that needs the support of her grandfather, Sarath Mahatthaya, an ex-Finance Ministry Official, to understand it. This led to an interactive dialogue between the two.

Aseni: Grandpa, Stiglitz and Guzmán have said in their report that IMF’s DSA has major implications for debt negotiations that are conducted to provide relief to countries which are unable to repay their external debt. The point is that debt restructuring involves distributional consequences between the debtor and the creditor, on one side, and among the creditors, on the other. What is this distributional consequence?

Sarath: When a country borrows, resources are transferred from the lending country to the borrowing country. When that debt is repaid with or without interest, there is a reversal of this resource transfer. However, if the borrower does not repay this debt and if it is restructured – either by postponing the debt or by offering a debt forgiveness, called a haircut – one party may suffer, while the other may gain. This is called a distributional issue. It can happen between the debtor and the creditor if an undue gain is passed to one party at the expense of the other.

Similarly, when two groups of creditors like bilateral creditors and commercial creditors are involved in the debt restructuring, one group may be given a better deal causing a distributional issue between the two groups. To come up with a fair deal satisfying all parties involved, these distributional possibilities should be eliminated and if it is not possible, should be minimised.

Aseni: Why should a country be concerned about the sustainability of its debt? I hear both IMF and World Bank are concerned about it. Above all, why should they be concerned about it?

Sarath: To ensure continuous economic growth, countries should add to their capital stock – plant, machinery, roads, buildings, ports, airports that help produce goods and services – by investing in them. When used in production, they wear out and that part should be replaced. In addition, to have growth, new capital should be added. Money needed for this investment comes from the savings of the people, the excess amount they have after using income for consumption. If these savings are not adequate to meet the level of investment needed – a situation where there is a gap in the savings and investment as is the case in Sri Lanka – the country should get the savings of foreigners who have a surplus in savings.

Those savings can be obtained as gifts or grants, investment in businesses called foreign direct investments or FDIs, asking foreigners to invest in local shares or debentures, or by borrowing with a commitment to repay with or without interest. The first three are not reliable and important sources for many countries. Sri Lanka is a case in point. Hence, they must borrow to fill the savings-investment gap. This is what we know as the global financial architecture. To ensure a smooth operation of this architecture, what is borrowed should be repaid. That depends on the sustainability of external debt.

IMF and World Bank which are key players in this architecture are concerned about its smooth operation and, therefore, concerned about debt sustainability of borrowing countries. They are specifically concerned about it, because if a country fails to repay its debt, they also get affected since they too have lent to them. Hence, from a personal point too, they are concerned about it.

Therefore, they have jointly developed a debt sustainability framework or DSF for assessing the debt sustainability of countries and give advance warning about an impending external debt crisis[2]. There are two such analyses, one for low-income countries which cannot borrow from commercial sources and the other for emerging countries which can borrow from commercial markets. Since Sri Lanka cannot borrow from the market now, what is applicable to it is the analysis made for low-income countries. The original DSF prepared in 2005 has been revised in 2017[3].

Aseni: What are the reforms that have been suggested in this policy paper?

Sarath: A lot. Basically, countries are classified into four groups based on the thresholds of debt levels. These groups are low risk, moderate risk, high risk, and in debt distress according to their levels of debt-triggers. To make this classification, four thresholds are used. They are the present value of debt to GDP, present value of debt to exports, debt service to government revenue, and debt service to exports. Both IMF and World Bank use this DSF when they lend to member countries. The deciding criterion is that public debt is sustainable when the government can meet its current and future payment obligations without exceptional financing methods like borrowing from IMF.

Sri Lanka’s external public debt had been classified as unsustainable long before the country had to announce that it would suspend debt servicing for bilateral and commercial creditors in April 2022. According to IMF rules, it cannot lend to a country whose debt is not sustainable now or whose future sustainability is high risk. If it provides any financing to a country, it is linked to the restructuring of debt owed to commercial and official bilateral creditors. DSF will give the amount of debt relief needed by the country which is required to restructure its debt from these two sources.

Aseni: What are the suggestions by Stiglitz and Guzmán?

Sarath: They have raised five important issues relating to the present DSA system operated by IMF when it plans to lend to a country. The Jubilee-USA Network and Friedrich Ebert Stiftung have presented this report to IMF at its annual sessions in October 2024 for consideration of the reform of the currently used DSA.

Aseni: Grandpa, can you elaborate on them so that we can appreciate their validity and significance for reform of DSA?

Sarath: I will deal with them one by one.

The first one is concerned about having an IMF DSA undertaken and having it published. Stiglitz and Guzmán have said that it is not necessary for a country to have an IMF facility for undertaking a DSA. For instance, Argentina in 2001 did such an analysis independently of IMF. When you go with IMF, there are certain deficiencies present. They say that IMF’s sponsored DSA could influence the expectations and the bargaining power of creditors. If IMF’s DSA has suggested a greater restructuring than what the creditors believe as justifiable, invariably, the creditors will seek to distance from it. At that point, the debt restructuring country will find it difficult to reach consensus.

The duo has further elaborated this point. Argentina in 2020 placed the agreement with IMF before its legislature and got its approval for the uninterrupted implementation of the conditions. You know that Sri Lanka also did it in 2024 by getting its Parliament to approve a new legislation wrongly titled as Economic Transformation Act. The problem with such enactments is that they bind future governments to adhere to them even when it is not desirable to do so. Because of this political manoeuvring, DSA might lose its credibility. Because of this reason, some countries will choose not to do an IMF sponsored DSA.

Even when they do so, they may choose not to release it publicly. Creditors often claim that a DSA showing that the country can only repay a more limited amount than they would like to do, they will seek to access DSA before it is published. This empowers the creditors that they could push indebted countries to accept their terms. If they persuade the country to accept a smaller debt restructuring than what is needed, it will lead to another debt crisis.

You will see, Aseni, that this is exactly the situation which Sri Lanka is facing today. It has agreed to the terms of creditors, mainly the commercial creditors, and therefore, there will be a bigger debt crisis once the country starts repaying its debt after 2028.

Aseni: What is the second issue they have raised?

Sarath: That is treating IMF as a senior creditor in DSAs. What we mean by senior creditors is that they should be paid without delay before all other creditors whatever the economic conditions in the country. Hence, limited foreign exchange reserves will be used by a country to service debt owed to these senior creditors. This is because under IMF rules, for IMF to provide sufficiently large amounts as assistance, there should be assurance to repay the dues to the Fund. Therefore, it assumes that the country will regain access to credit markets and roll-over the existing debt and service the debt to IMF when it becomes due.

The problem with this is that private creditors may not be willing to give a large amount as new debt to a country when it sees a large debt stock due to IMF. Therefore, large loans from IMF, according to Stiglitz and Guzmán, may discourage private creditors to provide sufficiently large amounts of funds to the country. In the long run, it will create a bigger roll-over issue in the country.

Aseni: I understand. What is the third issue they have raised?

Sarath: That is about the treatment of the local currency debt in DSA. As we have mentioned earlier, IMF’s DSA looks at debt to GDP ratio, gross financing needs of the government to GDP, ratio of foreign debt servicing to GDP or such servicing to exports. If the thresholds in these cases exceed the benchmarks, the debt is considered unsustainable. But a country can service its domestic debt by further borrowing or by printing new money unless that country is faced with hyperinflation. In a situation of hyperinflation, the country’s currency is not accepted by people and therefore it cannot roll-over its domestic debt by borrowing or printing money. Domestic debt becomes unsustainable only in this extreme case, like Russia in early 1990s when its inflation was higher than 1000%. The government could not borrow or print money to finance its expenditure and it is reported that teachers were paid in Vodka bottles[4].

But the foreign currency creditors of the country may demand that both domestic and foreign debt should be pooled in the debt sustainability analysis. This was what happened in the debt restructuring program of Sri Lanka. Though there was no problem with repaying the domestic debt, due to the insistence of the international sovereign bond holders, the Government was forced to go for a hidden system of domestic debt optimisation. The victims were selectively chosen provident and pension funds and the Central Bank. As Stiglitz and Guzmán have argued, this may limit the capacity of Governments to raise funds domestically and finance their gross financing needs.

Aseni: What is the fourth issue raised by them?

Sarath: That is about the choice of the right discount rate for calculating the present value of future debt repayments.

This rate should naturally be the rate at which the Government could borrow new money from commercial markets. For instance, Sri Lanka’s yield rates on the existing international sovereign bonds are between 30-32% and it is not prudential to borrow any money at those high rates. But once Sri Lanka reaches an accepted debt restructuring with creditors, its rating from the present selective default could be increased to CCC. At this rating which will prevail for many years, the country may be able to borrow at about 10%.

But IMF uses a unified discount rate of 5% for calculating the present value of the debt stock which is very low compared to the ground conditions faced by a country. This will force the creditors to provide more relief to restructuring countries. But markets are correct readers of the real conditions and therefore, they will demand higher interest rates than what have been included in IMF’s DSAs. This will reduce the chance of countries for ensuring long-term debt sustainability.

Aseni: What is the last concern?

Sarath: That is the overoptimism which countries will have IMF’s DSA. This overoptimism relates to the period within which the country will be able to reach debt sustainability.

In Sri Lanka’s case, it is firmly believed that the country will reach debt sustainability under the present DSA after 2028. But without real sector high growth and substantial increase in the export of goods and services, the country will not be able to service the restructured external debt. DSA is silent about this risk.

Aseni: Thanks for elaborating on the issues raised by Stiglitz and Guzmán. I hope that IMF will seriously consider these issues when it revises its DSA system.

Footnotes:

[1]https://assets.nationbuilder.com/jubileeusa/pages/2263/attachments/original/1723647777/The_Practice_of_Sovereign_Debt_Sustainability_Analysis.pdf?1723647777

[2]https://www.imf.org/en/About/Factsheets/Sheets/2023/imf-world-bank-debt-sustainability-framework-for-low-income-countries

[3]IMF Policy Paper: Review of the Debt Sustainability Framework in Low-Income Countries: Proposed Reforms, September 2017.

[4]https://www.reddit.com/r/ANormalDayInRussia/comments/ou4zfz/during_the_1990s_economic_crisis_russian_teachers/?rdt=60281

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com