The DSF Revisited Status of World Bank-IMF Review Jeffrey D. Lewis Director, Economic Policy and Debt Department World Bank. Presentation at the European Commission, Brussels, Belgium. October, 2011

Outline Motivation: DSF critics How have the Fund and the Bank responded? The 2009 revision of the DSF The 2011 revision of the DSF: ongoing efforts – Thresholds re-estimation – Stress tests – External and domestic debt The way forward

Motivation: DSF critics The DSF does not properly assess: – Countries repayment capacity (remittances; investment-growth nexus) – Countries indebtedness (external vs total debt) It unduly restricts countries borrowing At a technical level – Stress tests are partial equilibrium – Contingent liabilities, PPP, and private external debt are poorly treated

How have the Fund-Bank responded? Part of the criticism is partly due to an incomplete understanding of the DSF framework itself calls for greater outreach efforts and for making DSF template simpler and accessible But part of the criticism is absolutely valid: remittances, domestic debt, and investment-growth nexus are neglected stress tests are partial equilibrium in nature (if looking for precise quantitative answers)

The 2009 revision of the DSF The framework is periodically revised, following criticism and cumulated experience from applications to countries (DSA). The 2009 revision has added flexibility: Improving the treatment of SOEs debt Including remittances as a source of income and foreign exchange Suggesting an assessment of the investment-growth nexus in each DSA (This, however, remains a country- specific issue, subject to availability of data and appropriate growth models and estimation techniques).

The 2011 revision of the DSF An ongoing joint effort by Bank and IMF Current work revisits a number of topics, with potential implications for a countrys risk rating. – Thresholds: Are they still valid? – Stress tests: Can one capture co-movements of key macro variables in DSAs? – How can we better incorporate domestic debt into the DSF? Should total public debt be addressed rather than only external debt?

The 2011 revision of the DSF Thresholds Are current DSF thresholds still valid? – Original estimation uses mainly 1980s and 1990s – Updated series are available (arrears; PV of PPG external debt; CPIA) – Some technical issues can be improved: selection of distress/normal-time episodes (i.e. arrears, IMF commitments vs. disbursements, length of episodes, HIPC-CP) debt service indicator focused on PPG external debt GDP growth: a good proxy for macroeconomic shocks? including remittances and separating LICs and MICs

The 2011 revision of the DSF: Thresholds Note: Thresholds calibrated with probability of debt distress at 22% and GDP growth at 3.5%. Estimating thresholds: an example

The 2011 revision of the DSF Stress tests Are current stress tests realistic enough? – DSA stress test analyses a shock to one variable but disregards the contemporaneous immediate impact on other variables (in practice, shocks are correlated across variables) the subsequent macro adjustments (in practice, feedback effects lead the dynamics of the economy) – Example: shock to exports effect on current account balance, but also on GDP growth – Is size and timing of a standardized shock properly calibrated so as to capture the representative disturbances observed in LICs? – Should we also consider tail risks, i.e. shocks with low probability but severe consequences, such as banking and currency crises?

The 2011 revision of the DSF Stress tests Are current stress tests realistic enough? (contd) – Ongoing research focus on: Panel VAR estimation to capture shock correlations and feedback effects in a comprehensive empirical macro dynamic model representative of LICs Panel VAR also useful to conduct stochastic simulations, assess fiscal risks under uncertainty, and estimate confidence intervals around baseline projections Event analysis to investigate tail risks – Trade offs: technical sophistication vs ownership standardization vs country-specific shocks and macro- dynamics (analysis of homogeneous groups –e.g. oil importers, Africa- might strike a balance?)

The 2011 revision of the DSF Stress tests Country X Debt/GDP projection Baseline scenario and stress test with shock to exports in Exports Current account balance worsens Debt Exports Economic activity deteriorates GDP Introducing feedback effects: an example

The 2011 revision of the DSF External and domestic debt Is PPG external debt the relevant debt in LICs? – DSA addresses domestic public debt but it has a fairly secondary role; e.g. there are no thresholds for total public debt. – Domestic public debt is growing and countries are encouraged to developed local financial markets. – Should analysis of domestic public debt be expanded? (collect data, introduce sustainability indicators, identify benchmarks) – Should risk ratings be introduced for total public debt in addition to external public debt?

The way forward A joint Board paper is being prepared for discussion in December 2011 that will report on the findings and implications of this analysis Boards views will inform whether and how to further modify the DSF