The DSF RevisitedStatus of World Bank-IMF Review

Jeffrey D. LewisDirector, 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 SOE’s 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 DSFAn ongoing joint effort by Bank and IMF

• Current work revisits a number of topics, with potential implications for a country’s 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 DSFThresholds

• 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 DSFStress 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 DSFStress tests

• Are current stress tests realistic enough? (cont’d)– 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 DSFStress tests

Country X

Debt/GDP projection

Baseline scenario and stress test with shock to exports in 2011-12

Exports Current account balance worsens Debt

Exports Economic activity deteriorates GDP

Introducing feedback effects: an example

The 2011 revision of the DSFExternal 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

• Board’s views will inform whether and how to further modify the DSF