This Decade’s Best Chance to Get Debt Sustainability Right: Necessary Changes in the Review of the Debt Sustainability Framework for Low-Income Countries

By Tim-Hirschel-Burns

For the first time in nearly 10 years, the International Monetary Fund (IMF) and World Bank have a chance to revise a key framework that will shape whether low-income countries are set up for a decade of growth or a decade of lost opportunity. The IMF and World Bank’s review of their Debt Sustainability Framework for Low-Income Countries (LIC DSF) is nearing its final stages, with profound implications for economic growth, financial stability and climate action in developing countries. Given its critical role in helping countries manage debt responsibly, the review of the framework has drawn input from a diverse range of bodies including the G20; the United Nations (UN) Financing for Development Conference; the Vatican’s Jubilee Commission; the Expert Review on Debt, Nature and Climate; and the UN Secretary General’s Expert Group on Debt.

The LIC DSF is a central tool in the IMF’s surveillance, and it serves as one of the most influential guides to countries’ fiscal decision-making. It applies to the 66 countries that qualify for the IMF and World Bank’s concessional funds, the Poverty Reduction and Growth Trust (PRGT) and the International Development Association (IDA). (In contrast, the Debt Sustainability Framework for Market Access Countries is applied to middle-income countries that are more likely to borrow from international capital markets.) The LIC DSF has tangible implications: it is used to assess how much debt relief is needed when countries restructure their debts, and it helps determine eligibility for IDA grant financing.

The combination of the LIC DSF’s importance and the infrequency of LIC DSF reviews (the last took place in 2017) makes it essential that IMF and World Bank staff and executive directors do not let this review pass without addressing the continuing flaws that undermine the LIC DSF’s efficacy. Concretely, the LIC DSF review must correct the anti-investment bias that undermines its accuracy, account for both climate risks and the benefits of climate investments and ensure the LIC DSF identifies a pathway to meeting resource mobilization needs.

1. Correct the anti-investment bias that undermines the accuracy of the LIC DSF

The LIC DSF displays a well–documented optimism bias in which countries’ growth forecasts exceed actual outcomes. One cause of this inaccuracy is the insufficient integration of fiscal multipliers. Fiscal multipliers are considered in the LIC DSF’s realism tools but do not factor into the baseline projections. The result is that the LIC DSF overestimates the growth potential of fiscal consolidation while overlooking the potential for productive investments to generate growth. In reality, while fiscal consolidation can generate negative fiscal multipliers, public spending and expansionary policy can generate positive fiscal multipliers, particularly during economic downturns.

This anti-investment bias links to the LIC DSF’s focus on valuing public liabilities (what countries owe) but not public assets (what they own). As a result, the LIC DSF can obstruct prudent borrowing aimed at investing in public assets. In contrast, a public sector net worth approach encourages investment in public assets that generate positive externalities and contribute to long-term growth.

Integrating public assets and fiscal multipliers into the LIC DSF will require a nuanced approach to distinguish contributions to productivity and growth. While this can be technically difficult, existing IMF research offers guidance, and failing to account for the benefits of investment is even more certain to generate inaccuracies. Relatively simple steps in this direction would include distinguishing between debt used for investment and consumption and only counting the net debt of state-owned enterprises as contingent liabilities.

2. Account for both climate risks and the benefits of climate investments

The escalating global impacts of climate change are hitting LICs the hardest. It is increasingly urgent to consider these concrete effects on countries’ debt sustainability and better integrate them into the LIC DSF. Climate change belongs on both sides of the LIC DSF’s ledger: climate risks decrease the sustainability of countries’ debt, but investments in resilience increase debt sustainability by preventing greater climate impacts in the future—even if it means incurring more debt in the short-term. The LIC DSF’s failure to account for the benefits of climate investments links to its broader anti-investment bias.

In addition to integrating fiscal multipliers into the baseline, extending the LIC DSF’s time horizon beyond 10 years would improve its efficacy, both by capturing growing climate risks and by providing enough time to capture the long-term benefits of investments in resilience. In the context of the Operational Guidance Note for the Resilience and Sustainability Facility, the IMF has already called for debt analysis over a time horizon up to 20 years.

Several other changes would improve the LIC DSF’s ability to account for climate change. It should integrate the latest generation of climate scenarios, such as those of the Network for Greening the Financial System. Scenarios should account for physical climate risks like hurricanes or droughts, transition risks like the impact of falling demand on fossil fuel exporters and resulting effects such as changed investor expectations and monetary policy responses. Analysis of climate risks should be tailored to the different risks facing different countries and consider slow onset events in addition to rapid shocks. The LIC DSF’s ability to account for these risks depends on increasing the collection of granular, country-specific data, much of which already exists in some form. Moreover, when incorporating climate risks, the LIC DSF should avoid assuming a frequency of climate events in line with historical trends, as the nature of climate change means that these events will increase in frequency.

The LIC DSF took important steps towards accounting for climate change in the Supplemental Guidance Note released in 2024, but it provides only a partial solution. It is focused much more on climate risks than the benefits of climate investments, devoting only superficial attention to the latter. Further, incorporation of climate considerations remains optional in most cases.

3. Ensure the LIC DSF identifies a pathway to meeting investment needs

The investment needs of LICs far outstrip their ability to absorb new debt, particularly without a change in the availability of affordable finance. Our analysis found that 47 out of 66 LIC DSF countries would breach solvency thresholds in the next five years if they made the investments necessary to achieve the Sustainable Development Goals and the Paris Agreement. However, the need for relief is not always evident in the LIC DSF, since the model underestimates required spending. As it stands, the LIC DSF can recommend a pathway that implies development and climate failure. In order to fill the gap between public debt thresholds and climate investment needs, the Supplemental Guidance Note’s strategy hinges on unrealistic assumptions about the scalability of private financial flows.

The LIC DSF could make several changes to ensure it responsibly facilitates—rather than obstructs—investment needs. First, as noted above, it can correct an anti-investment bias that erroneously implies countries have less ability to invest while preserving debt sustainability than they actually do. Still, there will continue to be a significant gap between many countries’ ability to take on debt and their investment needs. In these cases, the IMF can provide alternative scenarios that outline the mix of debt relief, domestic resource mobilization and grant-based, concessional and market-rate finance that could allow countries to meet their investment needs while keeping debt at sustainable levels. The IMF’s Climate Macroeconomic Assessment Program report for Samoa provides one example of how such a scenario could be constructed.

Not the time for a rubber stamp

Without reform in this current review, the LIC DSF will reinforce an investment gap that risks condemning countries to a lost decade. By the next LIC DSF review, the deadline for the 2030 Agenda for Sustainable Development will have passed, hundreds of millions of people will have completed their educations and entered the workforce and transformative technologies like artificial intelligence may have already reshaped economies. It is also possible that a number of additional countries will have undergone restructurings on terms set by the LIC DSF.

In this critical period, it is essential that the LIC DSF accurately analyzes countries’ debt sustainability needs and their ability to make investments. However, the LIC DSF continues to display significant flaws that lead to inaccurate forecasts and undermine economic growth. While no model is perfect, there are feasible options available to improve the LIC DSF that are worth the time and attention required to implement them. The stakes are far too high to let the LIC DSF’s flaws persist.

Read the original post on BU’s Global Development Policy Center’s website.