Debt Sustainability Model

A form of structured examination on a developing country based on the Debt Sustainability Framework

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What is the Debt Sustainability Model?

The debt sustainability model, or debt sustainability analysis, is a form of structured examination on a developing country based on the Debt Sustainability Framework. It is utilized by the World Bank and the International Monetary Fund (IMF) and measures the lending and borrowing decisions surrounding low-income and developing countries. The model is essential for measuring a developing country’s financing needs with its capacity to repay borrowed funds.

Debt Sustainability Model

Types of Debt Sustainability Models

The debt sustainability model is not meant to be a rigid structure or model. Instead, it is fluid and assessed against country-specific circumstances. Each country is subject to different underlying factors, including political situation and policy track record. In general, the two types of frameworks implemented by the IMF are:

1. Market-Access Debt Sustainability Model

The market-access debt sustainability framework is applied to developed or emerging market economies. They are economies that can readily access international capital markets.

2. Low-Income Country Debt Sustainability Model

The low-income debt sustainability framework is applied to low-income economies. They are economies that face significant challenges in meeting development objectives. They are the focused countries for the debt sustainability model, since their risk and return profile for investors is much more uncertain.

Forecasting borrower payments in low-income economies is challenging, given the economic and political uncertainty that the countries face.

Understanding the Debt Sustainability Model

The debt sustainability model is instituted by the World Bank and the IMF. They are two international institutions that promote the sustainability of growth in developing countries. The World Bank provides grants and loans to the governments of low-income countries to pursue capital projects.

The IMF is an organization that focuses on facilitating global monetary cooperation, securing financial stability, and fostering international trade to support sustainable economic growth and reduce poverty.

The debt sustainability model comprises three pillars or goals:

  1. To ensure that countries that borrow funds are on track for sustainable development
  2. To allow lenders to anticipate and measure future risks and tailor financing terms
  3. To assist low-income countries in balancing their requirement for financing with their capacity to repay debt

Debt sustainability reports are periodically published for various low-income countries. The reports highlight two risk factors:

  1. Risk of external debt distress
  2. Risk of overall debt distress

The components above include a base scenario that is calculated based on a series of macroeconomic forecasts and projections that factor in the government’s intended policies. Assumptions and parameters are clearly defined, and sensitivity tests are applied to the base scenario, which provides a confidence interval of probabilistic scenarios that could occur with changing factors, including different:

  • Policy variables
  • Macroeconomic developments
  • Financing costs

Sovereign Debt Sustainability

Sovereign debt sustainability is more difficult to measure than for a corporation. For a corporation, insolvency is defined simply as when the value of liabilities becomes larger than the value of its assets. However, measuring the balance sheet of a sovereign is much more difficult.

At the core, the concept is similar to measuring debt sustainability for corporates. A sovereign must have enough capacity to generate surpluses in order to meet future debt payments. The difference is that the future potential surpluses are much more uncertain, which makes it significantly more difficult to measure solvency for a sovereignty.

Measuring sovereign debt sustainability is crucially a forward-looking exercise, and it is why the debt sustainability model is critically important for determining the future state of developing an economy based on the factors that were observed in the past or are observable in the present.

Importance of the Debt Sustainability Model

It is well documented that a market-based economy is dependent on consistent growth. The growth is usually measured with the gross domestic product (GDP), which measures the value of goods and services produced by a certain country or economy. Although almost every economy in modern society is market-based, some countries are disadvantaged and are less developed than others.

In order to promote continuous global economic growth, low-income countries must be provided funding and assistance from developed countries and international institutions. The debt sustainability model is important in allowing lenders of funds to understand the risk profiles of the countries that they are lending to. By understanding the risks of such countries, the investors can better evaluate the returns they should expect or what their potential losses could be.

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