When a country is in debt-related trouble, they can call the International Monetary Fund (IMF), which offers a path to get debt organised. It is not a guaranteed fix, but for many countries it is their best hope of getting some credit or relief back into their financial system. But that is all once the country is already in debt distress, a situation that we are seeing around the world this year as governments grapple with the challenges of higher interest rates. To avoid the distress in the first place we need to get back to basics.

If you are a finance minister, there are many things you need to do to keep your public debt sustainable – and you have to do them all well. You must consider your fiscal accounts, your medium-term fiscal framework, and ensure your accounts are viable. This allows you to see that any borrowing is being done with care.

Here are 10 practical steps that governments can take to strengthen debt sustainability and reduce the risk of debt distress:

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1. Know How Much Debt is Too Much Debt

The first thing to know is how much debt is too much. That is the million-dollar question. And there is of course no static answer – it changes as the world changes. Ten years ago, countries were encouraged to take on more debt, especially to fund infrastructure, because interest rates were so low. Some people believed they were going to be low forever. And today there are regrets as interest rates go up. However, the methodologies for managing debt sustainability have not changed that much. There are still four main approaches to answering the question, “How much debt is too much debt?”

Market Access Countries Debt Sustainability Framework (MAC DSF)

This first methodology was created out of necessity, back in the early 2000s, by the IMF. It was a good attempt at making a judgement as to whether a country or government carried too much debt, but it was mostly developed for countries that had market access; in other words the ability to raise capital through international markets. And it has been reviewed many times over the last two decades.

Low-Income Countries Debt Sustainability Framework (LIC DSF)

This second methodology is the one most people talk about these days because more low-income countries are falling into financial distress. This methodology, developed by the World Bank and the IMF to assess countries without market access, is quite static. It uses thresholds to put countries into one of three debt-carrying capacities – weak, medium, or strong. These categories determine the maximum level of debt burden a government can manage sustainably, assessed in relation to GDP, exports, or fiscal revenues. This was created in 2005, shortly after the Multilateral Debt Relief Initiative was adopted by the IMF, the World Bank, and the African Development Fund to relieve the debts of very low-income countries, and accelerate their progress towards the United Nations’ Sustainable Development Goals. LIC DSF was reviewed in 2017 and I would not be surprised if it were to be reviewed again soon.

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The problem is that LIC DSF debt thresholds are becoming outdated. And this is because many of these LIC governments are issuing more domestic debt to creditors such as local commercial banks, pension funds, and insurance companies. These institutions fall under local laws and regulations which are “easier” to control, in the sense that these creditors are a captive market and subject to how the government decides to structure or restructure the debt. LIC DSF ceilings were set when thinking only about external debt from foreign creditors. They did not take into account that there is now a greater risk from debt distress for local creditors, which then risks spreading to the rest of the domestic financial system and economy. Examples of this scenario are currently Zambia and, to some extent, Sri Lanka.

Sovereign Risk and Debt Sustainability Framework (SRDSF)

This third methodology came about during the COVID-19 pandemic and was produced by the IMF to replace the MAC DSF. It is quite complicated, technical, and in many ways its operations are rather opaque. This is because it uses regressions and parameters which have not yet been fully disclosed or are not commonly understood. The framework is a lot more probabilistic, rather than based on thresholds, and involves various rounds of fan charts, financeability indices, and stress tests. Rather than producing a definitive quantitative assessment, the SRDSF findings allow users to make judgements about various debt-related risks.

Debt Dynamics Tool (DDT)

This is the final methodology, created by a group of IMF economists. It began informally but has now become very popular. It uses Excel spreadsheets for a simple way of running regressions under different scenarios and deploying commonly available data. This tool works especially well for Debt Management Offices (DMOs) in low-income countries that are looking to build their own capacity in public debt projections and analysis.

Nobody cared much about methodologies for debt sustainability analysis when things were going well, or at least when things seemed to be going well. Today, reality is biting. Now that there are countries in distress that require relief and creditors are being asked to absorb losses, things are getting more complicated. Countries are now relying – in fact, are forced to rely – on the IMF and the World Bank’s debt sustainability analysis to establish how much debt will need to be cut or forgiven. So, the application of these methodologies has become a matter relevant to the whole financial and economic community.

To reiterate, the first step to managing government debt is to choose the right methodology. Then, once you have trained up your DMO to run the numbers yourself, you will be better prepared and not surprised by the IMF’s results.

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2. Know How to Borrow

A deep understanding of how borrowing works is crucial. You need to build and regularly update your Medium-Term Debt Strategy (MTDS). This strategic framework makes you assess, and decide on, the cost-risk trade-offs between borrowing long versus short, using local or foreign currency, and whether you take a floating or fixed interest rate. If your DMO has not published an MTDS yet, then that is a red flag.

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3. Know When to Borrow

A vital skill concerns timing. You need to develop an Annual Borrowing Plan (ABP). This displays when bonds are going to be issued on the capital markets, both domestic and foreign, usually through an auction calendar. Needless to say, for emerging markets, publishing the ABP takes guts. This is because you have to announce that you will go to the market to issue so much on such a day, without knowing exactly what the domestic or global economic conditions will look like. What if the market has gone crazy because somebody in your government has said something silly the day before? Or another government has faced a crisis or some other contingency that affects the market? You also need to ensure people come to your auctions. For that, you must build and develop an investor base. Nurturing and keeping it up-to-date requires a lot of relationship management.

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4. Optimise Your Borrowing

Once you have borrowed, you should not just sit on your debt portfolio – you must constantly optimise it as circumstances and outlooks change. This is about liability and risk. It involves debt buy-backs, debt exchanges, interest rate swaps, currency swaps, and fiscal hedges (such as taking out options on commodity prices that affect your budget). It is quite technical and entails specific legal requirements, but this is vital for debt to remain sustainable.

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5. Know Your Infrastructure Borrowing

It is particularly important to conduct a deep-dive investigation into anything that has to do with borrowing for infrastructure. The fact that these are typically long-term fiscal commitments decided (or pushed) by sectoral ministries (such as transport, energy, or water) means that they require special attention. When crises hit, it may be tempting to cancel or postpone projects, but you do not want to end up with a bridge that is only half-built, for example. So, for infrastructure borrowing and public-private partnerships (PPPs), you want your DMO to be aware of, and not to be surprised by, where these commitments and obligations lie.

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6. Disclose Contingent Liabilities

Contingent liabilities are obligations for which the government may or may not be responsible. It is important that governments publish a record of these contingencies, along with an estimation of their value at risk. Examples of contingent liabilities could be a pension fund liability that might take 30 years to realise, or a weak banking system, or guarantees given to a sub-national government or to a state-owned enterprise. Ministers must at least acknowledge these liabilities and disclose them. Optimally, there should be a clear process to determine where these liabilities will lie and how risks can be addressed or mitigated, before they are taken on.

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7. Uphold Disclosure Standards

High disclosure standards must be vigilantly maintained. First, do you record and account debt properly? Who has the final word in government on what you owe to whom? Second, what do you disclose? For developing countries, this can be done through one of those things that in the past was considered a bit boring and only for World Bank experts – something called the External Debt Reporting System (DRS). It was set up in 1951, so it is an old, venerable system. People tended not to pay much attention to it until debt distress came along and they suddenly needed to know exactly the terms of the debt and who the creditors were.

Proficiency and transparency in these disclosure standards is an absolute priority. Keep in mind that there can be big money behind this: if your obligations to a specific creditor are not disclosed, when other creditors forgive your debt, they are effectively bailing out the “hidden” lender.

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8. Establish a Proper Legal Framework

The legal framework around public debt must be secure and stable. Are your laws and regulations aligned to facilitate the authorisation of borrowing, and to make decisions on optimising your debt portfolio? A proper legal framework must already be in place well before you go to the market, for normal times and in anticipation of potential times of distress.

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9. Institutional Setup

The structure and operations of your institutions must be impeccable.  Is your DMO properly set up? Is it well staffed, do those staff have the appropriate reporting lines, and is its mandate made apparent to all? The World Bank has a diagnostic tool for evaluating a country’s debt management processes and institutions – the Debt Management Performance Assessment (DeMPA). It is mostly used by low-income and emerging market countries, but not all countries disclose or update their DeMPA reports.

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10. Fiscal Insurance

The field of fiscal insurance is still in its infancy. For example, a commodity-exporting country may see its fiscal plans go off the rails when the global price for that commodity falls. A typical government response would be to cut public investment, such as infrastructure projects, rather than current expenditure, for example teachers’ salaries, which tends to be very “sticky”. This in effect involves the government being forced to postpone national development. But it does not need to be like that. Now you can have your DMO buy insurance against these eventualities, whether using hedging instruments such as options or futures, or buying insurance against natural disasters. The World Bank is making good progress in this area, for example issuing Catastrophe (CAT) bonds, which have paid out for earthquakes in Chile, Colombia, Mexico, and Peru. Bringing this line of business up to the needed scale may require a fully-dedicated, explicitly-mandated multilateral institution.

Take the case of Uruguay, a very well managed country (and debtor). Ninety-five percent of its electricity is produced by hydroelectric power. In recent years, Uruguay has suffered from several droughts. The Government must buy expensive fuel oil as a substitute to generate electricity, and it cannot pass this higher cost to consumers because energy is a political issue. The Uruguayan fiscal accounts have become tied to the weather – the worst commodity to be tied to. Droughts risk becoming a fiscal hole. But the Government had hedged this risk in advance by buying a call option on oil. Thankfully, it has worked very well for them.

Not surprisingly, research is now being done on how having fiscal insurance might influence credit ratings. This could have a massive impact on the terms for loans and generate interest savings. In a year heavy in debt rollovers, those savings may be more than enough to pay the cost of the hedge. There may be a “free lunch”, in that the fiscal insurance pays for itself. One hopes multilateral organisations will pick this up, or that a new multilateral organisation is created with the mandate to research and advise on the provision of fiscal insurance.

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