decomposing the composite real interest rate into its local currency and foreign currency parts provides a clearer idea of vulnerabilities stemming from currency mismatches on the public sector balance sheet. But to be meaningful, this analysis has to be done using nominal debt rather than the discounted present value of debt. The PV of debt obscures a clear picture of debt dynamics because it creates confusion about which r to use. Using nominal debt and actual r to look at dynamics is also applicable to LICs that rely primarily on official, concessional external funding; absent financial repression, domestic funding is likely to be at market terms. In this case, concessionality will show up simply as a low r, and the dynamics will still be meaningful in gauging whether public debt is on a sustainable trajectory.

- Third, _a five-year look back period plus a five-year projection period should be adequate for assessing debt sustainability_ . Identifying country idiosyncrasies—such as the intermittent growth spurts in Ghana on account of new oil discoveries or the rebasing of GDP—and controlling for these to isolate the underlying dynamics is essential for an accurate picture of sustainability.

- Finally, _developing relevant counterfactuals are of the utmost importance_ . Country-specific counterfactuals are not easily dealt with by the current LIC DSF; such an exploration is not part of the “realism tools” added to LIC DSF by the 2017 overhaul. We illustrate this with Ethiopia, the second most populous nation in Africa after Nigeria, based on IMF Country Report 20/150 issued in May 2020 (IMF 2020).

In Ethiopia as with Ghana, the public sector deficit—equal to investment minus the sum of saving and official transfers—has been driving the current account deficit. In fact, over the three years 2017/18 to 2019/20, the private sector ran a significant surplus—private saving plus transfers exceeded private investment—as seen in Tables 1 and 4b of IMF (2020).

The public sector DSA in IMF (2020) uses the 2017 LIC DSF to update the assessment in the 2019 Article <u>IV report done a few months earlier. It concludes that the risk of external and overall debt distress is</u> high; but public debt is “deemed sustainable”, albeit with higher downside risks on account of the thennascent COVID-19 pandemic. The high risk of debt distress is mainly on account of external sector vulnerabilities related to “an overvalued exchange rate and a small export base”.

Pre-COVID, Ethiopia was among the fastest growing economies in the world, with growth driven by large debt-financed large infrastructure projects such as Addis light rail, the Ethiopia-Djibouti railway line and ambitious power projects.<sup>11</sup> It was recognized that public sector-led growth would pave the way for private sector growth. For this to happen, financial repression (that has enabled the public sector to issue local currency debt at highly negative real interest rates) and the parallel market for foreign exchange (leading to a market rate more depreciated than the official rate) would have to be eliminated by adopting market-determined interest and exchange rates.

Table 5 outlines Ethiopia’s public debt dynamics for the three years 2017 to 2019 using data from IMF (2020) prior to the onset of COVID-19 and the 2020 civil war. The DSA’s conclusion that public debt is sustainable is borne out at first glance by the numbers in Table 5. But a useful counterfactual would be to ask what impact a move to market interest rates and exchange rates would have on debt levels and dynamics. Take 2019 as an example. The public debt-to-GDP ratio d was 56.9%. But r was -5.0% while g

> 11 NB: The analysis here is based on data before Ethiopia’s civil war which began in November 2020, worsening the macroeconomic and debt outlook further and dimming the prospects for private sector-led growth.

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