<mark>The goal of the realism tools is to avoid excessive optimism or pessimism on underlying macroeconomic projections in the baseline scenario. We have two suggestions here. The first suggestion is to restrict the set of comparator countries to EMs and leave AEs out.</mark> While the econometrics underlying the SRDSF attempt to control for differences between EMs and AEs in terms of borrowing structure and vulnerability, the differences are vast, especially in terms of sustainable debt levels. One possibility is to have a single framework for LICs and MICs, that is, for all emerging market and developing economies (EMDEs), with a separate one for AEs. As argued in Gill and Pinto (2023), the LIC DSF was designed for a time when public debt was virtually synonymous with concessional external debt from donors so that debt sustainability was delinked from market sentiment. The big shift in LICs to market borrowings both in the domestic market and overseas has therefore rendered the existing LIC DSF with its focus on the net present value (NPV) of public and publicly guaranteed (PPG) external debt at an arbitrary discount rate of 5% obsolete: four out of the five debt distress indicators in the LIC DSF pertain to PPG external debt. This may be the time to debate whether a separate DSF for LICs is needed at all or whether a unified framework for all EMDEs, which looks at public debt dynamics in terms of d, pd and (r-g) makes sense: concessionality in LIC borrowing will be reflected in the level of the composite real interest rate and its dollar component.

<mark>The second suggestion is to do a deeper dive into r and its components.</mark> The purpose of the composite real interest rate is to mimic a single-currency environment so that debt dynamics in EMs can be based on d, pd and (r-g) as in AEs. Any concern that this would hide information is counterbalanced by the recommendation that the impact of the composite interest rate on debt dynamics be broken down into components attributable to the real interest rate on local currency debt and that on FX debt, as shown in Table 1 in the previous section and discussed in the Sri Lankan context in the two paragraphs following Exhibit B. A good startin <mark>g point would be the composite nominal interest rate as set out in equation (9) and its local currency and $ components. The latter would require exchange rate projections—as do the realism tools, see Figure 10, IMF (2022). In our view, incorporating the exchange rate effect into the $ cost of borrowing is helpful because it tells us the effective, overall cost of such borrowing, enabling a comparison with local currency borrowing.</mark><sup>8</sup> <mark>Likewise, projecting nominal GDP growth G would be helpful. These variables can all be converted into real terms using the GDP deflator.</mark> <mark>The advantage of going the nominal route and then converting into real terms is that it lends greater transparency to what is driving debt dynamics: is it nominal interest rates and growth, or inflation? If inflation is above target, then the question of sustainability will arise, for example, if monetary policy</mark> −g tightening is needed. Besides, the identity = can be made use of. ii1cc−GG rr1cc <mark>Our main comment on the Logit Stress Probability (LSP) model to gauge the probability of near-term</mark> +GG +gg <mark>Our main comment on the Logit Stress Probability (LSP) model to gauge the probability of near-term stress (section V, IMF 2022) is that this could be usefully complemented with judgment based on d, pd and (r-g), especially for EMs, which have far less fiscal and monetary space than AEs. For example, based on past EM crises—the Russian Federation in 1998, Argentina in 2001—we know that d rising significantly above say 60% with a large primary deficit and r-g>0 spells trouble. This could be supplemented with information on market signals contained in domestic real interest rates and sovereign Eurobond spreads. Such simple analysis would convey whether d is on an explosive path or not and provide early warning about a potential crisis.</mark> <mark>This thought carries over into the fan charts constructed as part of assessing medium-term risk (section VI, IMF 2022). First, we do not see any merit in predicting variables such as z (the bilateral real exchange rate) or inflation differentials with the US (recall from Note 4 that, when combined, these two effects add up to the capital gain/loss from $ debt because of exchange rate movements). Not only does this add to the information requirements, it makes the DSA less transparent. Knowing whether the real exchange</mark> 8 Of course, with open capital accounts, we would expect some arbitrage across borrowing costs in local currency and $ averaged over time. But the latter is riskier because of the volatility of exchange rates and balance sheet effects: a government with heavy exposure to $ debt might put pressure on the central bank not to let the currency depreciate as when there is a negative terms-of-trade shock, for example.

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