using the approach recommended in this paper. To see this, we revisited the May 2015 DSA (IMF 2015), which rated Zambia at moderate risk of external debt distress but judged public debt dynamics sustainable. However, using the data from the May 2015 DSA, ADF Lab (2016) concluded in March 2016 that public debt dynamics were “definitely unsustainable” with a primary deficit of 5% of GDP and r close to 5 percentage points above g. Public debt had been projected at 40% of GDP for end-2015, but full-year data indicated that d was above 50%.

What about the high level of private external debt? Would its impact have been ignored if the focus had been on public debt dynamics combined with market signals and a thorough analysis of international liquidity? No, because this vulnerability would have been picked up in the assessment of foreign exchange reserve adequacy and measures like the CAD plus short-term external debt divided by foreign exchange reserves. Indeed, the column for 2015 in the external DSA in IMF (2017a) has a large residual of 57 percentage points of GDP, which probably indicates massive under-reporting of the CAD. The fact that the private sector was borrowing large sums abroad means that private investment greatly exceeded private saving.

Zambia’s experience underlines that LIC DSF world has changed dramatically and that LIC DSF countries can no longer ignore the lessons from EM crises. If we combine the results from the three generations of crisis models, LIC DSF countries need to go beyond the narrow confines of PPG external debt.<sup>14</sup> They need to broaden their macroeconomic monitoring to include:

- Fiscal and growth fundamentals as reflected in the sustainability of public debt dynamics

- International liquidity

- Market signals on devaluation and default risks

- Vulnerabilities posed by private external borrowing and currency mismatches on private sector balance sheets.

It makes obvious sense to have a DSF that reflects the above monitoring list instead of the present overwhelming emphasis on PPG external debt. Box 2 summarizes the lessons from Zambia.

# **Box 2: Lessons from Zambia**

**Early warning is essential.** ADF Lab (2016) warned in March 2016 that Zambia’s public debt-to-GDP ratio was on an unsustainable path based on d, pd and (r-g). 18 months later, the LIC DSF DSA (IMF 2017a) urged fiscal consolidation. After another 22 months, it concluded d was on an unsustainable path (IMF 2019). After another 16 months, Zambia defaulted on its Eurobonds in November 2020. _The DSF should be simple enough to be quickly updated between IMF Article IV consultations because of the volatile macroeconomic environment which characterizes most LIC DSF countries._

**The LIC DSF cannot ignore lessons from EM crises.** It needs to be reformulated to reflect these lessons by taking into account fiscal and growth fundamentals, international liquidity, market signals and private balance sheets.

**The market is an unreliable source of development finance.** Zambia was issuing Eurobonds to finance infrastructure investments (for the case of market access countries, see Gill and Pinto (2005)). Designing instruments to frontload official development assistance (ODA) could help with public debt sustainability. Frontloading ODA and better collaboration across the donor community would also enhance the leverage of donors in the policy dialogue with LIC DSF countries, which has been diluted by easy market access.

> 14 For a summary of the lessons from EM crises and the main features of the three generations of crisis models, see chapter 8, table 8.2 and Annex 4 in Pinto (2014).

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