by higher cost domestic financing, which leads not only to higher absolute cost levels but also risk levels. The higher cost because domestic interest rates in LICs are typically higher than in high‐income countries, and higher risk because the higher absolute level of interest payment is more significantly affected by the shock scenarios.<sup>32</sup> When comparisons are made between external and domestic market borrowing strategies, the outcome is more nuanced. While typically the interest rates associated with external borrowing will have lower coupon rates, baseline projection of the exchange rate may be such that the interest payments on the depreciated (i.e., higher domestic currency equivalent) principal value can be higher than the interest payments on domestic debt, rendering domestic debt effectively cheaper than external debt. Similarly, risk may be higher for external debt if the deviation in interest cost on the depreciated principal is greater than the deviation on the domestic interest cost as a result of interest rate shocks, or as a result of a depreciation shock. Cost and risk measured in terms of debt to GDP, however, displayed a range of results among the sample countries. This measure assesses the vulnerability in terms of debt sustainability created by the path taken by alternative debt management strategies. In countries where the domestic debt market was severely constrained and commanded a high premium, external concessional borrowing continued to outperform domestic borrowing in terms of cost and risk. However, where interest rates in the domestic debt market were more moderate, and assumptions projected an important baseline exchange rate depreciation, the results showed a trade‐off between a strategy that had a higher share in domestic debt (with higher cost and lower risk) and a strategy that had a higher share in external debt (with lower cost and higher risk). Without exception, exchange rate shocks dominate the risk outcome (relative to interest rate shocks) for the debt‐to‐GDP measure, as this shock affects not only interest cost but also the principal valuation.

Thus, conflicting results could emerge using different cost‐risk measures. The results of the MTDS are highly country specific, and depend on the characteristics of the existing debt portfolio, the assumptions about baseline future exchange and interest rate projections, as well as shock scenarios and the macroeconomic projections that drive the pricing assumptions. In this regard, monitoring other risk indicators is crucial. For example, it is difficult to gauge the implications of refinancing risk from the cost and risk analysis. Closely examining and comparing the principal repayment schedule at the end of the time horizon for different debt management strategies, as well as comparing the average time to maturity and the percentage of debt maturing in a particular year, may highlight an uncomfortable level of refinancing risk that may have resulted from a strategy that appeared to be attractive from a cost‐risk perspective.

As discussed, the main risk to debt sustainability arising from debt composition derives from exchange rate risk. However, given the relatively short maturities of domestic debt vis‐à‐vis external debt, there is a need for an aggressive domestic issuance strategy just to maintain the current domestic to external currency mix in the portfolio. To illustrate, Table 4 exhibits the domestic and external currency composition of the existing debt portfolio for a sample of 5 countries. Without taking into account new debt, if this debt were allowed to mature according to its principal repayment schedule, after three years, external debt will have barely matured, with 82‐99 percent of the original debt still outstanding,

> 32 Suppose a 2 percent external loan coming due is replaced by a 10 percent domestic loan. This substitution will result in an increase in interest cost of 8 percent. Domestic debt will also exhibit higher risk because of a) the higher absolute level of interest payments, and b) the higher interest rate shock that is applied to domestic interest rate relative to foreign interest rate (say a 2 percent shock for domestic interest rate and a 1 percent shock for foreign interest rate).

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