# **Box 1: The Debt Sustainability Analysis (DSA) in a nutshell**

The World Bank and IMF periodically carry out DSA exercises, in which a country’s debt is projected over a twenty years horizon, to assess whether such debt is on a sustainable path or, alternatively, the country faces a higher than advisable probability of debt distress over the projection period. The analysis applies mostly to low income countries and is undertaken using the Debt Sustainability Framework (DSF), a macro-accounting tool developed jointly by the World Bank and the IMF in the context of debt relief initiatives.

The DSF consists of the following three elements or blocks:

- a) A standard financial programming exercise to make projections of key macro variables (exports, imports, GDP, exchange rate, inflation, government revenues and expenditures, etc.) and the financing gaps faced by the country as a whole (current account balance) and by the government (government deficit);

- b) A set of dynamic deterministic equations used to project future debt and debt service as a function of past debt and its amortization profile, interest payments and the financing gaps projected in a) above;

- c) A set of country specific threshold indicating the maximum debt a country can carry for a given probability of debt distress.

It should be noted that the financial programming exercise, by which the key macro variables and financing gaps are projected, although a pre-requisite, is done outside the DSA and not strictly part of it. The financial programming exercise is usually the result of the country monitoring activities carried out by country economists in the Bank and in the Fund and imported into the DSA. Elements b) and c), on the other hand, are unique to the DSA.

As mentioned, component b) consists of a set of dynamic equations that project future debt and debt service as a function of past debt, its amortization profile, the accrual of interest and the financing gaps faced by the country or the government. However, to make such projections it is needed to assume going forward in what terms (currency, maturity and interest rate) the new debt will be contracted to finance future gaps.

Component c) consists of policy-dependent thresholds for five debt burden indicators, namely: (a) PV of debt-toGDP ratio, (b) PV of debt to exports ratio, (c) PV of debt to government revenues ratio, (d) debt service to government revenues ratio, and (e) debt service to exports ratio. The thresholds are country specific because they depend on the quality of a country’s institutions and policies (i.e., countries with stronger policies and institutions can carry more debt than countries with weaker institutions without falling into distress). The thresholds are for a pre-determined probability of debt distress set at about 15 percent and kept equal for all countries.

The assessment of the sustainability of a country’s debt results from comparing the five indicators above vis-àvis their corresponding thresholds under both a baseline and alternative scenarios. The baseline or most likely scenario is the one projected under the financial programming, while alternative scenarios are built by applying a set of predetermined shocks to the former. Depending on whether a country’s debt burden indicators over the projection horizon breach the thresholds or not, for protracted or short periods, and whether this occurs under the baseline or alternative scenarios, the country is ranked as low, moderate or high risk of debt distress.

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