state of domestic market development, or simply the lack of a viable domestic market, as in the case of small states<sup>19</sup> .

Table 1 presents a simple example of the analysis debt managers could do to determine the relative advantages or disadvantages of accessing external versus domestic debt. The analysis looks at the forward exchange rate in time (t) using both implied real interest rates and comparing it to the forward exchange rate calculated using real interest rates. This gives the debt manager two different theoretical rates. In theory, the forward exchange rate gives the rate at which there should be no preference between contracting external and domestic debt. If using the implied rates translates into a greater depreciation necessary to reach the equilibrium point, then the bias is toward external debt because under the implied scenario, the external option is cheaper that the domestic alternative. The message is twofold: First, due to concessionality, the traditional preference in LICs to maximize concessional debt is apparent, as can be seen in countries C and G. However, it is not always as large or cost effective as many assume – as illustrated in the cases of countries A and E. In some cases, despite the donor concessionality, contracting domestic debt may still be more advantageous due to highly negative real implied domestic interest rates such as is the case in countries B, D, and F. Countries with a bias toward domestic debt, or small bias toward external debt, can also use such an analysis support decisions to further develop domestic markets. The ability to carry out an analysis illustrating this tradeoff emphasizes the importance of developing the requisite analytical capacity in DeM offices.

**Table 1: Analysis of External / Domestic Debt Bias**

||Country A|Country B|Country C|Country D|Country E|Country F|Country G|
|---|---|---|---|---|---|---|---|
|Real Interest Rate|7.80%|‐0.40%|0.80%|7.50%|5.59%|10.30%|‐4.10%|
|External Real Interest Rate|2.90%|2.90%|2.90%|2.90%|2.90%|2.90%|2.90%|
|Implied Domestic Real Interest Rate on Gov't Debt|3.40%|‐3.10%|7.00%|‐0.40%|2.20%|6.40%|‐3.60%|
|Implied External Real Interest Rate on Gov't Debt|‐2.84%|0.80%|‐0.10%|‐0.20%|‐1.80%|‐0.40%|2.00%|
|Fwd FX Rate at Real Rates|71.87|6.61|67.76|3,913.20|1,227.57|11.14|110.44|
|Fwd FX Rate at Implied Rates|73.01|6.56|74.09|3,738.15|1,245.04|11.10|125.38|
|Percent difference in Fwd Rate (positive = external debt bias)|1.58%|‐0.68%|9.34%|‐4.47%|1.42%|‐0.34%|13.53%|

Source: Author’s calculations; sample of 7 countries in which DeMPA and MTDS analysis was performed; US real interest rates and inflation rates are used for the external scenario, cross‐rates are not considered in this analysis.

# **IV. The Current State of DeM in LICs and Ways Forward: A Look at the DeMPA and MTDS Analytical Tools**

While debt restructuring and debt relief initiatives have greatly benefited heavily indebted countries in putting them back on the track of debt sustainability, they do not provide an answer as to the cause of debt distress, particularly in the face of crises. In 2003, the World Bank and IMF published the Public Debt Management Guidelines (2003), the purpose of which was to assist in reducing developing country vulnerability to international financial shocks. However, despite the growing recognition of the benefits of DeM, current measures of DeM performance have not shown improvement in LICs. Debt management, as measured by the Country Policy and Institutional Assessment (CPIA) Debt Policy Indicator, has actually shown marginal deterioration in recent years (See Figure 19). This is important because the quality of DeM and the probability of becoming heavily indebted are closely related in

> 19 See Doemeland, O’Boyle, Stucka and  (forthcoming, 2010) for further analysis on the evolution of domestic debt in Small States.

10