FAQs: What is the Debt Sustainability Framework for Low-Income Countries, and Why Does It Matter for Climate Action?

By Rishikesh Ram Bhandary and Tim Hirschel-Burns

The importance of debt sustainability has come to the fore as countries around the world grapple with high debt burdens, which are capacity of governments to invest in climate action, and high costs of borrowing, even after the recent lowering of the interest rate by the US Federal Reserve. With developing economies needing to mobilize $3 trillion annually by 2030 to meet their development and climate change goals – and $2 trillion of that to be generated domestically – mobilizing investments at scale without triggering debt vulnerabilities is a tall order for many countries, if not impossible.

The 28^th United Nations Climate Change Conference in Dubai in 2023 recognized the importance of fiscal space and climate action, and reforming debt sustainability analyses (DSAs) has constituted an important part of various proposals to reform the international financial architecture, including the Pact for People and the Planet, the Vulnerable 20 Group (V20) Accra-to-Marrakech Agenda and others. That these proposals all devote attention to this highly technical issue underlines the importance of the debt sustainability framework.

The International Monetary Fund (IMF)/World Bank Debt Sustainability Framework for Low-Income Countries (LIC DSF) is currently under review by both institutions, presenting a key opportunity to better integrate climate risks into its methodology, though notably, climate change already features prominently in its recently released supplemental guidance for IMF and World Bank staff.

Given that debt sustainability is both highly technical and highly relevant to issues of climate and development, this FAQ blog seeks to demystify the debt sustainability framework and its close relationship with climate action. It is important to note here that the methodology for low-income countries (LICs) differs from that used for market access countries (MACs), or those countries that have access to international capital markets, and this blog addresses only the former.

This blog draws significantly from a new policy brief by the Task Force on Climate, Development and the IMF, which provides actionable insights to improve the LIC DSF to guide climate-related investment decision-making in LICs. The Task Force, a consortium of institutions primarily from the Global South seeking to advance a development-oriented approach to climate change at the IMF, has published extensively on the intersection of debt sustainability and climate.

What are debt sustainability analyses, and how are they used?

 As part of their regular “health checkups,” the IMF and the World Bank perform DSAs on developing countries, and these DSAs serve two major functions: First, it examines the fiscal health of a country. In particular, the DSA helps to analyze whether a country’s debt level is in line with its capacity to repay. Second, when a country needs to undergo debt restructuring, the DSA identifies how much of a debt reduction a country needs to be back on sustainable debt trajectory.

For LICs, the LIC DSF is also important because its results determine the cost of borrowing from the World Bank. The LIC DSF rates countries as being in debt distress or at high, medium or low risk of debt distress. The World Bank’s concessional lending arm, the International Development Association (IDA), uses a grant allocation framework that draws on the ratings from the LIC DSF exercise. In practice, this means a country rated as being in debt distress would have access to grants, while a country in low risk of debt distress would receive not receive grants but standard IDA terms.

Why is it important to integrate climate change into the LIC DSF?

DSAs should cover both expenditure needs as well as the risks that a country’s public finances are subject to. While the IMF has identified climate change as a policy challenge with major economic implications for all countries, climate change is particularly important for LICs for two main reasons. First, LICs tend to be highly vulnerable to the impacts of climate change, and by extension, the economic implications of climate change, whether they be localized climate impacts or the of climate policies adopted by other countries to transition away from fossil fuels, are especially salient.

Second, one of the most significant challenges faced by LICs is how to pursue a structural transformation of their economies in a manner that maintains fiscal and financial stability. Recent research from the Task Force reveals, for example, that for select countries in Central America and the Caribbean, transitioning to a net-zero economy could lead to explosive debt levels. DSAs need to capture this challenge.

Furthermore, climate investments are growth enhancing compared to investments in fossil fuels and they reduce sovereign risk, which is essential to reducing the cost of capital. Understanding the mix of financing required, from domestic and external sources, and their terms, such as the cost of capital, will be vital. LICs face major constraints to raise the necessary revenue domestically or meet climate investments through domestic debt.

Third, when climate investments are not included in the DSA, they become invisible. As of now, debt restructuring exercises would not take climate change into account, but the climate vulnerability of LICs requires the opposite: Climate investments must be central to any debt restructuring exercise. Furthermore, the existing approach to the LIC DSF, and DSAs more generally, trigger fiscal consolidation upon breaching certain thresholds, which leads to underinvestment and leaves countries less prepared to absorb climate shocks in the future.

What are the limitations of the existing methodology?

Some of the major limitations of the methodology have been well established, and these include over-optimistic gross domestic product (GDP) growth and revenue forecasts in DSAs. In terms of climate change, models are yet to fully account for growth potential of clean energy investments and the benefits of investing in climate resilience. Due to modeling choices, the methodology also leads to underestimates of the macro-financial impacts of climate risks. Furthermore, existing research shows that forecast errors tend to be higher for LICs than middle-income countries.

When climate risks are underestimated, national response strategies will be inadequate, leaving countries further – and unnecessarily – exposed to these risks. Similarly, DSAs can guide policymakers towards growth enhancing investments and away from less promising sectors, but only if those benefits are accounted for. In other words, the existing methodology needs to be improved so that the DSA accounts for both the risks of climate change and the benefits of climate action.

How can climate risks be better integrated into the methodology?

The new policy brief from the Task Force referenced above identifies four ways by which the methodology can be improved:

• Data: The LIC DSF should use more granular (geo-located asset specific data) to better understand physical climate risks.
• Climate scenarios: Forward-looking, science-based scenarios should be used to capture physical climate risks and transition risks.
• Macro-financial models: Modeling efforts should shift from assumptions about perfect foresight (rational expectations) to adaptive expectations. Climate change is plagued by uncertainties, and those uncertainties need better characterization.
• Financial risks and network effects: The LIC DSF needs to better account for the risk of financial crises spreading to other countries and the ability of governments to access finance.

The Task Force also recommends adopting a risk management approach, which includes accounting for not only average, or anticipated events, but also the low-probability, high-impact events that could be catastrophic shocks. This would help set the guardrails to prevent extreme impacts.

How can DSAs support climate finance mobilization?

The LIC DSF should help identify the appropriate mix of grants, concessional finance and debt relief that will enable the government to make the necessary climate investments while maintaining fiscal sustainability.

The Supplement to the Guidance Note, however, that the private sector will be able to account for the shortfall. This is concerning for two reasons. First, climate vulnerable economies face a high cost of borrowing. Private finance will require a high rate of return to enter markets where such return profiles may be difficult to achieve, potentially threatening debt sustainability. Second, even when public finance has been engaged to encourage private capital flows, for example through multilateral development banks (MDBs), public finance has been able to crowd in private capital only by a leverage factor of 1.2. That is, for every public dollar, only 1.2 dollars of private money has been mobilized.

One example of how the LIC DSF can support finance mobilization comes from the IMF itself. In the Climate Macroeconomic Assessment Program for Samoa, the IMF calculated the different trajectories of public debt to GDP depending on the extent of concessional finance that Samoa has access to. If Samoa invested a total of two percent of its GDP in adaptation capital for the next five years, it would save 4.5 percent of its GDP in terms of output losses if a disaster happened in 2027, as seen in Figure 1 below. If Samoa was able to borrow on highly concessional terms including 80 percent grants, the impact on its debt to GDP ratio would be highly contained.

Figure 1: The Role of Concessional Finance in Debt Sustainability

Given that the LIC DSF is the primary navigation tool guiding LICs’ public finances, understanding the fiscal health of economies and supporting debt restructuring negotiations, a climate-informed DSA is crucial to align the international financial architecture in support of development and climate change goals.

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