SOAS Research Online

Abstract

We argue that the 'New Debt Sustainability Framework' (DSF), as recently introduced by the Bretton Woods Institutions, is tailored to suit the aid allocation mechanism centred on the Country Policy and Institutional Assessment (CPIA), but fails to take into account low-income countries' economic vulnerability and exposure to exogenous shocks. As a result, the DSF further undermines the effective delivery of aid by the International Development Association (IDA), and fails to support recipient countries in their efforts to achieve lasting debt sustainability. Furthermore, we demonstrate that the findings of the empirical studies underlying the DSF and IDA14 replenishment are not robust to the introduction of vulnerability measures, such as the Economic Vulnerability Indicator (EVI), which undermine the significance of the CPIA in predicting debt distress episodes. In order to overcome the shortcomings of the DSF, we propose the introduction of a Contingency Debt Sustainability Framework (CDSF), which distinguishes between the causes of vulnerability underlying the external debt problem affecting most of the low-income countries. Drawing on the most established strands of sovereign debt and contract theory literature, we argue that state-contingent debt contracts represent the most effective financial instrument to link aid allocation and debt relief to recipient countries' financial requirements, contingent on the state of nature. To implement state-contingent contracts in the specific context of low-income debtor countries, we devise an accounting method by which shock and trend factors in the balance of payments are distinguished by their exogenous or endogenous origin. On the basis of this distinction, the CDSF financially compensates debtor countries for exogenous shock and trend factors, without giving rise to significant moral hazard implications. The CDSF is then simulated for the case of Uganda during the period 1988-2002, demonstrating its effectiveness in dealing with Uganda's severe exposure to price shocks and negative terms of trade.