Are debt sustainability frameworks compatible with climate and nature action? Findings from a new dataset of the IMF’s Debt Sustainability Analyses

Climate change and nature degradation pose existential threats to the wellbeing of people and the planet. It is indisputable that addressing these problems requires financial investment. But several regions across the world are experiencing ever-narrowing fiscal space and are highly vulnerable to debt, inhibiting their ability to cope with climate-related emergencies. This report focuses on the degree to which assessments of debt sustainability are compatible with ambitious climate and nature action.

The authors evaluate the International Monetary Fund (IMF)’s debt sustainability analysis (DSA) for Market Access Countries (MACs), now called the Sovereign Risk and Debt Sustainability Framework for Market Access Countries (SRDSF MAC), and the ways in which climate change has been integrated into this framework. They create a novel dataset using all the debt sustainability analyses published by the IMF for advanced economies; evaluate how successful the framework is in adequately projecting debt sustainability within each IMF Article IV report in the case of surveillance and within each programme review in the case of countries that have been part of an IMF lending programme; and examine the different elements that constitute the inclusion of climate change in DSAs.

Key findings

1. There are large errors – up to 30 percentage points of GDP – in projecting public debt-to-GDP ratios in advanced economies.
2. Errors in projections increase with the forecast horizon.
3. The source and direction of error differs according to type of country and projection horizon.
4. Natural disaster stress testing is rolled out unevenly and inconsistently across advanced economies. This type of stress testing is currently triggered for countries that fit narrowly-defined eligibility criteria. Given the far-reaching impacts of climate change, this should be applied across all countries.
5. Over time, climate change affects underlying baseline macroeconomic performance. Climate change has not been incorporated at all into the underlying macro framework.

Recommendations for policymakers at the IMF to enhance DSAs

1. First and foremost, address underlying weaknesses that lead to large forecast errors in DSAs, to improve macroeconomic projections.
2. Do more to identify and tackle the underlying causes of persistent forecast errors in constituent components in the public debt-to-GDP ratio, notably the residual term.
3. Publish macroeconomic forecast errors in debt dynamics routinely in IMF staff reports to avoid the exacerbation of additional errors due to erroneous climate estimates. This could form an additional robust ‘realism tool’ alongside other realism tools introduced in previous reviews. It would be useful to separate climate errors from baseline macroeconomic errors, to avoid confounding the sources of errors.
4. Customise the natural disaster stress test using available country-based or natural-disaster-specific studies. This would counteract the lack of realism in designing a stress test by assuming a similar and small-sized shock will affect all countries in a similar way.
5. Increase the diversity of stress tests and scenarios to recognise the effect of climate shocks on the uncertainty of projection risks. This entails creating more ambitious scenarios for meeting climate and development goals and associated financing pathways. In contrast, introducing climate as an add-on leads to the proliferation of more ‘black-boxes’ within the DSA, weakening policymakers’ ability to draw firm conclusions.
6. Acknowledge ecosystem collapse and widespread nature loss scenarios and integrate these into specific medium- and long-term risk scenarios.