Multilateral indexed loans and debt sustainability

We evaluate the benefits and costs of indexing multilateral loans to variables related to developing countries’ ability to pay; i.e. whether a reform of multilateral lending is feasible and economically justified. The analysis covers 40 International Development Association (IDA) countries from 1990 to 2010 and focuses on three types of debt: GDP-indexed loans; export-indexed loans; inflation-indexed loans denominated in local currency. The insurance that indexed debt might offer against macroeconomic shocks depends on the conditional covariances of GDP growth, real exchange-rate depreciation, and net exports that we estimate as the covariances of the forecast errors obtained from a vector autoregression (VAR) model. The analysis shows that both GDP-indexed loans and inflation-indexed local-currency loans would help to stabilize the debt ratio of the majority of IDA countries in our sample. However, the adverse policy incentives created by local currency debt tends to favour GDP-indexed debt. The cost of indexation would be small; the estimation of a capital asset pricing model (CAPM) suggests that loans indexed to GDP could be introduced at current interest rates since the estimated risk premium is less than 1 per cent. Any additional risk for multilateral lenders would be more than offset by a lower frequency of debt crises.