Multilateral indexed loans and debt sustainability

We study the potential for introducing indexation on loans provided by multilateral lenders to LICs, and thus whether a reform of their lending policy is feasible and economically justified. To this end, we provide new evidence for a group of 40 IDA countries over the 1990-2010 period for three types of debt: i) foreign currency loans indexed to real GDP; ii) foreign currency loans indexed to the dollar value of exports; iii) inflation-indexed loans denominated in local currency. We find that both GDP indexation and domestic currency lending are feasible policies, since individual country risk could be easily diversified in a portfolio of loans to IDA countries. The estimation of CAPM beta coefficients suggests that, while the risk of export-indexed loans is difficult to hedge, loans indexed to GDP or denominated in local currencies could be introduced at current interest rates; their risk premium is no greater than one percent. The insurance that indexed debt might offer to LICs against macroeconomic shocks threatening their debt sustainability 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 VAR model. The analysis shows that GDP-indexed or export-indexed loans would help to stabilize the debt ratio of the majority of IDA countries in our sample, but a larger number of them would benefit from a re-denomination of loans in local currency. A main lesson from our analysis is that a ‘one size fits all solution’ does not exist to the problem of stabilizing the debt ratio. This suggests that a reform of multilateral lending that is desirable to all LICs would be difficult to implement