IDB Study Provides Recommendations for Countries to Reduce Debt, Boost Growth
· Strengthening fiscal institutions is key to manage debt and transition to prudent debt levels
· Corporate debt and risk seen as a drag on growth and investment
Countries in Latin America and the Caribbean should prioritize bringing down debt to prudent levels to boost economic growth, allow for productive investment and reduce the risk of a debt crisis, according to a new flagship report by the Inter-American Development Bank (IDB).
The study finds that total debt has risen in Latin America and the Caribbean to some US$5.8 trillion or 117% of GDP, from under US$3 trillion in 2008. Public debt in the region grew from 58% in 2019 to 72% in 2020 due to COVID-related fiscal packages, lower revenues, and a recession, according to “Dealing with Debt: Less Risk for More Growth in Latin America and the Caribbean,” part of the IDB’s Development in the Americas series.
High debt levels can hinder development because it prompts investors to demand higher yields, crowding out private investments and forcing governments to divert scarce resources to pay interest instead of investing in infrastructure and public services. High debt levels also reduce a country’s ability to respond to future economic shocks to support families and firms and increases the risk of a crisis. The pandemic, the Russian invasion of Ukraine, high inflation, rising interest rates and low world growth, combined with high debt, increase the region’s vulnerability.
In response, governments in the region should reduce public debt ratios from an average of 70% to a range of 46-55% of GDP, a level that the study considers prudent, noting that the range will vary for each country, depending on specific characteristics. Countries dependent on volatile commodity revenues should bring debt levels down further.
“Well-managed and sustainable debt can help unleash Latin America and the Caribbean’s abundant growth potential,” said Eric Parrado, Chief Economist of the Inter-American Development Bank. “Our new flagship report outlines a pro-growth agenda, where debt becomes an engine and not a drag on growth. It provides governments in the region with comprehensive policy recommendations to strengthen macro-fiscal institutions, reduce public debt and ensure a supporting financing environment for firms.”
Strengthening fiscal institutions
The study analyzes several policies that can help governments bring debt to prudent levels and promote debt sustainability.
Stronger fiscal institutions can encourage governments to stop overspending in good times, build a cushion to deal with bad times, and can help countries provide credible fiscal guidance to bring public debt levels down. Fiscal rules help governments set numerical goals for budget and macroeconomic aggregates in a transparent way, so they become accountable for these results. The study shows counties in Latin America and the Caribbean complied with only 57% of the targets specified in the rules due to poor design of the rules.
Ingredients of effective fiscal rules include solid legal foundations, credible enforcement mechanisms, flexibility to deal with shocks, and well-defined escape clauses. Independent fiscal councils are also key for the effectiveness of fiscal rules and the promotion of responsible policies because they oversee and monitor the implementation of such rules.
The study highlights that the best way to reduce debt is through higher growth combined with efficient public spending and adequate public revenues raised in a way that does not sacrifice growth.
In general, countries – especially those with high levels of spending and taxes as a share of GDP – should focus on improving the efficiency of both revenue collection and spending. The quality of public investment can be enhanced at all stages of the project cycle, transfer payments should be targeted to those who really need them and monitoring of taxes improved. In countries where revenues and spending are a lower percentage of national income, enhancing the tax base and increasing public sector revenues could allow for greater public investment with beneficial impacts on growth.
Other opportunities include reforms to reduce labor informality, such as reducing the tax incentives for firms to hire informal labor and shifting the financing of benefits from labor taxes to more general taxation.
Debt management strategies
The report also finds that countries should pay close attention to debt management strategies. Efficient institutions, such well-functioning Debt Management Offices and innovative debt instruments, are vital for managing debt composition. Pre-pandemic advances in improving debt composition have stalled and countries need to actively manage amortization schedules. Over half of the countries in the region face debt service of over 2.5% of GDP, and a quarter more than 5% – a similar amount to the spending on education.
Countries should take full advantage of multilateral development banks and other official lenders providing competitive long-term financing. Besides providing lending at lower rates and longer tenors than private markets, development banks offer technical knowledge and other instruments to help countries manage risks.
The report recommends creating a regional forum to improve debt restructurings coordination. This would complement the current international efforts that have largely focused on low-income countries.
Private debt also rose before and during the pandemic. Overall, domestic banking sectors in the region have grown, and a quarter of countries have domestic credit of at least 100% of GDP. However, for another quarter, credit is less than 50% of GDP. Access remains sparse, especially for households and small and medium-sized enterprises (SMEs) and female led firms.
Estimates point to a gap of $1.8 trillion between demand and supply for funds available for SMEs in the region. Despite the availability of programs to keep credit open to firms during the pandemic, access remained a significant factor in allowing companies to survive the health crisis.
Overall levels of indebtedness of households in the region remain relatively low by international standards. Household debt in the region is 22% of GDP on average, much lower than in other emerging economies (35%) and developed countries (77%). The report provides new comprehensive data on household credit in the region. The study recommends that governments continue efforts to improve access to credit to both households and SMEs.
The report recommends that governments design interventions that are accurately targeted to those promising firms that need support but offer a wider set of instruments including equity or quasi equity so as not to add to debt burdens.