The Rise in Debt
Total debt in Latin America and the Caribbean has risen to 5.8 trillion US dollars from under 3 trillion in 2008, or to 117% from around 60% of GDP. Total debt in the five largest economies is around 140% of GDP. While this is lower than in many advanced economies, emerging economies face higher interest rates, greater risks and a larger drag on growth from higher debt levels.
Public debt had grown before the pandemic and then soared to 72% of GDP, with the exceptional fiscal programs to support families and firms through the crisis. Reducing public debt would bring many advantages. It would lower interest payments, reduce risk and interest rates, provide space for greater public investment and allow the region to respond to future negative shocks.
The benefits of bringing down public debt further
Countries in the region are already reducing deficits. Baseline projections indicate debt ratios should fall gradually to around 62% by 2032, but there are many risks to that scenario. New COVID-19 variants could emerge, energy and commodity prices may rise further, tougher supply constraints could reemerge and interest rates may rise beyond market expectations.
The IDB’s 2022 flagship report “Dealing with Debt” argues that fiscal consolidation should be swifter. The region should not just target sustainability but bring debt down to a prudent level that would reduce risks further.
It seems odd to suggest lowering public debt would bring advantages. Isn’t debt reduction going to reduce growth? Not necessarily. It would be great to reduce debt-to-GDP ratios through higher growth. So growth enhancing reforms such as boosting investment, especially for infrastructure that crowds in economic activity would be the ideal response. But that reveals a type of Catch-22, as public finance are tight in part due to high interest payments on the debt. Still if debt can be reduced and high-quality public investment increased that could be a win-win. How can that be achieved?
Previous work at the IDB suggested that countries could save over 4% of GDP on average just by making sure wasteful spending was eliminated and each peso was spent on people who really needed it. Consumption will rise if spending is better targeted to poorer households, as by definition, they will spend a larger proportion of those resources. And with the higher spending levels of today that 4% is likely an underestimate. In addition, these figures do not take into account potential efficiency gains from changes to tax systems.
An additional fiscal effort of about 1.4% of GDP, which is about one and a half times the average fiscal reform, is required to achieve prudent debt levels of around 52% over the next years. Policy packages could increase efficiency and be progressive, helping those that really need assistance. The right way to boost growth and improve fiscal balances depends critically on individual country factors.
Improving fiscal institutions would be complementary and provide tremendous help. We found that the drag high debt has on growth declines with better institutions, and they also improve the growth performance of increasing debt at low debt levels.
The region has relied on discretionary fiscal policies to provide support in bad times. But programs have been inefficient and difficult to remove when growth was strong, and the region has been more expansionary than countercyclical. Reducing informality, enhancing automatic stabilizers, introducing fiscal councils and striving to provide credible medium-term fiscal guidance could bring down interest rates. Such measures could help manage the high levels of debt, assist the gradual transition to lower debt levels and reduce the likelihood of unnecessary debt spikes in the future.
Implementing high quality fiscal rules would be a good start. Less than half of the countries in the region had a fiscal rule before the pandemic. As countries that did have fiscal rules strive to comply once again, there is a great opportunity to improve the quality of those frameworks. Improving public investment frameworks would also assist in boosting growth with whatever public investment is feasible.
Debt composition is as important as the level of debt. Many countries established well-staffed debt management units with some independence to seek medium-term targets, and both currency composition and debt maturities improved. But those advances stalled even before the pandemic, and dollar debt and short-term debt have been on the increase. Amortization schedules reveal sizeable concentrations of maturities and ample space to smooth debt profiles.
International financial institutions can assist countries manage debt as well as assets. Multilateral development banks can offer long-term loans at low rates. They have become more flexible, able to lend to some countries in local currency, and to offer interest rate swaps and commodity and disaster-linked instruments to manage risks. Countries should take full advantage of what is on offer.
Several successful debt reductions have been a mix of higher growth and fiscal effort. Brazil, Colombia, Jamaica, Peru and Trinidad and Tobago all provide interesting examples of debt reductions of between 15% and 50% of GDP.
But inflation has actually been the most frequent driver of reductions in debt. Still, innovative analysis reveals that the successful inflation episodes to reduce debt ratios are not accompanied by very high inflation. Instead, they tend to feature moderate inflation and independent central banks that can keep expectations anchored, to keep real interest rates low. Countries should maintain credible monetary frameworks and ensure inflation remains under control to reap the rewards in terms of both price stability and debt sustainability.
But in some cases, debt has become unsustainable. Five countries in the region have already restructured. The region has been at the forefront of innovations in debt restructuring since the 1980’s. But many unresolved issues remain. These include the controversial use of new generation, collective action clauses (that assist countries coordinate a change in the terms of bonded debt), the increase in lending from China’s official banks and other players, and whether and how to best link debt and climate challenges. The IDB flagship recommends that a regional forum focus on Latin America and the Caribbean to complement international efforts that have largely focused on low-income cases.
Private Debt Challenges are Varied
Private debt has also risen, but its important to distinguish between different elements of the private sector. A new database shows that while it has risen, formal household debt remains relatively low. While some households have contracted relatively high credit card or bank loans that may indeed be a concern, this is unlikely to constitute a systemic problem, either threatening growth or overall financial stability. Central banks and consumer protection agencies should continue to monitor the progress as families’ access to credit improves.
Around 23% of small- and medium-sized enterprises (SME’s) still identify credit access as a major constraint. New analysis also finds that having access to credit was a critical factor for SME survival through the crisis. Credit access is then still only partial to say the least. Better access would help promising SMEs grow and survive through negative shocks.
Larger, listed firms are in a quite different position. In general, they have good access to credit. They borrowed significantly before the pandemic and debt-to-asset ratios in Latin America and the Caribbean were among the highest in the world. During the pandemic, these firms borrowed more but investment dwindled. In the process, they built a significant chest of liquidity to survive through the crisis. Now debt levels have fallen back to the relatively high pre-pandemic levels, and due to the lack of investment fixed assets (generally thought of as firms’ productive capital stock) have fallen. The question is whether firms are in a position to rebuild their capital. Unfortunately, the combination of debt ratios and higher market volatility may provoke an overhang on investment and a further drag on growth.
Countries are now phasing out large-scale guarantee programs that assisted firms in obtaining loans through the pandemic. These programs served a useful purpose and likely help explain the relatively low numbers of firm closures. But in this new phase, programs need to be more selective, aimed at firms that have healthy prospects but really need assistance. At the same time, assisting firms contract more debt may not be the best approach: A wider set of financial instruments should be on offer including equity-like injections. If handled correctly, such investments should be profitable, but the key is good governance. Programs should promote improvements in corporate governance and be free of political interference.
To conclude, policy makers may wish to focus on the following five key elements. First, find the right policy mix to bring public debt levels down. Second, improve fiscal institutions. Third, improve debt composition. Fourth, assist those firms that really need help and consider a wider set of instruments and fifth, consider developing a regional forum to discuss issues related to debt restructuring, and debt and climate challenges.