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Debt, Growth, and Interest Rates: Assessing Sustainability in Latin America and the Caribbean

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Debt levels in Latin America and the Caribbean increased steadily during the last decade and soared in 2020 with the COVID-19 pandemic, reaching 72% of GDP. In response to the pandemic, countries mobilized considerable resources to support families and firms. Since 2020, debt ratios have declined as economies recovered and fiscal deficits were shaved. Still, with falling growth rates, higher interest rates and tighter financial conditions the future looks challenging to say the least.

The relationship between growth and the real interest rate is a critical factor in understanding debt dynamics and gauging how fiscal balances need to adjust to maintain debt sustainability. The interest rate-growth differential (or “r-g” in mathematical terms where r is the real interest rate and g is the real growth rate) measures the difference between the cost of credit in real terms and growth. When growth exceeds the interest rate, countries can run fiscal deficits and still keep debt ratios stable. But when growth is lower than the interest rate, countries need fiscal surpluses to prevent debt from exploding.  

Interestingly, the sharp rise in inflation after the pandemic meant that real interest rates (which are nominal interest rates minus inflation) fell. Figure 1 shows that in 2021 and 2022 growth was clearly above the level of real interest rates for most of the region’s economies, resulting in falling debt ratios despite fiscal deficits. Still, at the end of 2022, the median debt-to-GDP ratio was 60%, above IDB estimates of what constitutes a prudent level.

Looking Forward to 2023 and Beyond

Higher inflation in advanced economies prompted significant increases in global policy interest rates.  Together with banking sector stress in the US and in Europe, it may lead to depressed growth and tighter credit conditions. While China has been recovering from its zero COVID policy, its growth rates will be well below the boom years of 2002 to 2012 when it grew at an average of 10% per annum. This suggests, failing a concerted set of policies to increase growth, Latin America and the Caribbean may only grow at the rather meager estimates of potential growth (around 2.5% per annum).

The higher cost of financing may stifle the region’s growth prospects. The US 10-year bond yield surpassed 4% in 2022 after being well below 3% for most of the last decade. The yield of sovereign bonds issued in Latin America and the Caribbean reached 9% in 2022, driven by the higher global rates and a modest rise in spreads. As old debt with lower interest rates matures, it will be replaced by new liabilities at higher rates implying higher interest payments and a greater fiscal burden.

The outlook suggests real interest rates may rise above growth rates. Figure 2 shows the distribution of r-g across countries for recent years. Given the economic collapse in 2020, r-g was positive for most countries that year. As discussed, r-g then turned negative in many cases for 2021 and 2022. But by 2024 more countries (roughly half) are expected to face positive real interest – growth rate differentials.[1] Those countries will have to run fiscal surpluses in order to keep debt levels stable. On average, r-g is expected to rise by 10 percentage points of GDP from 2021 to the value that is expected in 2024.

The 2023 and 2024 curves in Figure 2 are based on the individual country projections in the IMF’s April 2023 World Economic Outlook. However, as discussed in that publication and in the IDB’s 2023 Latin American and Caribbean Macroeconomic Report, there are many potential risks.  If growth in the United States (or in Europe or China) turns out to be lower than expected; if inflation is more persistent so that interest rates have to stay higher for longer; or if the stresses in banking systems prove to have a greater impact on advanced economies than those currently forecast, growth in the region may dip. Debt ratios may also rise, and the cost of servicing that debt will increase. If any of these risks are realized the distribution of r-g would shift further to the right. That would mean that more countries would need to run fiscal surpluses to keep debt ratios stable.

Reducing Debt Ratios

Given the current context of sluggish economic growth and more costly borrowing, countries should prioritize the reduction of debt ratios. This is not an easy task, but tough times call for difficult measures. The alternative could be a low-growth, high-debt trap. Dealing with Debt, the IDB’s recent flagship report, advocates for policies that would boost growth and seek greater efficiency. There are considerable opportunities to improve efficiency in both tax and revenues systems. Those would provide for more space for high quality public investment to enhance growth. Improving fiscal institutions would help make each peso of spending count and allow for a gradual approach, keeping interest rates on public debt low during the transition to lower debt. 

Figure 1. Growth Adjusted Real Interest Rates

Note: Data for Latin America and the Caribbean excluding Venezuela. The sample excludes default and hyperinflation periods. r and g are the implicit interest rate and the implicit growth rate, respectively. See Chapter 5 of this report for further information on the methodology behind these estimations.
Source: IDB staff calculations based on data from Mauro et al. (2013) and IMF (2023).

Figure 2. Distribution of r-g (%)

Note:  Data for Latin America and the Caribbean excluding Venezuela. The sample excludes default periods, hyperinflation periods, and outliers below –15 and above 15. r and g are the implicit interest rate and the implicit growth rate, respectively. The Kernel distribution (y-axis) of r-g depicts the approximate proportion of observations that corresponds to each value of r-g on the horizontal axis.
Source: IDB staff calculations based on data from Mauro et al. (2013) and IMF (2023).

[1] The estimates are based on country-by-country projections in the IMF’s April 2023 World Economic Outlook.


Martha Elena Delgado Rojas

Martha Elena Delgado Rojas works as a consultant in macroeconomics at the IDB Research Department. She holds a bachelor’s and master’s degree in Economics from Universidad Nacional de Colombia, as well as a master’s degree in Public Administration from Columbia University in New York. Previously, she worked as Director of Macroeconomic and Sectoral Analysis at Fedesarrollo, where she conducted research on international macroeconomics, sectoral perspectives, and public policy. Martha Elena also worked as a lead economist at the Regulatory and Public Affairs Directorate of Telefónica Movistar, a senior economist at the Banking Association of Colombia (ASOBANCARIA), and as a research economist in both the Congress of the Republic of Colombia and the Research Department of the Central Bank of Colombia.

Juan M. Hernández

Juan M. Hernández is a Research Economist in the Research Department at the Inter-American Development Bank. He received his Ph.D. in Economics from the University of Pennsylvania in 2017, just before joining the IDB. He holds a B.Sc. in Economics, a B.Sc. in Mathematics and a M.Sc. in economics from the Universidad de Los Andes in Colombia. Prior to starting his Ph.D. studies in 2011 he spent 4 years as an Economist in Colombia’s Central Bank (Banco de la República). His research interests are in the fields of international finance, macroeconomics and financial frictions. Juan has been working on Sudden Stops and balance of payments crises, analyzing the role of international reserves and macroprudential policies in preventing such events. He also works on understanding the incidence of taxes and access to credit on the decision to become an entrepreneur, taking into account information asymmetries; designing optimal financial regulation and taxation policies that maximize productivity. Another topic Juan is currently studying is optimal progressive taxation in environments where informality and tax evasion diminish the revenue redistribution the tax authority can achieve.

Andrew Powell

Andrew Powell is the Principal Advisor in the Research Department (RES). He holds a Ba, MPhil. and DPhil. (PhD) from the University of Oxford. Through 1994 he dedicated himself to academia in the United Kingdom as Prize Research Fellow at Nuffield College, Oxford and Associate Professor (Lecturer) at London University and the University of Warwick. In 1995, he joined the Central Bank of Argentina and was named Chief Economist in 1996. He represented Argentina as a G20/G22 deputy and as member of three G22 working groups (on crisis resolution, financial system strengthening and transparency) in the late 1990’s. In 2001, he returned to academia, joining the Universidad Torcuato Di Tella in Buenos Aires as Professor and Director of Graduate Programs in Finance. He has been a Visiting Scholar at the World Bank, IMF and Harvard University. He joined the IDB Research Department in 2005 as Lead Research Economist and in 2008 served as Regional Economic Advisor for the Caribbean Region until returning to the Research Department as the Principal Advisor. He has published numerous academic papers in leading economic journals in areas including commodity markets, risk management, the role of multilaterals, regulation, banking and international finance. Current projects include new papers on capital flows and corporate balance sheets, on sovereign debt restructuring and on the preferred creditor status of multilateral development banks.

Oscar Valencia

Oscar Valencia es Especialista Líder en la División de Gestión Fiscal del BID y líder de la plataforma FISLAC, Sostenibilidad Fiscal para América Latina y el Caribe. Antes de unirse al BID, Oscar fue Director General de Política Macroeconómica en el Ministerio de Finanzas de Colombia. Se ha desempeñado como secretario técnico del Comité Independiente para la Regla Fiscal de Colombia y miembro de varios consejos de administración en organizaciones colombianas como Colpensiones (Sistema Público de Pensiones Definido de Colombia), Coljuegos (Regulador Nacional del Juego de Colombia), así como Director Gerente Interino de Fogafin (Fondo de Garantía de Instituciones Financieras). También fue investigador del Banco Central de Colombia y del Departamento Nacional de Planeación de Colombia. Previamente fue consultor en temas fiscales en el Departamento de Investigación del BID. Los intereses de investigación de Oscar se encuentran en los campos de la política fiscal y la macroeconomía, principalmente las economías emergentes. Ha publicado en varias revistas académicas sobre temas relacionados con la política macroeconómica. Tiene un Ph.D. en Economía con Honores y Maestría en Economía Matemática de la Escuela de Economía de Toulouse (TSE), y Licenciatura y Maestría en Economía con Honores de la Universidad Nacional de Colombia.

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