Thursday, November 09, 2006

Debt Not All Bad for Latin America

Sources: Financial Times, Virtuous Path for the Debtor; Inter-American Development Bank, Report on Economic and Social Progress in Latin America.

In a recent report, Living with Debt: How to Limit the Risks of Sovereign Finance, the Inter-American Development Bank (IDB) argues that Latin American debt is not all negative. The report cites three reasons why moderate debt levels may be helpful: (1) redistribution of wealth, (2) development, and (3) to help support private capital markets.

The IDB’s first argument for maintaining moderate debt levels rests on the assumption that future generations in the region will be wealthier than the current one. By maintaining debt now, governments can essentially redistribute income from future generations to the present because it is the future, richer generations that will be responsible for the loan repayments. The second argument for maintaining limited debt is that it helps fund important development projects. Finally, debt can also help finance policies necessary to mitigate the negative effects of business fluctuations and financial shocks.

While debt can be helpful, the report also warns against the dangers of too much debt. To keep the debt load at moderate levels, the report recommends that governments develop sustainable fiscal policies. Part of this approach includes ensuring that governments borrow for the right reasons. For example, a justifiable reason to borrow would be for infrastructure development or redistribution of wealth, as mentioned above. An inappropriate reason to borrow would be to pay the salaries of civil servants.

Furthermore, the report recommends using a combination of debt instruments. Generally, a diversity of debt instruments provides governments with the ability “to minimize vulnerability to a debt crisis and lessen the constraints imposed by debt.” In other words, by not putting all of its eggs in one basket, a country is able to better adjust to problems that may arise.

Finally, the report recommends a reformation of the international financial environment so as to make sovereign borrowing safer, including the development of new debt instruments. For example, the IDB recommends using debt instruments that are contingent on a particular aspect of the country’s economic situation. Instead of maintaining a flat payment schedule for the interest, governments could tie interest payments to their gross domestic product (GDP). When the GDP drops, so would the interest rates. Because the sustainability of a debt is often measured by the debt-to-GDP ratio, by reducing the volatility of this ratio the probability of a debt crisis may lessen.


(1) What are some of the benefits of creating new types of debt instruments such as those that are contingent upon economic conditions? What are some examples of other possible instruments?

(2) The IDB believes that the costs of development of new debt instruments can be fairly prohibitive, but that such development it must be done. Whose responsibility is it to develop new debt instruments?

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