Latin American and Caribbean governments should take advantage of benign conditions prevailing in global markets to adopt safer strategies to manage public sector debt and reduce their vulnerability to financial crises, according to a new report released today by the Inter-American Development Bank.
The book-length study entitled Living with Debt: How to Limit the Risks of Sovereign Debt notes that while Latin American debt-to-GDP ratios are not higher than in other regions and spreads of emerging market bonds have reached record low levels in recent months, “caution is still in order.”
“The current relatively benign global environment is partly due to better policies and safer debt management, but it heightens the risk that the international community will become complacent and needed initiatives will be postponed,” says the report. “Tranquil times are the best for discussing and introducing new initiatives aimed at reducing the vulnerabilities that still lurk in the global financial system.”
Among steps sovereign borrowers could take to address the risk of a sudden stop in capital inflows, the report recommends countries to continue to shift their debt structures away from foreign currency-denominated debt and into debt denominated in their own currencies.
Countries should develop sound domestic bond markets based on a core of institutional investors, such as private pension funds, and consider using contingent foreign currency debt as a mechanism of insurance against adverse shocks caused by recessions, commodity price collapses or natural disasters.
Strong fiscal rules and stabilization funds can help build confidence and credibility at the same time as they control deficits and establish limits on debt issuance, the report added.
Living with Debt: How to Limit the Risks of Sovereign Debt is the latest edition of the IDB’s flagship annual study, the Report on Economic and Social Progress, know by the Spanish acronym IPES.
The report also discusses the role international financial institutions could play in improving crisis prevention, such as establishing fast-disbursing liquidity facilities or supporting developing countries’ arrangements to pool their foreign currency reserves.
International financial institutions could also promote the development of markets for contingent and local currency financial instruments by including these features in their own bonds and in their loans to member countries.
The report’s authors acknowledged they are proposing a broad agenda that may not win universal support on every single aspect. But they emphasized that the risks of inaction are higher than the risks of adopting a reform initiative that is too ambitious.
The background research for the report focused on the development of domestic bond markets in six Latin American and Caribbean countries. The work was conducted and financed through an IDB-sponsored network of research centers in Latin America. Other background papers were produced in the United States and France.