The urgent reform of the global debt system

Around the world there is once again alarm over high levels of debt. In developed countries, attention is focused on the rapid increase in public debt; while developing economies find it difficult to meet their external obligations in a context of slowing growth and stagnant exports.

In the case of developed economies, most analysts consider that despite the difficulties they are going through, they will avoid a total crisis because they can issue debt in their own currencies and apply specific fiscal and monetary measures. In the United States, for example, the fiscal deficit exceeded 6% of GDP this year and foresees reaching 8% or more in 2025. Still, the drop in interest rates suggests that authorities are well positioned to address the issue, which did not receive much attention during the 2024 election cycle.

In contrast, the outlook for emerging and developing economies appears increasingly bleak. In 2023, developing countries spent 1.2% of their gross national income on interest payments; Meanwhile, debt service amounted to almost 6% of export income of countries eligible to receive aid from the International Development Association. Latest World Bank report on international debt warns that low-income countries face a “solvency crisis that is metastasizing.”

Several developing countries, including Zambia and Sri Lanka, have already defaulted on their external obligations, triggering a slow and painful process of debt restructuring and broad economic reforms. Many others are on the brink of a crisis: in Mozambique, for example, interest payments reached 38% of export income. According to the World Bank, the 52% of low-income countries are in or close to critical debt distress.

Since the end of World War II, the world has witnessed numerous financial crises arising from the particular nature of sovereign debt. On the one hand, a government can go into debt to make investments with high profitable potential that cannot be financed by appealing solely to domestic savings. This is what happened in the early 1960s when South Korea borrowed up to 10% of its GDP each year to make productive investments possible. These gave excellent results, and the country was able to meet debt payments with ease and maintain stability, despite sustained indebtedness.

But it is also possible to go into debt to finance unproductive expenditure, for example excessive levels of public employment or private consumption, which generate little or no return. When this is the case, debt payments grow without a corresponding increase in the ability of governments to sustain them. This problem does not usually affect countries that invest in high-profit projects. But when resources are misallocated and debt service costs increase without the means to cover them, a crisis becomes inevitable.

In these cases, international financial institutions (particularly the International Monetary Fund) play a key role, helping countries restore solvency through financing and reform recommendations. The IMF specializes in evaluating the macroeconomic prospects of indebted countries, identifying necessary economic reforms, and directing them toward financial stability and sustainable growth.

The reforms recommended by the IMF usually involve spending cuts (limits on future pension increases, reductions in salaries for public employees, and reductions in certain investments) along with efforts to increase tax collection. It is also common for them to include structural adjustments, for example modifications to the exchange rate regime and elimination of internal price controls and regulations that impede economic growth. It is essential to identify the most urgent reforms, as these measures often determine a country’s ability to encourage growth and improve living standards.

Economic policy reforms take on special importance when the government lacks resources to meet future debt payments or finance investments needed to strengthen incomes and growth. Without such reforms, highly indebted countries risk falling back into excessive spending patterns that will worsen their growth prospects and lead to recurrent crises.

Unfortunately, many well-meaning leaders and officials overlook the need for debt restructuring and new financing to be accompanied by economic reforms. Often, compassion for the impoverished populations of indebted countries and the recognition that the financial burden they face is excessive leads to calls for the IMF and the World Bank to provide financial assistance without demanding structural adjustments. When international institutions give in to these pressures, economic improvements tend to be short-lived: growth stagnates and debt repayment difficulties return.

These challenges are compounded by the emergence of new major creditors (notably China) and the growing involvement of private actors in the provision of sovereign loans. In recent years, China has overtaken the World Bank as the largest lender to many low-income countries. So economic reforms now need the support of China and other creditors.

The long discussions between creditors that occur every time a sovereign debt must be restructured highlight the urgent need for reforms, not only in countries with debt problems, but also in the mechanisms used by the international community to try to resolve them. The economies of Sri Lanka and Zambia were paralyzed for years as creditors, including international financial institutions, struggled to reach restructuring deals.

Traditional sovereign creditors (including the United States and the European Union) must persuade the new large lenders that a faster and more effective restructuring mechanism is necessary, without which the world’s poorest countries will remain trapped in an endless cycle of overindebtedness.

Copyright: Project Syndicate, 2025.
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