Over the past three years, the global economy has faced several unexpected challenges. Emerging markets and developing economies are not only striving to revive their growth and achieve a full recovery but are also grappling with increasing debt levels and various policy concerns.
According to the IMF’s recent staff discussion note, regulatory adjustments and market reforms can alleviate this challenge. These reforms include reducing barriers to entry in utility markets, establishing robust financial supervision and regulatory frameworks, and easing restrictions on foreign exchange transactions and cross-border capital flows.
As per the IMF, significant regulatory changes can lead to a notable reduction of around 3 percentage points in the debt-to-GDP ratio. This reduction occurs not only by boosting GDP but also by improving public finances through increased tax revenues and reduced borrowing costs.
Traditionally, the first step in managing debt is either reducing new borrowing through fiscal consolidation or restructuring existing debt. However, an alternative approach is to decrease the debt-to-GDP ratio by enhancing economic output. This can be achieved through improved market functioning, as demonstrated by IMF research in 2016 and 2019.
The IMF Structural Reform Database, covering 90 economies over four decades, evaluates market performance in areas such as trade, domestic finance, external finance, product markets, and labor markets. Given the significant disparity in market efficiency between advanced and developing economies, governments in developing nations have substantial room to employ market reforms as a policy tool to stimulate growth and alleviate debt burdens. Implementing regulatory changes that enhance market efficiency, such as fostering competition and establishing appropriate regulatory frameworks, can stimulate economic output.
Research reveals that enhanced market functioning not only reduces the debt ratio by increasing economic output but also leads to improved fiscal outcomes and reduced new borrowing. Nevertheless, some market-oriented policies, like reducing trade barriers, may initially decrease tax revenue and potentially increase debt. However, these effects could be offset in the long run by increased economic activity.
The benefits of reforms materialize through higher tax revenues and narrower sovereign debt spreads. The increase in tax revenues can be attributed to the positive impact of improved economic activity, compensating for the initial revenue losses caused by reforms. Lower borrowing costs reflect improved investor confidence following the reforms.
However, the effectiveness of reforms varies depending on factors such as the government’s ability to collect taxes, initial debt levels, and the timing of reform implementation during economic expansions. While reforms generally contribute to debt reduction, their impact may differ in various circumstances.
One obstacle to reaping the full benefits of reforms is increased government spending. Historically, developing countries have allocated some of the fiscal gains from reforms to fund other policy initiatives. Political dynamics during the implementation phase have also constrained fiscal gains. Therefore, prudent spending is crucial for reforms to successfully reduce debt ratios.
Ensuring that reforms enhance debt sustainability requires careful consideration of initial debt burdens, potential inequality effects, and improving tax collection efficiency. Investment in digital infrastructure can strengthen revenue mobilization and spending efficiency. Reforms are crucial for improving market functionality and fostering long-term growth, offering emerging markets and developing economies a valuable tool for balancing growth and debt stabilization.