High debt levels are again setting off alarm bells worldwide. In developed countries, attention is focused on the rapid increase in public debt, while developing economies are struggling to service their external obligations amid slowing growth and stagnating exports.
Despite current challenges, most analysts say developed economies will avoid a full-blown crisis, owing to their ability to issue debt in their currencies and implement targeted fiscal and monetary measures. By contrast, the outlook for emerging and developing economies is bleak.
Several developing countries have already defaulted on their external obligations, triggering a slow and painful debt restructuring process and sweeping economic reforms. Many others are on the edge of a crisis. According to the World Bank, 52% of low-income countries are in or near debt distress.
Since the end of World War II, the world has witnessed numerous financial crises stemming from the unique nature of sovereign borrowing. On one hand, government debt can reflect the pursuit of potentially high-return investments that cannot be financed by domestic savings alone.
This was the case in the early 1960s when South Korea borrowed up to 10% of its GDP annually to enable productive investment. Those investments paid off handsomely, enabling the country to service its debt with ease and maintain stability despite sustained borrowing.
But borrowing can also finance unproductive expenditures, such as excessive public employment or private consumption, which generate little to no return. Consequently, debt service grows without any corresponding increase in governments' ability to sustain payments. This is rarely an issue for countries that invest in high-return projects. But when resources are misallocated, and debt-service costs mount without the means to cover them, a crisis becomes inevitable.
In such cases, international financial institutions – especially the International Monetary Fund – play a critical role in helping countries restore creditworthiness by providing financing and recommending reforms. The IMF specialises in assessing indebted countries' macroeconomic outlook, pinpointing necessary economic reforms, and steering them back towards financial stability and sustainable growth.
IMF-recommended reforms typically involve expenditure cuts alongside efforts to increase tax revenue. They often also include structural adjustments, such as modifying the exchange-rate regime and eliminating regulations that impede economic growth. Identifying the most urgent reforms is essential, as these measures often determine a country's ability to foster growth and improve living standards.
Economic policy reforms become essential when a government lacks the resources to meet future debt-servicing payments or fund the investments needed to boost income and growth. Without such reforms, heavily indebted countries risk falling back into excessive spending patterns, undermining their growth prospects and resulting in recurring crises.
Regrettably, some leaders overlook the necessity of combining debt restructuring and new financing with economic reforms. Sympathy for the impoverished populations of indebted countries and acknowledgement of their overwhelming financial burdens often lead to calls for the IMF and World Bank to provide financial support without demanding structural adjustments. When international institutions succumb to such pressures, economic gains tend to be short-lived: growth stagnates, and debt-servicing difficulties return.
These challenges are compounded by the emergence of new major creditors, especially China, and the growing role of private-sector actors in sovereign lending. In recent years, China has overtaken the World Bank as the largest lender to many low-income countries. As a result, implementing economic reforms now requires the support of China and other creditors.
The protracted negotiations between creditors whenever sovereign debt must be restructured underscores the urgent need for reforms within heavily indebted countries and in the international community's approach to resolving these countries' debt problems.
Traditional sovereign creditors, including the US and the European Union, must persuade emerging major lenders of needing a faster, more effective restructuring mechanism. Without such a framework, the world's poorest countries will remain trapped in a never-ending cycle of debt distress. ©2025 Project Syndicate
Anne O Krueger, a former World Bank chief economist, is Senior Research Professor of International Economics at the Johns Hopkins University School of Advanced International Studies and Senior Fellow at the Center for International Development at Stanford University.