Debt-to-GDP ratio: Key indicator of Economic Solvency

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The Debt to GDP ratio is a key indicator to gauge any country’s ability to pay off its debt. It is a ratio of country’s debt to gross domestic product (GDP). By comparing, what a country owes with country’s total productivity, debt-to-gdp ratio hints at the health of the economy and prevalent economic policies.

The Debt-to-GDP often expressed in percentage, gives the number of year an economy would need to pay off its debt. E.G. if debt-to-gdp for a given country is 90% then that country would need 90% of a year to pay off debt or if ratio is 150% then same country would need 1.5 years to pay off the debt at the given level of GDP.

Among economists, there is no specific debt-to-gdp ratio which can be considered ideal. It depends upon several factors like whether the debt has been held with local currency denomination or debt has been used for consumption or investment purpose.

If a country can continue to pay current interest level without refinancing or without any harmful impact on gdp growth then debt-to-gdp ratio can be termed as good. A high debt-to-gdp ratio would require higher amount of interest payments and moreover creditors would charge higher interest to cover the default risk.

Deciding factors of optimal level of debt-to-gdp ratio:

Though, debt-to-gdp ratio is commonly used by rating agencies while studying economy of a country but deciding on an optimal level is a difficult task.  For instance, over the last decade Japan has debt-to-gdp ratio of more than 200% and still considered to be stable economy whereas Greece has debt-to-gdp ratio of 150% considered to be unstable. Even, Pakistan has a debt-to-gdp ratio of around 67% still while comparing with Japan; Pakistan is considered to be a weaker economy. There are several factors which needs to be considered while ascertaining optimal level of debt-to-gdp ratio.

  1. Buyers of Debt: A higher debt to gdp ratio is acceptable if buyers of the debt are domestic investors like in the case of Japan 90% of the debt is held by general public. Since Debt is denominated in local currency so Japanese government has the ability to print money and pay off debt though it might lead to inflation but still better than defaulting. Where as in case of Pakistan most of the debt is in foreign currency denomination.
  2. Economic Growth: If an economy is growing rapidly then economy as whole should be able to take care of debt and even higher level of debt-to-gdp ratios are acceptable which is the case with The U.S. which has ratio more than 100%.
  3. Economic Policies: Countries with good economic policies with a clear vision of growth might be able to pay off debt and thus even higher debt-to-gdp is considered to be safe. But having no economic policy or plan to pay off debt can result in deterioration of economic health which is the case with Greece which did not have any viable plan in 2011 to pay back debt and resulted into economic degradation
  4. Debt Usage: If extra debt been taken to invest in public welfare or development of infrastructure which might result into future economic growth and eventually country should be able to pay back debt rather than for consumption, as debt used for current consumption would not yield future benefits.

Debt-to-GDP ratio origins:

  1. Unexpected Slowdown: An unexpected slowdown would result into contraction of gdp and eventually high debt to gdp ratio.
  2. Demographic Changes: An aging population adds to the burden on the social security system which is funded by government. For example, the U.S. Social Security system is partially responsible for its projected increase in public debt and the subsequent predicted rise in its debt-to-GDP ratio.
  3. Government Spending: If government spending outpace productivity of a country then it would lead to an increase in debt-to-gdp ratio
  4. Macro-Economic conditions: A macroeconomic condition like recession sometimes reduces the public spending as well as requires an increased government spending which results into high debt-to-gdp ratio.
  5. War: World politics also destabilize economy of a country

Debt-to-GDP ratio Solutions:

  1. Cut Government Spending– Governments with a high debt-to-GDP ratio can cut spending to reduce their debt burden.
  2. Encourage Growth– Central banks can encourage growth by cutting interest rates, which (in theory) leads to easier commercial lending.
  3. Increase Tax Income– Governments can increase taxes as a way to pay off debt.

Key Takeaways:

  • ·A high debt-to-GDP ratio isn’t necessarily bad, as long as the country’s economy is growing, since it’s a way to use leverage to enhance long-term growth.
  • Countries can run into problems with debt-to-GDP ratios in several ways, including unexpected slowdowns, demographic changes or excessive spending.
  • There are several ways to deal with a higher debt-to-GDP ratio, including less government spending, encouraging growth, or increasing tax income.

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