Introduction to Debt to GDP Ratio
Debt to GDP ratio is defined as the ratio between total government/sovereign debts taken by a country to the total GDP of the country or the economic output for an entire year. A lower ratio of this number is always preferred as it means the economy is well balanced in terms of its total GDP when compared to debt and similarly a higher ratio may be alarming and may signal to the economy going to default.
A low debt GDP ratio is always preferable because it means a country is producing and selling goods and has sufficient ability to pay back its debt by taking any further debt. As the debt to gross domestic product ratio for a country rises the risk of the country becoming a default also rises. A study by World Bank shows that countries that have a debt to gross domestic product ratio of more than 77% for a longer period of time are expected to go through slowdowns in the growth of their economy.
Formula to Calculate Debt to GDP Ratio
The formula to calculate the debt to gross domestic product ratio is as follows:
It is defined as the ratio between total government/sovereign debts taken by a country to the total GDP of the country or the economic output for an entire year.
Examples of Debt to GDP Ratio
Let us take an example of country A whose debt is $ 3 trillion and similarly, we have another country B whose debt level is only $500 million. But when we talk about the GDP, country A has a GDP of $ 4 trillion whereas country B has a GDP of $300 million. Thus country A’s debt to GDP ratio is 75% whereas country B’s debt to GDP ratio is 166%. Thus country A is in a more favoring position with lower debt to gross domestic product ratio. A study by World Bank shows that countries that have a debt to GDP ratio of more than 77% for a longer period of time are expected to go through slowdowns in the growth of their economy. In the case of country B failing or going default, country A has the ability to bail out country B and not the vice versa.
Applications of Debt to GDP Ratio
The debt to GDP ratio is considered very helpful for investors, economists, and leaders. Countries investing in sovereign bonds of other nations take a close look at this ratio before investing in any economy. This economy actually gives a picture of how well the economy is performing and what is the chance of it becoming default and if a bailout is required. A country’s GDP is a kind of income.
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Banks and nations will invest in it or give it more loans if the production rate of the GDP of a nation is more. Once this goes down investor may worry about their debt and for fresh debt may charge a higher rate of interest which again increases the risk of a country going to default. Thus this increases the country’s cost of debt which may lead to a debt crisis. A study by World Bank shows that countries that have a debt to GDP ratio of more than 77% for a longer period of time are expected to go through slowdowns in the growth of their economy.
Every percentage point rise of this ratio will cost the country close to 1.8 % of growth in the economy. It is also a key indicator of recession. As the ratio rises it often triggers that a recessionary phase is soon approaching. This is because the GDP of a nation will decrease during a recession. This causes the tax and nation’s revenue to decline during the same phase when the government is spending more to stimulate the economy. If it works outs by the government the recession phase then ends and again tax and federal revenue will increase and thus debt to gross domestic product ratio should balance out.
Benefits of Debt to GDP Ratio
The following points can be considered as the several benefits of debt to GDP ratio:
- The debt to GDP is considered very helpful for investors, economists, and leaders. Countries investing in sovereign bonds of other nations take a close look at this ratio before investing in any economy.
- It is also a key indicator of recession. As the ratio rises it often triggers that a recessionary phase is soon approaching.
- It gives a key view of how the entire economy of a nation as a whole is performing and whether it is right for other nations to invest in it.
- Debt to gross domestic product ratio can also be considered as a measure to understand where the sovereign bonds issued by other nations are worth subscribing to.
- It is an indicator to show the chances for default a country has during a course of time.
Disadvantages of Debt to GDP Ratio
Some of the disadvantages are:
The prime disadvantage of Debt to GDP ratio is that it’s a higher number will not always mean a warning point or a bad phase. We can consider for example Japan as a country where the debt to gross domestic product ratio number was 253% in the year 2017. Now when we look at this number people might think that the country’s economy is in a bad phase and the risk of default is very high. In reality, it’s just the opposite. Japan is well placed and is in a growth phase too. This is because Japan has the ability to survive and sustain this high ratio due to the reason that most of its sovereign bond is held by the citizens of Japan itself and give at astonishingly low-interest rates.
Conclusion
Debt to GDP ratio apart from few exceptions like in countries like Japan works well for other nations to determine how well placed the economy is. It also proves to be very useful for investors, leaders, and economists to derive at a conclusion pertaining to a nation and its growth.
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