Relevance of Debt-to-GDP Ratio in Discerning an Economy’s Health

By Deepika S

Sovereign debt is the debt owed by the central government. It is issued in foreign currency in order to fund the country’s development needs. This debt can be further categorized as internal and external debt. Recession, ad-hoc spending and a quest for higher economic growth have resulted in higher levels of sovereign debt across the globe. Between the years 2002-2015, the global debt rose from 200% to almost 226% of the GDP.

Significance of debt-to-GDP Ratio

The continuous rise in debts has resulted in a new metric: debt-to-GDP ratio. It determines if the country’s sovereign debt is too high given its gross domestic product. For instance, if sovereign debt levels are too high, it might create panic among foreign investors resulting in a withdrawal of FDI or it might leave the government with the option of increasing tax rates resulting in low/stagnant economic growth. Further, it may lead creditors to seek higher interest rates when lending. These discussions have paved way for the argument that high debt-to-GDP ratios cause macroeconomic instability which is not healthy for the growth.

Reliability of debt-to-GDP Ratio

In actuality, there are many exceptions which can’t be explained using this ratio. For instance, Japan’s debt-to-GDP ratio in 2011 is over 220%, but its economy received very little analyst attention. Meanwhile, Greece’s was only 160% and many rating agencies were predicting its collapse. In addition to this, a close scrutiny of the ratios of different countries shows that the relationship between debt-to-GDP ratio and macroeconomic instability is weak.

123

dvzfz

abc

Analyzing the above graphs, we can infer that the countries with higher debt levels are highly developed and comparatively economically stable. But again, this inference doesn’t apply to all countries and has exceptions.

Reasons for Disparity

A higher debt-to-GDP ratio is acceptable when the creditors are domestic investors, when an economy is rapidly growing, and when an economy issues securities (debt denominated) in its own currency.

The ratio is mute about the interest rates associated with the debt. Let’s consider 2 countries, A& B, with similar debt-to-GDP ratios. A’s debt is due in 30 years at 5% interest rate, whereas B’s debt is due in 2 years at 20% interest rate. It is evident that B is worse off in comparison to A. They are liable to pay the same amount for a shorter duration at a higher interest rate. However, the ratio downplays the severity and shows both countries as equally well-off.

Conclusion

Overall, though debt-to-GDP is one of the important metrics to be looked at to discern the economic health of the country, there are many other metrics that must be factored in as well.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s