Updated July 10, 2023
Definition of Debt to GDP Ratio
The debt-to-GDP ratio represents the proportion of a country’s total government or sovereign debts to its annual economic output, measured by the GDP. A lower value of this ratio is generally desirable as it indicates a healthier balance between the country’s overall debt and economic productivity. Similarly, a higher ratio may be alarming and signal that the economy will 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 a country’s debt to gross domestic product ratio rises, the country’s default risk also rises. According to a study conducted by the World Bank, countries that maintain a debt-to-gross domestic product (GDP) ratio exceeding 77% over an extended duration are anticipated to experience economic growth deceleration.
Formula to Calculate Debt to GDP Ratio
The formula to calculate the debt-to-gross domestic product ratio is as follows:
It is the ratio between total government/sovereign debts a country takes to the country’s total GDP or the economic output for an entire year.
Examples of Debt to GDP Ratio
Let us take the example of country A, whose debt is $ 3 trillion; similarly, we have 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 is 166%. Thus, country A is more favored with a lower debt-to-gross domestic product ratio. According to a study conducted by the World Bank, countries that maintain a debt-to-GDP ratio exceeding 77% over an extended period are likely to experience economic growth deceleration. In the case of country B failing or going to default, country A has the ability to bail out country B and not vice versa.
Applications of Debt to GDP Ratio
This ratio holds significant value for investors, economists, and leaders alike, as countries exploring investment opportunities in the sovereign bonds of other nations carefully examine it. It serves as a crucial indicator of an economy’s performance, the likelihood of default, and the potential need for a bailout. A country’s GDP can be viewed as a measure of its economic income.
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, investors may worry about their debt, and 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 with a debt-to-GDP ratio of more than 77% for a longer period are expected to go through slowdowns in the growth of their economy.
Every percentage point rise in this ratio will cost the country close to 1.8 % of economic growth. 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 the 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 debt to GDP is considered very helpful for investors, economists, and leaders. Countries investing in sovereign bonds of other nations look closely 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.
- The debt to gross domestic product ratio can serve as a valuable indicator for assessing the attractiveness of subscribing to sovereign bonds issued by other countries.
- It is an indicator to show the chances of default a country has during the course of time.
Disadvantages of Debt to GDP Ratio
The prime disadvantage of the 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 strategically positioned and currently experiencing a phase of economic growth. A key contributing factor to its sustained success is its ability to maintain a high ratio of sovereign bonds, with a significant portion held by its citizens. Furthermore, these bonds are acquired at exceptionally low-interest rates.
Conclusion
The Debt to GDP ratio is a reliable indicator for assessing most nations’ economic health, except for countries like Japan. It serves as a valuable tool for investors, leaders, and economists to draw meaningful conclusions about a nation’s growth and overall economic status.
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