Most countries around the world rely on sovereign debt to finance their government and economy. When this debt is used in moderation, it can position an economy to grow more quickly. But too much debt can lead to a number of problems. The debt-to-GDP ratio is designed to help investors determine if a country has too much debt.
The debt-to-GDP ratio itself is an equation with a country's gross debt in the numerator and its gross domestic product (GDP) in the denominator. Therefore, a debt-to-GDP ratio of 1.0 (or 100%) means that a country's debt is equal to its gross domestic product. In general, the debt-to-GDP ratio is used to determine the health of an economy.
What's a Good Debt-to-GDP Ratio?
The debt-to-GDP ratio is a commonly used term among ratings agencies, but analyzing the ratio can be a very difficult task. For instance, consider the fact that Japan's 2011 debt-to-GDP ratio is over 200%, but its economy received very little analyst attention, while Greece's is only 160% and many ratings agencies were predicting its collapse.
The reasons for these differences vary, but can include:
- Buyers of the Debt - A higher debt-to-GDP ratio is acceptable when the buyers of the debt are either domestic investors (citizens) or repeat buyers that have a reason for buying. For instance, Japan's buyers are domestic and the U.S.'s buyer (China) purchases debt to keep a favorable trade balance with its largest consumer.
- Economic Growth - A higher debt-to-GDP ratio is acceptable when an economy is rapidly growing, because it's future earnings will be able to pay off the debt more quickly. For instance, a country projected to grow 5% next year will automatically see the ratio decline, whereas a country projected to contract will see it grow.
- Plan of Action - Countries with a viable plan to address a high debt-to-GDP ratio may receive some leniency from ratings agencies. But those without a plan often face sharp downgrades and criticism. For example, Greece in 2011 did not have a viable plan of action and faced harsh criticism from rating agencies.
Debt-to-GDP Ratio Origins & Solutions
Countries can find themselves burdened with a high debt-to-GDP ratio in many ways, from unexpected slowdowns to predictable demographic changes. Solving these problems requires one of two things that affect the basic debt-to-GDP equation (without print money outright): Cutting spending to reduce debt or encouraging growth to increase gross domestic product.
Here are some common causes of high debt-to-GDP ratios:
- Unexpected Slowdown - Countries that are growing quickly may take on more debt to support that growth, but an unexpected slowdown can result in a sharply higher debt-to-GDP ratio. For instance, Japan's stagnation after its rapid growth in the 1980s resulted in its elevated debt today.
- Demographic Changes - Aging populations can place a burden on social security systems, which may be funded in part by debt. 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.
- Government Spending - Government spending increases can lead to a higher debt-to-GDP ratio (or higher inflation) if they outpace the country's growth rates. For instance, some socialist governments that overtake capitalist predecessors tend to increase their spending and see their debt-to-GDP ratio increase.
Here are some common solutions to a high debt-to-GDP ratio:
- Cut Government Spending - Governments with a high debt-to-GDP ratio can cut spending to reduce their debt burden. However, the trick to successfully cutting spending is not to deter growth and undermine the GDP portion of the equation.
- Encourage Growth - Central banks can encourage growth by cutting interest rates, which (in theory) leads to easier commercial lending. Higher growth increases the GDP end of the equation and lowers the overall debt-to-GDP percentage.
- Increase Tax Income - Governments can increase taxes as a way to pay off debt. But again, the trick is to increase taxes in a way that does not affect GDP growth and undermine the denominator in the equation.
Key Points to Understanding Debt-to-GDP
- The debt-to-GDP ratio is an equation with a country's gross debt in the numerator and its gross domestic product (GDP) in the denominator.
- 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.