Delving Further: Debt-to-GDP Ratio

The pandemic has caused a global economic crisis, declining growth rates, tumultuous financial markets accompanied by limping health care systems. With a focus on elevating health care, relief bills, and stimulus packages, countries are increasing spending sans an increase in revenue by way of taxes.  Countries are borrowing to handle the expenditure that they have to incur, for instance, the United Kingdom’s public debt has increased by £227.6bn in a year as per ONS data. Yes, countries can print more money to spend but this causes problems of its own such as hyperinflation. Increased borrowing at such uncertain times when debt repayment is unplanned, have policymakers worried about an impending debt crisis.  As with everything in economics, there is an indicator that helps to measure if a country may face a debt crisis – the Debt-to-GDP ratio.

This ratio helps put things into perspective, it compares a country’s level of debt with the nation’s GDP. This measure is usually expressed in percentage terms, as per IMF reports, India’s Debt-to-GDP ratio is 89 percent while Japan’s is 266 percent. Since it’s in nominal terms and unit free so it can be used to make comparisons between countries. However, it can’t be simply compared to understand how debt would impact the economic growth of a country. For starters, how debt is calculated across countries varies, some countries consider only what is owed by the government as debt, others also take into account the debt that is guaranteed by the government while others may include what is owed by the nation’s central bank as a part of public debt. Also, the composition of debt differs from country to country as well.

To understand the importance of the ratio, consider the economy as a huge pie and the debt, a piece of the pie. If the pie i.e. the economy grows, the debt remains the same; there is enough left for everyone. The gap between the pie and the piece of the pie is usually referred to as Fiscal Space. For policymakers, this is important, it comes in handy in these turbulent times where a country cannot afford to increase taxes but is in a dire situation to spend. A country that has adequate fiscal space can increase spending without risking a debt crisis. On the contrary, consider a country whose pie is smaller than the piece. This would mean that the government would need to utilize its entire revenue to pay the debt and it may even need to borrow more to service the debt. In such a scenario, the piece of the pie keeps getting bigger and bigger. The country is unable to invest in infrastructure, education, or essential public goods that are necessary to promote economic growth. The debt crisis that ensues is usually met with debt restructuring, debt pardons, or debt rollovers.  

To avoid such occurrences, the International Monetary Fund (IMF) in its Debt Sustainability Framework mentions an optimal debt-to-GDP ratio, and if a country were to exceed it, the consequences would be worrisome. The IMF does state that the ratio is not a rule of thumb and there are other factors to consider as well that would point towards financial prudence.

However, in recent years this ratio has been criticized for not being an accurate predictor of economic growth or the probability of a debt crisis. Japan has a really big debt-to -GDP ratio of around 220 percent. It has not witnessed a sovereign debt crisis because of the nexus between its central bank and the fiscal authorities. The government owes most of its debt to the Bank of Japan, its central bank which has the authority to wipe off the entire debt if it wants to, making Japan’s situation very unique. 

However, the ratio doesn’t paint a clear picture, for instance, a rise of this ratio does not necessarily mean that the debt of the country has increased. It could also mean that the GDP has reduced due to austerity measures undertaken by the government. Furthermore, for the level of debt to be sustainable, future governments must be able to employ the same policies as the current one. For example, suppose that a country faces an aging population such as Italy which implies that the future government’s tax revenue would be altered as more and more people would leave the labour force. Similarly, if a country discovers oil, its tax revenues from oil would rise temporarily. The future government would be unable to benefit from this increased revenue because of the exhaustive nature of oil. So, if the decision is made to borrow more today owing to the increased tax revenue it is likely that in the future the country may face a hard time paying back the debt.  

To sum up, the debt-to-GDP ratio is not the only measure that helps policymakers decide how much debt they can take on. Numerous factors can determine the amount of debt a country can take on and if it is sustainable. Nonetheless, such measures do serve to help the general public to understand the complex workings of the economy. However, other statistics could also be looked at, such as the consolidated net worth of the public sector or the tax revenues of the government, these may give a more accurate picture of a country’s finances.

Further Readings

https://www.imf.org/external/pubs/ft/fandd/2020/09/what-is-debt-sustainability-basics.htm

https://voxeu.org/debates/commentaries/there-optimal-debt-gdp-ratio

https://economictimes.indiatimes.com/news/international/business/japans-debt-mountain-how-is-it-sustainable/articleshow/76298563.cms?from=mdr