The debt-to-GDP ratio compares a country's sovereign debt to its total economic output for the year. Its output is measured by gross domestic product (GDP).
Learn how to calculate this figure and what it can tell you about a country's financial footing.
What Is the Debt-to-GDP Ratio?
The debt-to-GDP ratio is a simple way of comparing a nation's economic output (as measured by gross domestic output) to its debt levels. In other words, this ratio tells analysts how much money the country earns every year and how that compares to the money that country owes. The debt is expressed as a percentage of GDP.
How Do You Calculate the Debt-to-GDP Ratio?
The formula for debt-to-GDP is simple: you divide a nation's debt by its GDP.
How Does the Debt-to-GDP Ratio Work?
The debt-to-GDP ratio indicates how strong a country's economy is and the likelihood of paying off its debt. It's used to compare debt between countries and determine whether a country is headed for economic turmoil.
The debt-to-GDP ratio is a useful tool for investors, leaders, and economists. It allows them to gauge a country's ability to pay off its debt. A high ratio means a country isn't producing enough to pay off its debt. A low ratio means there is plenty of economic output to make the payments.
If a country were a household, GDP is like its income. Banks will give you a bigger loan if you make more money. In the same way, investors will be happy to take on a country's debt if it has a relatively higher level of economic output. Once investors begin to worry about repayment, they will perceive a higher risk of default, which means they will demand a higher interest rate for their investment. That increases the country's cost of debt. When the cost of debt gets out of hand, it can quickly become a debt crisis.
In the second quarter of 2021, the U.S. debt-to-GDP ratio was 125%. According to the Bureau of Economic Analysis second-quarter estimate, that's $28.4 trillion U.S. debt divided by the $22.7 trillion nominal GDP.
What Is the Tipping Point?
A 2013 study by the World Bank found that if the debt-to-GDP ratio exceeds 77% for an extended period, it slows economic growth. Every percentage point of debt above this level costs the country 0.017 percentage points in economic growth.
Emerging markets are even more sensitive to debt-to-GDP ratios. In these markets, each additional percentage point of debt above 64% will slow growth by 0.02 percentage points each year.
Compare Debt Between Countries
The debt-to-GDP ratio allows investors in government bonds to compare debt levels between countries. For example, Germany's public debt is many times larger than that of Greece. But Germany's 2017 GDP was $4.2 trillion, much more than Greece's $299 billion. That's why Germany, the largest country in the EU, decided to help bail out Greece. The debt-to-GDP ratio for Germany was less than 64%, while Greece's was nearly 193%.
The debt-to-GDP ratio isn't always a good predictor of whether a country will default or not.
Japan's debt-to-GDP ratio is 234%. However, Japan is in the unique situation of having most of its debt held domestically, and it holds a large number of foreign assets, and both of these facts could mean that it's less at risk of default.
The Greek debt crisis occurred because foreign governments and banks held a lot of Greece's debt. As Greece's banknotes became due, its debt was downgraded by rating agencies like Standard & Poor's, which made interest rates rise. Greece had to find a way to raise more revenue. It agreed to cut spending and raise taxes to do so. This action further slowed its economy, reducing revenue and its ability to pay down its debt.
The Debt-to-GDP Ratio Can Signal a Recession
As a country's debt-to-GDP ratio rises, it often signals that a recession is underway. A country's GDP decreases in a recession. It causes taxes (federal revenue) to decline while the government spends more to stimulate its economy. In an ideal scenario, economic stimulus spending is successful, and the recession lifts. The stimulus creates more economic activity, which increases taxes and federal revenues, which helps put the debt-to-GDP ratio back in balance.
The best determinant of investors' faith in a government's solvency is the yield on its debt. When yields are low, that means there is a lot of demand for its debt. It doesn't have to pay as high a return. The United States has been fortunate in that regard, and it can offer bonds with relatively low yields.
During the 2020 recession, investors fled to U.S. debt because it is considered an ultra-safe investment.
When the global economy improves, investors will be comfortable with higher risk because they want higher returns. Yields on U.S. debt will rise as demand falls.
Limitations of the Debt-to-GDP Ratio
To figure the debt-to-GDP ratio, you've got to know two things: the country's debt level and the country's economic output. This calculation seems pretty straightforward until you find out that debt is measured in two ways.
Many analysts, like the Central Intelligence Agency's World Factbook, only look at public debt. That is the total of all government borrowings less repayments.
The U.S. debt consists of public debt plus another category. According to the U.S. Department of the Treasury, debt held by the public consists of Treasury notes or U.S. savings bonds owned by individual investors, companies, and foreign governments. Public debt in the U.S. is also owned by pension funds, mutual funds, and local governments.
The Treasury also reports on another category called Intragovernmental Holdings. This category is not reported by the CIA World Factbook because it's debt the federal government owes to itself, not to outside lenders. However, many analysts may still find it useful for calculating U.S. debt as accurately as possible.
- The debt-to-GDP ratio is a formula that compares a country's total debt to its economic productivity.
- To get the debt-to-GDP ratio, divide a nation's debt by its gross domestic product.
- When a country has a manageable debt-to-GDP ratio, investors are more eager to invest, and it doesn't have to offer as high of yields on its bonds.