Debt-To-GDP Ratio, Its Formula, and How to Use It
How to Tell When a Country Has Too Much Debt
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. In the second quarter of 2020, the U.S. debt-to-GDP ratio was a record 136%. That's the $26.5 trillion U.S. debt as of June 30, 2020, divided by the $19.5 trillion nominal GDP.
The economy contracted in the first half of 2020 because of the COVID-19 pandemic. Businesses shut down and consumers sheltered-in-place, slowing consumption.
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 produces more. Once investors begin to worry about repayment, they will demand more interest rate return for the higher risk of default. That increases the country's cost of debt. It can quickly become a debt crisis.
What's the tipping point? A 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 1.7% in economic growth.
It's even worse for emerging markets. In such markets, each additional percentage point of debt above 64% will slow growth by 2% each year.
How to Use the Debt-to-GDP Ratio
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 $3.8 trillion, much more than Greece's $200.7 billion. That's why Germany, the largest country in the EU, had to bail out Greece, and not the other way around. The debt-to-GDP ratio for Germany is a comfortable 64%, while that for Greece is 182%.
So, is the debt-to-GDP ratio a good predictor of which country will default? Not always. Japan's debt-to-GDP ratio is 228%. Japan is not in danger of default, because its citizens hold most of its debt. 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 U.S. debt-to-GDP ratio is 136%. Why aren't investors concerned that it will default? Unlike Greece, the United States can simply print more dollars to pay off the debt. For this reason, the risk of default is very low. On the other hand, the debt holders wind up with money that has less value. This devaluation will eventually make them avoid U.S. debt.
As a country's debt-to-GDP ratio rises, it often signals that a recession is underway. That's because a country's GDP decreases in a recession. It causes taxes, and federal revenue, to decline at the same time the government spends more to stimulate its economy. If stimulus spending is successful, the recession will lift. Taxes and federal revenues will rise, and the debt-to-GDP ratio should level off.
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. During the Great Recession, investors fled to U.S. debt. It is considered ultra-safe.
As the global economy continues to improve, investors will be comfortable with higher risk because they want higher returns. Yields on U.S. debt will rise as demand falls. When yields are high, watch out. That means investors don't want the debt. The country must pay more interest to get them to buy its bonds.
That creates a downward spiral. High-interest rates make it more expensive for the country to borrow. The country's inability to borrow will increase its fiscal spending, creating a larger budget deficit, which creates more debt. A good example is the Greece debt crisis.
That's why the debt-to-GDP ratio, for all its faults, is still widely used. It's a good rule of thumb that indicates how strong a country's economy is, and how likely it is to use good faith to pay off its debt.
How to Calculate 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. Most analysts look at total debt. Some, like the CIA World Factbook, only look at public debt.
That can be a little misleading. In the United States, all debt is essentially owned by the public. Here's why. The U.S. Department of the Treasury has two categories. Debt held by the public consists of U.S. Treasury notes or U.S. savings bonds owned by individual investors, companies, and foreign governments. Public debt is also owned by pension funds, mutual funds, and local governments.
The other category is 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. The CIA figures if the government doesn't repay itself, so what? It's just a method of accounting between two agencies.
But it does matter a lot. The money the federal government "owes itself" is really owed mostly to the Social Security Trust Fund and federal department retirement funds. Thanks to the Baby Boomer generation, these agencies have taken in more revenue from payroll taxes than they have to pay out in benefits right now. That means they have excess cash, which they use to buy Treasurys. The government spends this excess cash on all government programs.
When the boomers retire, Social Security will cash in its Treasury holdings to pay benefits. But the cash to pay this debt will have to come from somewhere. There are fewer working-age people than boomers. As a result, the dependency ratio is worsening. The Treasury will have to issue more debt, or Congress must raise taxes.
Therefore, you should always look at the total debt, not just the debt owed to the public. That's because all federal debt is eventually owed to the public. That's why Intra-governmental holdings should be counted in the U.S. debt-to-GDP ratio.
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