International Investors Should Know the Debt-to-GDP Ratio

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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. This is much like using debt to finance a business.

The debt-to-GDP ratio is a financial measurement for a country, similar to a business' debt to equity ratio. Both ratios are designed to help interested parties determine if a country has too much debt. It is a measurement of financial health.

There is no set ideal ratio for a country to have to indicate it's financial health. However, when the ratio is used with other information, it can help you develop a working concept of a country's health. This can help you decide whether a country's economy is worth investing in.

Equal Ratios, Different Circumstances

Two countries can have the same debt-to-GDP ratio, but not be facing identical outcomes. A high debt-to-GDP may not indicate an impending collapse or any other future problems. Circumstances dictate whether this ratio is a bad indicator or not.

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.

A higher debt-to-GDP ratio is acceptable when an economy is rapidly growing because its 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.

Countries with a feasible plan to address a high debt-to-GDP ratio may receive some leniency from rating agencies. But those without a plan often face sharp downgrades and criticism. Greece, in 2011, did not have a viable plan of action and faced harsh criticism from rating agencies.

Fiscal policies, along with independent monetary policies and exchanges, have an influence on whether a high debt-to-GDP is bad for a country. The U.S. and its exchanges are an example of this.

The United States' debt-to-GDP continues to rise, the exchanges continue to rise and fall, recessions are entered and recovered from, and the cycle continues. Investors in foreign countries are still investing in the U.S.

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 printing money outright).

Common Causes of High Debt-to-GDP Ratios

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.

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.

Common Solutions to High Debt-to-GDP Ratios

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 cut spending on 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.

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 or affect consumers by diminishing their purchasing power.

Key Points for the Debt-to-GDP Ratio

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. Much like equity financing for businesses, it can be a way to leverage debt to enhance long-term growth.

Countries can run into problems with debt-to-GDP ratios in several ways. Unexpected economic slowdowns, demographic changes or excessive spending will all affect this ratio.

There are several ways to deal with a higher debt-to-GDP ratio. Governments should reduce spending, and encourage growth through production and exportation, or increase tax revenues.