Economic and financial crises are often linked to high levels of
debt. In absolute terms, this is difficult to judge. So, a more common
measure used is the debt-to-gross domestic product (GDP) ratio of a
country. This helps to estimate the financial health and risk of
defaults.
How debt-to-GDP ratio is calculated
It is calculated by dividing a country’s debt with its GDP. It indicates how long the country needs to repay debt through value of goods and services it produces. Government debt is the money raised by it through bonds and other securities; through internal borrowing or from external sources. This ratio is expressed as a percentage, and usually the lower it is, the better. This is not too different from individual debt. If your existing loans (debt) as a percentage of overall income is high, any incremental loan will put pressure on repayment.
While there is no optimal level as each country has a unique position of growth and leverage, what needs to be seen is the trend of change in this ratio. If the debt-to-GDP ratio rises too fast, it signals a dangerous trend. It could mean that the pace of borrowing outstrips creation of goods and services. This lowers the ability to pay back debt, and can lead to defaults.
It’s easier to reconcile with high debt-to-GDP ratio in extraordinary times like wars or when natural disasters strike. If this is not the case, then a high ratio can indicate financial and economic crisis, which can even lead to recession if not addressed accordingly.
Financial crisis
Right from the Japanese financial crisis in 1990 to the global crisis triggered in 2008 by high levels of private debt, the debt-to-GDP ratio has been a prudent indicator. There are variations to the original concept. Along with government debt, private debt or the amount individuals and companies borrow as a percentage of GDP also makes for a good indicator of financial stress in the banking system. Banking being an integral part of any economy, a rising private debt-to-GDP ratio can be a cause of worry.
These days, red flags come up when experts talk about China’s economic growth and its debt. According to calculations published by McKinsey and Co. in 2015, China’s total debt-to-GDP ratio is around 282%, and its total debt has risen nearly four times since 2007. Even as the world is recovering from the 2008 crisis and the crash in European economies, another country grappling with high debt has resulted in further lowering of global growth estimates.
Post-2008, in many developed economies low interest rates have prevailed in an attempt to assuage the situation of high debt. But the underlying problem continues; debt levels have risen consistently.
The focus on debt-to-GDP ratio is justified, but a high ratio doesn’t indicate imminent financial doom. Governments can address the issue by increasing productivity, the ability to repay and also by limiting further accumulation of debt
How debt-to-GDP ratio is calculated
It is calculated by dividing a country’s debt with its GDP. It indicates how long the country needs to repay debt through value of goods and services it produces. Government debt is the money raised by it through bonds and other securities; through internal borrowing or from external sources. This ratio is expressed as a percentage, and usually the lower it is, the better. This is not too different from individual debt. If your existing loans (debt) as a percentage of overall income is high, any incremental loan will put pressure on repayment.
While there is no optimal level as each country has a unique position of growth and leverage, what needs to be seen is the trend of change in this ratio. If the debt-to-GDP ratio rises too fast, it signals a dangerous trend. It could mean that the pace of borrowing outstrips creation of goods and services. This lowers the ability to pay back debt, and can lead to defaults.
It’s easier to reconcile with high debt-to-GDP ratio in extraordinary times like wars or when natural disasters strike. If this is not the case, then a high ratio can indicate financial and economic crisis, which can even lead to recession if not addressed accordingly.
Financial crisis
Right from the Japanese financial crisis in 1990 to the global crisis triggered in 2008 by high levels of private debt, the debt-to-GDP ratio has been a prudent indicator. There are variations to the original concept. Along with government debt, private debt or the amount individuals and companies borrow as a percentage of GDP also makes for a good indicator of financial stress in the banking system. Banking being an integral part of any economy, a rising private debt-to-GDP ratio can be a cause of worry.
These days, red flags come up when experts talk about China’s economic growth and its debt. According to calculations published by McKinsey and Co. in 2015, China’s total debt-to-GDP ratio is around 282%, and its total debt has risen nearly four times since 2007. Even as the world is recovering from the 2008 crisis and the crash in European economies, another country grappling with high debt has resulted in further lowering of global growth estimates.
Post-2008, in many developed economies low interest rates have prevailed in an attempt to assuage the situation of high debt. But the underlying problem continues; debt levels have risen consistently.
The focus on debt-to-GDP ratio is justified, but a high ratio doesn’t indicate imminent financial doom. Governments can address the issue by increasing productivity, the ability to repay and also by limiting further accumulation of debt
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