Debt to GDP Ratio Formula and Calculation Explained
Debt to GDP ratio is the ratio between how much a country owes and how much it produces to pay off the debt. It’s an indicator that’s used to gauge a nation’s economic health and how well it is paying off its debts. Usually, a low debt to GDP ratio indicates a healthy economy with minimal debt.
This blog talks about the formula for debt to GDP ratio, its calculation and importance in determining a nation’s economic standpoint.
What is Debt to GDP Ratio?
The ratio between a nation’s total debts to its gross domestic product (GDP) for a particular year is its debt to GDP ratio.
For example, as of 2020, Japan’s percentage debt to GDP ratio is 266%, implying that its debt exceeds its total output. Russia, however, has a debt to GDP ratio of 17.8%, implying that its output exceeds its global debts. This means Russia has been successfully producing and selling goods and services without accumulating much debt, which is always a healthy sign.
Countries with a low debt to GDP ratio produce enough to pay off their debts. Many countries have adopted austerity measures like raising taxes and cutting off excess expenditure to avoid a high debt to GDP ratio.
How to Calculate the Debt to GDP Ratio?
Formula to Calculate Debt to GDP Ratio
The debt to GDP ratio is represented by the following formula:
Debt to GDP ratio = Total Sovereign debts / Gross Domestic Product
Higher values of this ratio indicate greater national debts with respect to its GDP and vice versa. This ratio also indicates the time required for an economy to pay off its debts.
Calculating the debt to GDP ratio involves calculating the GDP and debt figures of a nation for a particular year. Expressed as a percentage, it shows the likelihood of investors and foreign entities lending money to a nation.
Essentially an indicator of economic progress, the debt to GDP ratio collects data from the treasury and statistical departments. The National Sample Survey Office (NSSO) collects data and analyses current debt accounts to provide value for the calculation.
Let’s understand the calculation with the help of an example.
Total debt of a country: ₹11,788 billion
Total GDP of a country: ₹5,000 billion
Therefore, the Debt to GDP ratio = Total Debt / Total GDP = ₹11,788 billion / ₹5,000 billion = 2.35
Also Read: What is Debt-to-Equity (D/E) Ratio? – Formula, Benefits & Calculation?
How to Interpret the Debt to GDP Ratio?
After careful analysis of debt to GDP ratio data, the World Bank states that countries with a ratio higher than 77% are prone to economic slowdowns.
However, it does not necessarily imply that the country will declare bankruptcy or have an insolvent currency. The likelihood is less if the country has the finances to pay off its costly debts.
Greece had a debt to GDP ratio of 177% (in 2017) when its economy defaulted on a debt of around Rs. 1320 crores. In contrast, Japan’s debt-to-GDP for 2017 was 253%, yet its economy managed to survive.
Economists believe that a sustainable economy and public holding of government bonds lower interest rates, thus promoting investment.
Good vs. Bad Debt to GDP Ratios
A lower debt to GDP ratio indicates that an economy produces enough goods and services to pay off its debts.
A high debt to GDP ratio is undesirable as it deters investors, leaders and economists. It indicates that a country’s debts and GDP are not well balanced, and it might not be able to pay off its debts.
However, the effect of the debt to GDP ratio on a country’s economy depends on how the nation reacts to it.
The US economy saw a 106% debt to GDP ratio after the Second World War. However, it saw a steady decline till the 70’s when it maintained a ratio of less than 40% before it struck a historic 23% low figure in 1974. It soon started rising, and eventually, after 2007, it witnessed a massive jump owing to the housing crisis.
With globalisation, any effect on the US economy affects other nations. High default rates due to a high debt to GDP ratio tend to have global repercussions. Since governments use this ratio as an indicator for financial planning, countries with a higher value need to take austerity measures.
Measures include increasing money supply and issuing low-interest bank loans to insurance companies and investors. This might boost consumption expenditure, thereby boosting GDP. At a current public debt to GDP ratio of 89.6%, India thrives on withstanding the ill effects of national debt while simultaneously boosting its domestic industries.
Benefits of Debt to GDP Ratio
The debt to GDP ratio is an indicator of economic progress. Investors use this data before they accept government-issued bonds. Economists use this data to find patterns that call for policy changes or interventions. Following are some benefits of using the debt to GDP ratio as a measure of economic growth:
- Countries investing in foreign sovereign bonds use this ratio to identify their creditworthiness and capability to repay debts without borrowing again.
- Economists determine the incidence of a recessionary period with the debt to GDP ratio. With falling taxes, the government spends more than its revenue. Rising demand for debt is an indicator of a recession and eventual economic slowdown.
- This ratio essentially signals a potential economic disaster for policymakers to work on. This pushes governments to take immediate action and improve their solvency.
Limitations of the Debt to GDP Ratio
Despite indicating a potential economic blunder in an economy, the debt to GDP ratio may sometimes be misleading. A higher ratio does not necessarily imply that the economy is drowning with sovereign debts.
Countries like Japan have survived and sustained a high ratio despite maintaining lower interest rates and substantial consumer spending.
Again, countries like Afghanistan have a low debt to GDP ratio because of its political and economic turmoil resulting in a complete no-confidence in terms of lending.
How Does the Debt to GDP Ratio Affect Individual Investors?
Although a national statistic, the debt to GDP ratio is more deeply felt by individual investors; they believe that a 1 unit rise in this ratio (for countries with greater than 64%) would mean a 2% fall in economic growth.
This reduction in growth implies that the country cannot reach its full potential. Investors lose interest in purchasing such sovereign bonds because they worry about repayment.
Also Read: What is Debt Restructuring and How Does it Work?
Final Word
Economists consider economic indicators as a statistic that can help interpret future investment and welfare possibilities. The debt to GDP ratio of a countryis a crucial indicator that determines investors’ willingness to invest and denotes how indebted the country is.
FAQs
Ans. It measures the relative strength of a country’s power to clear off national debts without borrowing again. It is an indicator of economic progress; thus, countries with a higher ratio tend to undergo economic slowdowns.
Ans. Economists believe that a ratio of 77% is the threshold point beyond which countries experience an exponential fall in economic growth.
Ans. A nation with a high amount of external debt deters prospective lenders. Since it cannot raise any more debt, the country might fail to repay the existing external debt, which leads to debt default.
Ans. Third world countries that have high foreign debt cannot afford development because the money has to be used for repayments and is not, therefore, available for key investments, such as technological advancement and infrastructure.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
