Tuesday, April 3, 2012

Economic Indicators : Debt/GDP Ratio

Ratio of Debt to GDP is one of the imp factors from economic point of view, used to gauge the economic health of the country. Usually countries strive to have this ratio as low as possible so as to avert such financial and unexpected circumstances.
To start with , lets understand the concept of  GDP   -In a simple way, it’s summing up what all the people earned OR spent over a definite period of time .Logically; both the measures should arrive at the same conclusion.
Alternative Definition is: Gross domestic product (GDP) refers to the market value of all final goods and services produced in a country in a given period.
There are multiple ways of calculating this GDP. For details on how to calculate, click here

Next, what is Government Debt?
Debt, as we know is the amount we borrow from someone to meet our needs. But why does Govt. need Debt? To answer this, let’s see the Expenditure and the sources of Income for a government.
Sources of Income (A):  Income from all kinds of taxes collected by the Govt. at Local, State and Central level like Tax, Corporation, Excise duties , Wealth tax, Estate Duties so and so forth .  Non Tax revenues include net contribution from the public sector undertakings like Railways, Posts and Telegraphs, Currency and Mint etc.
Sources of Expenditure (B):   Government requires money for financing tis own projects like roadways, infrastructure, pension schemes, etc.
So the difference (B-A) is the amount Govt. needs to borrow, which can be described as debt. For that, Government borrows money through internal or external means, by issuing treasuries, bills, bonds.  These in turn become liabilities for the government, since they have to pay interest and repay this amount as and when the loan period matures.
What I would like to highlight here is that things are much more complicated. It’s not like taking a home loan, and repay it with an EMI every month.  Lots of planning and analysis is required in calculating how much funds are required, how to circulate these funds... because National debt goes into billions of dollars... in some case trillion dollars also. Usually such are planned keeping in mind, a horizon of about 5- 20 years.
But how does this Debt/GDP ratio help us in analyzing the economy?
The debt-to-GDP measure is simply a percentage number using total debt outstanding as the numerator and GDP as the denominator.  GDP is used as a measure of the government’s ability to pay since a government’s income is taxes. As defined earlier, GDP measures the total value of the economy. A Govt. cannot collect tax of   $1 Billion from an economy of $500 Million but surely from an economy of $10 trillion. The higher GDP is, the more it is assumed the government has an ability to collect taxes and pay the interest.  Thus when the ratio is higher, it indicates that a lot of debt is outstanding and that implies (but only implies, not requires) a lot in interest payments.  So, it is assumed by many that a higher debt-to-GDP ratio means interest payments are likely a greater burden and thus the chance of eventual default higher.
Using a debt-to-GDP ratio carries two major advantages over just using amounts of debt.  First, it allows us to compare two different countries regardless of their size. For example, big economy like France having 83.5% as debt/GDP ratio while that of while Iceland has around 123%. In terms of absolute debt, Frances burden might be higher but so is its ability to pay back.  Iceland's overall debt is very less than that of France but still very big compared to the size of its economy, it’s very high.When we are comparing 2 economies on the basis of this ratio , we do not  take into account the repayment capability of the nations, their political stability , the efficiency f the economic and fiscal policies.  So this ratio can be an indicator to compare 2 economies of diff size along with certain factors mentioned above.
Secondly, since the value of the currency under consideration keeps fluctuating is it Rupee, Dollar, Yen, to analyze the actual debt of an economy over a period of time does not give accurate results. In such cases, the Ratio can provide a clearer. Have a look at the following diagrams of US economy for the past 50 years.
From figure 1, we can see that the curve of the GDP and the total Outstanding Debt is almost similar. But no conclusions can be drawn from this diagram about the health of the economy.
While figure 2 represents the Debt/GDP ratio. We can see that during the time of Second World War, the Debt of the US has increased greatly compared to its economic growth. Also during the end of the last decade, 2008-2010, we see that the debt factor is rising due to the Financial Crisis of 2008.

Comparison of US Debt and GDP of last 50 years

What happens when we compare the Debt GDP Ratio with Per Capita Income ?
In the figure given below, I have mapped the Debt/GDP ratio of 128 countries to its Per Capita Income as of 2010.  In the Graph, the Debt/GDP ratio is sorted in decreasing order and then the corresponding Incomes are plotted.
Per Capita Income :   the gross domestic product at purchasing power parity(PPP) of countries per capita, i.e, the value of all final goods and services produced within a country in a given year divided by the average (or mid-year) population for the same year.
I have compared the Debt/GDP ratio with Per Capita Income rather than GDP because Per Capita provides a better picture of the economy. The size of the economy (GDP) may be big , but whether  is it big enough to provide its population enough purchasing power can be understood by comparing the Per Capita Incomes at PPP so that amount of good and services are brought on the same scale.

1.)   The Debt ratio is greater than 75: From the graph above and referring to the Table 1, we can see that the cluster with high Debt ratio contains high levels of Per Capita Income. Developed nations like Japan and USA can afford to take more loans from the market because of the backing of the strong economy and Political system. Countries like Japan, UK, Singapore, Iceland, Austria, Netherland fall in this cluster.In the graph above, there are 3 different zones highlighted.
2.)   The Debt ratio is between 40 and 75: The average Per Capita Income of this cluster is almost equal to the overall average. Countries in this cluster are mostly the developing nations like India whose economy is growing but obviously is not as stable and strong as the developed nations. As a result, to extend their debt beyond this belt would require borrowing on higher interest rates, resulting in higher payments, eventually increasing the burden on the economy.
3.)   The Debt ratio is below 40:  The Average of this cluster is around 12% less than the overall average, hence representing the cluster of, mostly .and not all. Underdeveloped nations. Countries having economic in stability who are unable to have steady GDP growth find it difficult to have the debt burden since the chances of getting default in such cases are very high . As a result, they do not have very high debt ratios which again slow the growth since the Inflow of funds is less.

The inferences derived above from the graph represent the general trend with respect to the Debt/GDP ratio. We cannot conclude anything solely on the basis of the ratio alone .From the graph itself we can see the amount of uncertainties i.e. The entries which do not  fall in the highlighted zones of their respective categories. We cannot conclude that any country with high Debt/GDP ratio is surely a developed nation or has high Income .  For e.g.: Japan has 225.8% Debt/GDP ratio but its per capita income is $34,013 while that of Zimbabwe is 149% and $434 respectively. Other example is Qatar with 10.3% Ratio and $ 88559 Income while that of Uzbekistan is 9 % and $ 3039 respectively.
Hence, Debt/GDP ratio is an economic indicator used to indicate how much debt one owns relative to its capacity. . But this ratio combined with other economic indicator can give us clearer picture.

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