The Risk Of High Debt VS GDP

Having access to credit, does not mean an individual, business or government is impoverished or liquidity deficient.

Individuals, businesses and governments as part of a financial strategy or financial expedient move, can opt to use credit or borrowings to undertake other worthwhile projects rather than using their own funds that may be tied up in other short term or long-term investments.

For example, if an individual, business or government has funds tied by in an investment vehicle for a specified tenor, accessing alternative means to raise funds at a cheaper cost will prove to beneficial and proper rather than liquidating your tied-up investment and forfeiting any interest or returns that might accrue.

That being said, not all borrowings or debt prove to be beneficial, one has to weigh the benefit and costs associated with the borrowings vs the investments keeping in mind the different maturities.

In this post, we will cover the following relating to economies:

Debt Crisis

Economic crises are the result of investors both domestic and international, rating agencies, and foreign financial institutions losing the trust in a debtor or borrower. This could be caused by a sharp increase in public sector debt. If trust is lost, the risk of default will be looming, creditors, traders and other financial intermediaries will start selling the public sector bonds which will trigger a downward movement of the sovereign ratings by the rating institutions. This selling leads to rising interest rates. deteriorating exchange rates, and a loss of confidence the government. Institutions like the IMF and European Central Bank may have to intervene, measures will be initiated to help curb the debt and assist in restructuring the economy, if need be, to prevent adverse effects on other economies.

The risk of high debt

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 has a relatively higher level of economic output. Once investors begin to worry about repayment, they will perceive a higher risk of default, which means they will demand a higher interest rate for their investment. That increases the country's cost of debt. When the cost of debt gets out of hand, it can quickly become a debt crisis.

A 2013 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 0.017 percentage points in economic growth.

Emerging markets are even more sensitive to debt-to-GDP ratios. In these markets, each additional percentage point of debt above 64% will slow growth by 0.02 percentage points each year.

Developing economies with weak exchange rate should be wary of piling on their stock of sovereign debt as these debts are normally denominated in foreign currencies, this takes much more of their local currency to be able to service their debts compared to if the debt servicing was denominated in their local currency.

As a country's debt-to-GDP ratio rises, it often signals that a recession is underway. A country's GDP decreases in a recession. It causes taxes (federal revenue) to decline while the government spends more to stimulate its economy. In an ideal scenario, economic stimulus spending is successful, and the recession lifts. The stimulus creates more economic activity, which increases taxes and federal revenues, which helps put the debt-to-GDP ratio back in balance.

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, and it can offer bonds with relatively low yields

Higher interest rates slow the economy because businesses borrow less and don't have the funds to expand and hire new workers, which can reduce demand. As people spend less money, businesses may lower prices which means they also make less money. When that happens, there’s the risk of layoffs. All of this could cause a recession.

But when the debt exceeds the tipping point, your standard of living could be impacted. Interest rates may increase and that could slow the economy. The stock market could react to a lack of investor confidence, which could mean lower returns on your investments. And a recession may even be possible.

High debt risk also affects your ability to raise more funds from the international financial market as it affects your sovereign credit rating and thus your creditworthiness.

In August, 2011 Standard & Poor's lowered the U.S. credit rating from AAA to AA+.5 That action caused the stock market to plummet and other consequences.

Determinants of credit worthiness

Creditworthiness is essential for any individual, business or government, once that is lost or impaired, risk of default or economic crisis is certain for nations. Creditworthiness incorporates both qualitative and quantitative measures and used to evaluate borrower’s risk of default.

Most nations issue bonds in external debt markets to raise capital or financing for their developmental projects. To be able to raise financing on these markets, countries obtain sovereign credit rating to attract Foreign Direct Investment into their countries

Having a high public sector debt may not necessarily mean a nation will be in economic crisis.

Countries like Japan and Italy may have high debts but as a result of their proper debt management strategies, ability to pay debts, debt denominated in local currency, their asset base and responsive monetary policies in economic management, they are able to experience economic growth and ward off the loss of trust.

In US and EU countries, it is also the use of their currencies, thus the US dollars and Euros in international financial markets combined with other guarantees and favorable economic aspects contribute to the trust the international financial community and creditors have on their economy.

With developing economies and as well as most economies, bad debt management practices, political and economic instabilities greatly affect their credit worthiness.

Debt to GDP Ratio

The debt-to-GDP ratio is a quantitative way of comparing a nation's economic output (as measured by gross domestic product or output) to its debt levels. In other words, this ratio is what informs analysts and governments the value of a country output every year in comparison to the money it owes. The debt is expressed as a percentage of GDP.

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.

Any two countries can have the same debt-to-GDP ratio, but not be facing same economic challenges.

A higher debt-to-GDP ratio is mostly acceptable when the buyers of the debt or creditors are either domestic investors (citizens) or repeat buyers with vested motives for buying. For instance, Japan's buyers are 90% domestic where the buyers of U.S. debt are only 60% domestic. Domestic borrowings, though may crowd out the private sector if overly used, some may argue that its more convenient as it has less impact on a countries sovereign rating. Many countries buy U.S. debt as an insurance to get access to trade.

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.

The fiscal policy argument for debt

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.

Fiscal policy is said to be tight or contractionary when government revenue exceeds its spending and loose or expansionary when spending is higher than revenue. Government budget is in surplus when revenue exceeds spending, the reverse is true. Most often, the focus is not on the level of the deficit, but on the change in the deficit over the period. Any government that reduces its deficit from $300 billion to $150 billion is said to be pursuing a contractionary fiscal policy, although the budget may be in deficit.

Fiscal policy is pursued by government whereas monetary policy is pursued by the central bank these two policies are sometimes misconstrued.

Taxation may be used in fiscal policy slow or boost economic growth whereas interest rate may be used in monetary policy to propel economic growth or stifle economic growth.

CONCLUSION

The risk of debt distress cannot always be predicted using the Debt-GDP ratio, the confidence investors and citizens have in a country’s currency as well as the economic conditions and growth prospect largely influence whether the ratio will be a fulfilling prophesy.

A comparison of Gross domestic product amongst economies may sometimes create a false believe if not compared in light of peculiar conditions in a domestic economy.