The Debt To GDP Ratio – A Matter of Currency Baseline & Context
We just have a quick question here asking us how we can use something like the debt-to-GDP ratio in our analysis and our training.
So, first of all, thanks for the question So, taking a quick look at what the dept-to-GDP ratio basically is, it’s just a comparison of a countries debt in relation to what it produces, so it’s a very quick and simple way of evaluating whether the country will be able to service its debts by comparing that to what the country actually produces in terms of GDP’s.
So, how we use it from a macro fundamental basis is basically analyzing whether a country’s external debt it owes the rest of the world is basically too high for them to pay it back, which obviously raises the likelihood of defaulting on its debts. So, when looking at the actual number, if we see a country has a, let’s just take an example of a debt-to-GDP ratio of let’s take 100 percent right, it means that the total debt that the country owes is equal to the countries GDP.
So, in that very general sense, it would seem that any nation that has a ratio higher than 100 percent is at risk, you know, but that’s not really the case, it’s not a very uncommon thing for major economies to have a budget deficit to run above 100 percent and it’s not always considered as a bad thing.
For example, take a country like Japan, on this list we can see at the top of the list, sitting at 238 percent of GDP. Now you would think wow, that is really really bad, but the country, in terms of default rating, is still deemed as stable, and the main reason for that is because most, if not all of Japan’s debt, is owned by the central bank and by the domestic financial system.
So this means they don’t have any real risk of external debt to the rest of the world, and that also means that using something like debt-to-GDP ratio as a means of deciding which country is better or not in terms of their fundamentals isn’t really the most accurate way of going about it.
But where it does become more useful is when countries that are considered as unstable already, or countries that already have a very high default risk and debt-to-GDP ratio. If they suddenly go into a massive recession and there’s a massive downturn and all of their debt is externally owned, that suddenly causes a big concern for that country because they need to borrow more money in order to service their debts or they need to get a bail out from somewhere.
Now in a recent example of this is if we just quickly take a look at Europe, we know that debt-to-GDP in countries like Italy as well as Spain as well as Greece is a real real big concern and they, at this stage, they need funding in order to combat the downturn that they’re facing by Covid-19, but they already have a very high debt-to-GDP ratio.
So, if they borrow more money, they will increase the ratio which will obviously increase the default risk. That they have which, in turn, causes investors to lose interest in buying their bonds which, in turn, causes further distress because they can’t raise money, or enough money, by selling their government bonds.
So, the only way that they can really get investors to buy their bonds is by increasing the yield for those bonds.
But again, if they increase the yields for the bonds… It also means that they have to pay back all of those loans at much higher prices which, again, then just further exacerbates that negative cycle so, when we know the market is focused on debt-to-GDP for a specific country and something happens that exacerbates those fears, that is more useful from a trading point of view then just using it as a basic hit list if you want, as a rating for the country.
So, always make sure that when you look at something like dept-to-GDP, to make sure that it is something that the markets are focused on and know why it is a concern for them, and obviously then you can trade that accordingly.