What is debt?
To the layman, debt is the simple act of borrowing money. To governments, however, debt is a bit more complicated than that. Governments not only possess foreign debts to other countries, but also have domestic ones. Yes, a country can owe itself, or rather its own people, money. To the layman, being in debt often means trouble and is generally unfavorable.
On the other hand, there rarely exists a country that is not in debt, no matter how “small” the amount is. To be able to make that distinction makes all the difference when it comes to large-scale investment.
What is the debt-to-GDP ratio?
To assess the economic state of a certain country, economists can not entirely rely on the amount of money it owes to foreign countries. This approach can prove to be misleading since it essentially ignores that country’s production aka Gross Domestic Product (GDP).
That’s why economists came up with the debt-to-GDP ratio as an indicator of how well a certain country’s economy is doing.
Consequently, the smaller the ratio between the debt (foreign and domestic combined) and the gross domestic product, the better. Foreign debts are generally viewed as more dangerous than their domestic opponent.
This is essentially because domestic debts are in their country’s same currency and the government can produce more currency when in need at the cost of inflation. Printing more money with little to no corresponding increase in production will increase prices.
Why is the debt-to-GDP ratio important?
In order to establish that, we still have to first establish that borrowing money is not necessarily a bad thing.
John’s monthly income is 100,000 USD. He visits a bank and issues a loan of 60,000 USD. Is he likely to meet payment deadlines? Probably.
How do we know that? His monthly income allows him to repay portions of the debt on a long term basis while investing the money elsewhere. Chances are John is not going to suffer providing for his family either since the ratio between his income and his debt is 60%.
While the debt seems big from the outside, we only get to know what it actually represents to John once we are aware of his monthly income. John can now use the money to invest in other projects.
Applying the same concept on a bigger scale, a 2 billion government debt can only be assessed in comparison to its production. This helps investors know where to invest. A country with a 0.9 debt-to-GDP ratio is probably not the place to invest no matter how seemingly small its government debt is.
How can a country owe itself money?
Domestic debt is the amount of money the government owes its people. The government collects money to spend on projects by issuing securities that promise a pay-back with interest.
A problem arises when the collected money is not saved or invested but rather entirely spent on already existing projects that don’t necessarily create revenues.
When this happens, the government prints more money to pay back its residents, but with no corresponding increase in production, the currency’s values drops and prices increase.