Rise in Public Debt-to-GDP Ratio: How Does It Impact an Economy?

According to the World Economic Outlook Report released by IMF this week, India’s public Debt-to-GDP ratio is likely to increase to a record high of 89.3% in 2020, from 84.2% earlier in 2003.

What this means is that we are officially the third-most indebted emerging economy (after Brazil and Argentina). We are also worse off than our neighbours (Nepal, Pakistan and Bhutan).

That makes us ponder what Evsey Domar, a Russian-American economist, said in 1944: “The problem of the burden of debt is essentially a problem of achieving a growing national income.”

75 years on, is the Indian economy headed towards Mr. Domar’s premise?

Like all fun questions in life, the answer to this may be…it depends.

What is a Country’s Public Debt-To-GDP Ratio?

Quite simply, it’s the total outstanding debt owed by the government divided by the country’s GDP, usually calculated as a percentage.

Critics may say that an increasing debt-to-GDP ratio means an economy is not producing and selling enough goods and services to pay back its current debts without accumulating further debt.

(FYI: The Debt-to-GDP ratio is not the same as Deficit-to-GDP ratio. The latter is only the net fiscal loss in one year as a percentage of GDP. Net fiscal loss is a proxy for how much the government had to borrow that year to fund its expenses which weren’t covered by its revenues. Debt-to-GDP is an indicator of the total debt accumulated and outstanding to-date.)

How Do Countries Acquire Debts So High?

On a going concern, debts are taken to meet short-term fiscal targets (government expenditure, recapitalise infrastructure, minimise fiscal deficits etc.).

Sudden exigencies such as war, recession, a pandemic or economic stagnation can lead to sharp increases.

Also, let’s not forget the quest for the good old Keynesian style deficit funded growth (i.e. government spending more on infrastructure and public projects) as yet another driver.

Is There a Right Number?

A World Bank estimate says that in developing countries, each additional percentage point of debt over 64% leads to an annual slowdown of growth by 2%.

Although that is a striking assessment, there is no fixed precedent as to how an economy’s high Debt-to-GDP ratio will govern its growth trajectory.

Chart below, showing countries being all over the place, may be a case in point.

So What’s the Catch?

Now as a country’s GDP growth increases, so does its building and spending capacity, commensurately triggering a cyclical process of refinancing its expenditure through debts.

And governments generally increase borrowing to stimulate growth and increase demand. Nobel Prize-winning economist Paul Krugman argues — as long as GDP growth stays above the cost of raising debt (i.e. Interest rates), increasing one’s debt burden shouldn’t be a concern. But to ensure that GDP growth stays above, the government’s return on investment needs to stay up. Building infrastructure works. Giving handouts do not.

But the reverse argument is that after a certain point, however quickly you propel the GDP engine, will it be able to outpace a burgeoning national debt?

Yes. No. It Depends?

First, a high debt ratio isn’t automatically or inversely proportional to GDP growth. A 2010 IMF study says that the “growth-debt elasticity” (dependence of growth with respect to debt) is only -0.02%, whereas elasticity of growth with other variables is much higher. This means that if debt pulls you down by a high percentage point, it can be easily overwhelmed through a much lower percentage increase in growth-promoting variables like public spending.

Second, the most perceivable danger of fiscal insolvency that is posed by a higher Debt-to-GDP ratio isn’t existential as long as the economy has sufficient primary balance (the net budget balance of interest payments on the debt) to take further loans or withstand immediate adverse shocks, if any. So the advice is to borrow within prudential limits.

Interestingly, the Modern Monetary Theory in economics suggests that sovereigns can never go bankrupt because they can always print more currency to service debts. Two reasons why this doesn’t work:

• It’s true for domestic debts but not foreign debts, which are borrowed in different currencies (led to insolvency for many Latin American countries in the 1990s). Plus, if you borrow in foreign currencies, your debt obligation is prone to forex fluctuations which also puts a cap on borrowing limits. Hence, borrowing domestically is preferable for both repayment and fiscal considerations.
• Many sovereigns don’t control their own monetary policies (most of the EU).

Lastly, it is about your currency. Governments raising foreign debt means they’re exposed to domestic currency devaluation i.e. Their interest obligations are in say a strong USD but source of income is in a depreciating INR.

Governments raising domestic debt may take it a bit easier.

But not too much.

(Originally published October 25th 2020 in transfin.in)