A debt-to-GDP ratio measures a nation's total debt from loans and borrowed funds against its gross national product (GDP). GDP typically represents the market values of all goods and services a nation produces. Under Say’s law, real GDP growth will equal the real income necessary to support this GDP amount. The debt-to-GDP ratio is therefore similar to a company’s debt-to-income ratio that supports the company’s ability to repay its debt. The GDP debt ratio is similar as it presents a nation’s ability to repay all borrowed funds.
Many nations use borrowed funds to help offset the cost of creating infrastructure and further development; this represents one crucial piece of the debt-to-GDP ratio. The most common way for a government to borrow money is by issuing bonds, just like a large organization would do. The nation finds willing investors — be they individuals, companies, or other nations — to purchase bonds at specified interest rates and prices. Other times, borrowed funds can be actual loans from other nations or a central bank. This provides the external funds necessary to meet development needs when tax revenues are insufficient.
Like all borrowers, a nation must repay its bills or risk default with those individuals who purchased bonds or lent money. GDP is the primary way a government can measure its ability to repay debt. Tax revenues typically come from the many different activities that occur in the private sector. Therefore, a portion of GDP will go to the government so the nation can cover current operating costs and debt repayment. Hence, the second factor that makes up the debt-to-GDP ratio.
Problems occur when a nation continues to borrow funds and total national debt becomes a larger portion of GDP. With more funds required for debt repayment, less money is available to pay current operating costs. A government may also begin overtaxing the private sector, which is the primary source for government tax revenues. Increased taxes typically retard the natural growth that occurs in the private sector. Therefore, debt will stay steady or slowly increase as fewer funds come from taxes, creating a vicious cycle of borrowing and spending.
The debt-to-GDP ratio is also a crucial solvency measure in a nation. When a nation’s debt is higher than its GDP, it could be said that the nation is slowly becoming insolvent. In short, it no longer has the income to pay all its bills, including debt. Proper debt management is necessary to prevent this from happening. Reduced spending and reductions in debt use are common measures to prevent this problem.