The total amount owed by the government of a country to its creditors.
The national debt is the total amount owed by the government of a country to its creditors. In addition, it refers to the total amount of debt taken on by a government from either outside creditors or the people of its own country.
A government has its own revenue and expenditures. It receives money mainly from progressive taxes, which are paid by people and businesses, known as direct taxes, and it also receives regressive taxes known as indirect taxes.
Almost every country's government works on this basic structure and follows the same principles. However, sometimes the government is short on cash. This can be because of many reasons, such as:
- Low tax collection
- High expenditure because of global inflationary pressures by the government
- Defense spending in times of war
- Emergency spending in times of contingencies
- Capital expenditure for the development of the economy, etc.
These are important expenses that the government has to make, irrespective of the revenue situation. This is when governments all across the globe start taking debt. Government debt varies according to which country is taking up the debt.
Countries are given debt with respect to their ability to pay it back.
For example- If country A has a very healthy economy and low debt and another country B has high debt and low economic growth projections because of some internal conflicts, then country A is likely to get debt at a cheaper interest rate than country B.
Also, certain loans have cheap interest rate obligations but a high level of rigidity when it comes to the usability of that debt.
For example, If a country provides debt to a small country at a very cheap rate, lower than the market rate, then such a country can impose many restrictions on how to use that money and where to use it.
Why do countries take up debt?
Countries take up debt mainly because they can get a higher return than the interest obligations which they have to pay.
What this means is that if a country takes debt at a certain interest obligation and then puts that money into its economic development and the economy grows more than what that country has to pay to its creditors as interest, the economy makes money.
This is how all major economies make money. But, of course, some countries have debt-taking ability, and some have expired that long ago.
This is known as the debt saturation point. It is when a government has lost the ability to repay its debt. If it takes up more, it will suffer a loss.
The main source of debt for governments is the bonds they issue to the public and institutional investors. That is the cheapest long-term debt a government can generally take up.
Very rarely does it happen that commercial loans taken up by the governments carry lower or equal interest rates? Governments, both at state levels and national levels need debt.
In the case of a federal form of government, a parliamentary form of government, or even a Sovereign Socialist Secular Democratic Republic, all need debt at all levels of the government to foster economic growth.
National debt only includes debt taken up by the Central Government or the Federal Government.
Causes of Debt Accumulation
Debt can be very beneficial for an economy. However, debt is a dangerous instrument, and governments can sometimes mismanage debt to such an extent that even economies collapse on themselves.
We have seen how debt can destroy economies after the financial crisis of 2008.
There may also be certain emergencies that demand more debt being taken up for the continuation of certain necessary activities like logistics and financial services.
The main causes for debt accumulation by governments are-
If ruling governments lose popularity among the people, governments tend to spend more money on what is demanded by the people to increase popularity.
When people in power are short-sighted and do not care about the future obligations of debt repayment, they take up more debt than required, and then it keeps piling up.
In case of a global shortage that drives up the prices of essential commodities, governments need to spend more to keep the economy running.
In the case of global price hikes by OPEC nations which increases the price of power and energy supplies drastically, that also increases a country's fiscal deficit. For example, countries like India and Brazil spend a major chunk of their deficit on payments for energy and power.
Taking up risk is one thing and accumulating debt is another. If a country accumulates more and more debt over time, then it can prove fatal.
Risks associated with taking on debt
Debt is a risky tool, and if not used wisely and properly, it can prove fatal. Unfortunately, governments all over the world have developed this habit of taking more and more debt as it amuses the more populist leaders and radical supporters.
Also, debt is relatively easy to finance nowadays, and less accountability is required as the public is generally unaware of the government's debt obligations.
Interest obligations can put a strain on the finances of the government. It can, over time, become a major chunk of a country's fiscal deficit. Moreover, it is very hard to control if it exceeds the sustainable levels.
Sometimes currencies lose their value because of the interest obligations, which supersede the principal repayments.
Generally, smaller nations that depend on a cyclical sector for their income source, like countries that depend on tourism, can take a big hit when the current economic cycle is not in their favor.
These nations then move towards debt, and if they are unlucky or inefficient, they get into a debt trap. This is when nations cannot repay their loans and their interest obligations, and then they sell national assets to pay off existing debt.
If governments take up too much debt and then spend all of it or eject it directly into the economy, it can create a catastrophic situation of high inflation.
Inflation is directly related to government spending and can be very detrimental to growth, which hinders the sole objective of taking up the national debt.
Suppose governments do not take up debt through external creditors but print more currency in the economy. In that case, that also increases inflation at the basic level and devalues the currency against all the other benchmarks.
Inflation with high-interest obligations is a very powerful combination as inflation decreases the value of a nation's currency and increases its debt obligations, both the principal repayment and interest, over time because of inflationary pressure.
Inflation also forces governments to take up more debt. Moreover, because of the decreasing value of the currency, the government's money parked in the domestic currency becomes less valuable and cannot be then used for public welfare activities with the same efficiency.
So to get chores done, the government needs to borrow more money, which multiplies inflation. This gap keeps growing, and the economy goes into a state of hyperinflation. E.g., Venezuela and Iran after the oil crisis and sanctions by the US.
Exchange Rate Risk
Suppose a country takes up loans in a Global Reserve Currency GRC, or it takes up a loan in any foreign currency. In that case, it cannot do away with the inflationary pressures on its currency only by repaying the loan.
Interest obligations also create new demand for that foreign currency, and because of this demand, the exchange rate of the currency in which the loan is sanctioned goes up.
This puts the domestic currency under pressure, resulting in an increase in the loaned amount in real terms for the government.
Also, suppose it keeps devaluing the currency frequently after a considerable time. In that case, the overall demand for domestic currency will fall in the free market as all that money is channeled towards the repayment of the loan in the foreign currency.
Many governments make loan payments using the GRC, which is a good way of combating exchange rate risks against the loan-sanctioning country's currency. However, it poses a problem for the domestic currency in free markets.
The common benchmark of all the common currencies used to determine the free market exchange rate of a singular currency also includes the US Dollar, the main GRC.
Doing this would devalue the domestic currency against the global benchmark, which decreases the value of the domestic currency sharply.
Credit Default Risk
A country can take debt through two main channels. First is the domestic issuing of bonds, and the other is external creditors. If a country misses out on its debt repayments on its domestic bonds, then it is not a big issue as it is a part of the money supply control under the central bank.
The government can also use many tools like printing more money or helicopter money tools which will have long-lasting impacts but would solve the issue in the short run.
In the case of external debt, if the government defaults or is going to default then it creates a global ruckus because of the supply chain issue.
Countries take up and give loans to each other very often, and regular debt transfers happen every day. Therefore, if a country is anticipating default, all the creditors would want their money back as soon as possible.
This creates a panicky situation, and these never play out well.
In these cases, the government needs to repay clients through the sale of national assets, which during times of sudden sale do not attract their market value price at the bid.
They are sold at far less than their value, and thus the economy suffers heavily.
Countries can also take up a nation's national territory for debt repayment. This is known as debt-trap diplomacy and is mainly conducted by non-democratic countries like China.
national debt: Debt to GDP Ratio
The debt to GDP ratio is nothing but a ratio tool used for representing the amount of debt taken up for each unit of GDP produced, or in other words, how much debt is required to produce a particular amount of GDP in a country.
It is a great tool for determining the economic condition of an economy. In addition, it shows the capability of a country to pay off its current debt without taking extra or more debt.
A lower debt-GDP ratio indicates that the economy is in a good position to pay off existing debts and is less likely to default on any payments while maintaining healthy GDP growth.
A higher debt-GDP ratio indicates the economy may need more debt to finance its existing debt and may also get into a debt trap. The country may be moving towards an economic disaster and is unstable to invest any additional money into it.
Countries with low GDP output and high debt are not seen as very attractive investment choices.
Countries with lower debt to GDP are preferable, but if a country is abstaining from taking any debt at all, it also raises alarms as it is missing out on the opportunity costs if it would have taken debt to foster growth.
Generally, big economies like the USA, India, Japan, etc., have higher debt-GDP ratios because they are investing heavily in their economic growth.
Implications of high debt to GDP ratio
The implications of a high Debt to GDP ratio are:
However, what is the highest ratio that a government can bear?
There is no absolute answer, and it differs according to the economy and the state in which its growth is projected in the future.
There can always be exceptions like Japan and the US. However, according to the World Bank and IMF, a country's GDP should not exceed 90% if it wants to rapidly foster economic growth.
Generally, developed economies can handle high debts, but emerging economies can get into a vicious cycle, a debt trap. As a result, emerging economies should vary how much debt they rack up and who they take loans from.
You do not want to take loans from an autocratic nation like China which can even colonize small nations economically.
Countries like Japan and the UK provide loans at a very low-interest rate, especially Japan. Its developmental loans are as low as 0.1% per annum and can go up to 1-1.5%.
- The national debt is the total amount owed by a government of the country to its creditors. It refers to the total amount of debt the government takes from outside creditors or from the common people of its own country.
- Countries take up debt mainly because they can get a higher return than the interest obligations which they have to pay.
- What this means is that if a country takes debt at a certain interest obligation and then puts that money into its economic development and the economy grows more than what that country has to pay to its creditors as interest, then the economy makes money.
- Debt can be very beneficial for an economy. However, debt is a dangerous instrument, and governments can sometimes mismanage debt to such an extent that even economies collapse on themselves.
- Debt is a risky tool, and if not used wisely and properly, it can prove fatal. Governments all over the world have developed this habit of taking more and more debt as it amuses the more populist leaders and radical supporters.
- To conclude, debt is a very useful and powerful tool as it can initiate a series of rapid growth in economies and change a nation's fate, but debt is as risky as it is powerful if not used properly. Short-term goals should never be financed with debt. Debt should only be for the long term.
- Also, while taking up huge amounts of debt, a country should determine its capabilities to pay that debt off. If they take up too much debt against their capacity for payment, they can face serious consequences, as seen in many African countries, like Djibouti and Somalia.
Everything You Need To Master DCF Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
Researched and authored by Aditya Murarka | LinkedIn
Reviewed and edited by James Fazeli-Sinaki | LinkedIn
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