Question

Much have been said about the ratio of government debt to GDP. Some say economy
will be in real trouble if the ratio figure exceeds the threshold level (e.g. 55%). Others
do not bother about the figure as long as the government can react to its best judgement
to get the economy going.
(a) Discuss your opinions about the strength and weaknesses of having the
threshold level for the government debt to GDP ratio.
(b) Using the debt dynamics equation, debt figure and related indicators from a
country (state any country with debt issues),
(i) explain factors to be considered in addressing the high level of public
debt.
(ii) discuss how the government can ensure fiscal sustainability.

Answer 1

A.

A high debt to GDP ratio of the country has both its pros and cons.

Cons- A high debt borrowing by the governement might lead to high default risk, which will reduce growth rate of the economy. As per the study by world bank, if the country has debt exceeding 80%, they will experience economic slow growth. But the exception of Japan tells us that it's not a strong indicator of default risk.

Pros- Having a high debt ratio is desirable it the economy is able to repay its interest without refinancing or harming the economy. For example, Japan has a debt to GDP ratio of over 200% for decades but they have never defaulted on their payments.

B.

1. Public debt

In short run, public debt is efficient as government can obtain additional finance to improve economic growth. It is also safe for theforeign risk averse investors, as it's backed by government itself. And if the finances are put to good use it increases the standard of living of the economy, such as positively impacting education, jobs, infrastructure and more.

In the long run, Public debt keeps on accumulating which allows the government to invest in the economy without raising taxes. And when debt reach a critical level say 55%, more public investment demand higher interest rate as the ability of the economy to pay back the debt falls. thus investors ask for higher interest rate to lend debt.

With high default risk bond ratings are impacted and with interst rate hike on debt, it becomes expensive for a country to refinance and thus all income generated in the country are channeled towards paying debt obligations.

Which has been the cause of Sovereign debt crisis in Europe.

Greece crisis: It had 160% of debt to GDP ratio in 2012. Which led them in recession rise in umemployment of 28%, political instability and hughely hit banking system.

2.

To ensure fiscal stability an economy must maintain its confidence amongst the public and make sure to be able to pay its debt obligation with proper advanced plannings.

• Country should keep a watch on its borrowings and avoid overburdening it with debt. A continous track of debt is crucial.
• Utilising the funds efficiently to create growth and ablilty to pay the debt.
• Proper fiscal policies on tax and spending should be well though of.
• Reducing fiscal deficit as much as possible.