There are serious measurement issues that should be addressed facing investors in the debt of countries. The debt-to-GDP ratio itself, normally used as a proxy for the debt burden, is measured with a country's gross sovereign debt in the numerator and Gross Domestic Product (GDP) in the denominator. A debt-to-GDP ratio of 1.0 (or 100%) means that a country's debt is equal to its gross domestic product. It is used extensively by credit rating agencies. In this paper it is argued that serious measurement errors mean that official GDP data, particularly, for emerging markets is biased downwards which means measures of sovereign indebtedness is biased upwards. In consequence, an issue of enormous importance as governments’ around the world combat the economic consequences of the corona virus, debt servicing charges may be far too high and governments’ may have more fiscal space to run deficits than they previously estimated.
Unadjusted debt-to-GDP ratios are currently measured with the value of the stock of outstanding gross sovereign debt at a moment in time in the numerator and official Gross Domestic Product (GDP) data, a flow variable for the most recent year, in the denominator. A debt-to-GDP ratio of 1.0 (or 100%) means that a country's debt is equal to its gross domestic product.
The use of the debt-to-GDP ratio to determine the fiscal limits is controversial. An influential paper published in 2010 by Carmen Reinhart and Kenneth Rogoff entitled “Growth in a Time of Debt” was used extensively to justify austerity programmes to reduce sovereign indebtedness which had risen in many countries following the fiscal response to the Great Financial Crisis. The paper’s conclusion that when government debt exceeded 90 percent of GDP the rate of economic growth declines by about one percentage point annually has been widely challenged. The authors’ have since been accused of serious data errors. Furthermore, in the light of rising debt ratios, as a result of the response of governments around the world to the corona virus, the validity of target debt-to-GDP ratios has been challenged. Former IMF chief economist Oliver Blanchard has recently warned that there is no one-size-fits all “magic” debt to GDP ratio.
Nevertheless, even if there is no automatic cut-off ratio a country’s calculated debt to GDP ratio is still widely used by investors, governments, central banks and credit rating agencies in the process of pricing debt issues in primary and secondary markets. These ratios have an important influence, therefore, on the interest cost of servicing debt. In the light of the fiscal response to the pandemic estimates of how much fiscal space a government has for borrowing is now focusing on the relationship between the cost of borrowing and expected GDP growth rates.
This means that using simple unadjusted ratios will provide incorrect estimates of the fiscal space available to finance ministries to fund deficits and will lead to overly pessimistic anticipations of the probability of sovereign default. This will cause a mispricing of debt with countries paying more than is necessary in interest charges in relation to expected GDP growth rates.
Research by World Economics has demonstrated that investors and finance ministries should not use unadjusted debt to GDP ratios which are inaccurate due to severe measurement errors. There are two sources of bias in the measurement of debt, the numerator, and in the measurement of GDP, the denominator.
Debts and debt instruments range from the simple to the complex and their value is not independent of the structure of interest rates and difficult to measure factors such as levels of confidence. Measuring public sector debt is dependent on accounting policies. Too many governments account for debt on a cash basis and not on accrual basis that measures long-term assets and liabilities when they fall due. Ian Ball, Chair of the Chartered Institute of Public Finance and Accountancy has noted that the application of current best practice International Public Sector Accounting Standards (IPSAS) would lead to large revisions of national debt to GDP ratios. For example, Greece’s debt measured conventionally at 179 percent of GDP in 2016 would weigh in at only 68% if total public sector debt was calculated using IPSAS. Unfortunately, these accrual standards are not applied universally so intercountry comparisons of debt to GDP ratios are flawed and lack transparency.
Official GDP data, used in the denominator of the debt ratio, is in most cases underestimated biasing the ratio upwards. This will have an impact on the interest servicing charges paid by countries and on estimates of GDP growth rates. The quality of economic data across the world varies enormously and the World Economics Data Quality Rating (DQR) methodology has assessed the reliability by using a rating system from A to D based on problems with official data. World Economics has also identified various ways that countries can improve the quality of economic statistics, potentially increasing measured GDP which can then be used to adjust debt to GDP ratios.
World Economics research recommends first that countries devote more devote more resources to measurement. Secondly, countries should use a more recent base year for estimating GDP. Base years define the structure of an economy at the time of measurement. Out of date base years can distort GDP measurements in rapidly growing economies by under or over representing the contribution of different sectors. Third, countries should use the most up to date version of the United Nations System of National Accounts (SNA 2008) to estimate GDP. A large proportion of countries still use previous 1993 SNA and SNA 1968 standards. Finally, countries should add in estimates of the size of the informal economy and adjust GDP upwards. In many economies, particularly in emerging markets, GDP is potentially appreciably larger than is recorded in the official statistics because of a neglect of informal, illicit or illegal economic activities by national statistics organisations.
World Economics employs estimates of the size of the shadow economy for 2015 provided by the IMF which show that if these activities were fully accounted for in official figures, they could raise recorded GDP significantly. Any country with a high level of debt and a large shadow economy would find it very cost effective to improve its own data using standard survey methods, or use estimates taken from the World Economics compiled data series to augment national data when taking to ratings companies or international organisations compiling data sets used to judge debt to GDP ratios.
The impact of making these adjustments to GDP based on better quality data can have a significant impact on debt ratios and potentially on interest servicing costs and on how much fiscal space is available. For example, the top ten countries measured by population size with data quality grades B to D, excluding the United States and Japan which have A ratings, are listed in Table 1 below along with 2019 gross sovereign debt to GDP ratios as calculated by the IMF. On the basis of the World Economics model of a series of historic base year changes and the assumption that better surveys and measurement efforts by statistical agencies could raise the proportion of the informal economy accounted for, GDP uplifts are estimated and current gross debt to GDP figures are revised downwards.
The results suggest that many large countries may be paying far more to borrow money than is necessary or are facing currency pressures based on mistaken estimates of the likelihood of default. The average reduction in debt to GDP ratios across the sample of countries is 14.8% with a standard deviation of 11.2%. The full data set is available to subscribers. Among the top ten populous countries in Table 1 with DQR less than A the downward adjustment in debt ranges from 3.5% in Russia to 20.2% in Brazil.
A list of the top ten countries that would benefit the most by more accurately estimating GDP in terms of the impact of an adjustment on debt to GDP ratios is shown in Table 2. All of them are emerging markets apart from Greece and seven are in Africa. Similarly, based on the criterion of falls in the debt to GDP ratio more than one standard deviation away from the average fall from improving the measurement of GDP, a further five countries would see a substantial benefit: Cape Verde Islands, The Gambia, Sierra Leone, India and Pakistan.
World Economics recommends that countries should use these revised data in place of non-uplifted data when negotiating loans. Counting GDP more accurately could transform the economics of development and the study of the impact of debt on growth. Not only would investors no longer have to rely on faulty ratios, but with lower interest costs and more accurate growth rates, countries will have a better idea of the fiscal space available to them. This is extremely important as the world assesses the economic impact of the pandemic.