Sovereign Debt, Why It's Important, and Rankings

Sovereign debt is how much a country's government owes. It means the same thing as national debt, country debt, or government debt because the word "sovereign" also means national government. It often refers to how much the country owes to outside creditors. For that reason, it's often used interchangeably with public debt.

Sovereign debt is the sum of the government's annual deficits. Over time, it reveals how much more a government spends than it receives in revenue.

Nations finance their debt through securities, such as U.S. Treasury notes. These securities have terms up to to 30 years. The country pays interest rates to give buyers a return on their investment. If investors believe they'll be paid back, they don't demand high-interest rates. This lowers the cost of the sovereign debt. If the government seems like it will default on its debt, then investors demand a higher interest rate.

Governments can also take on loans directly from banks, private businesses, or individuals. Some also borrow from other countries.

How It's Measured

When comparing sovereign debt between countries, you've got to be very careful about what is actually included. Sovereign debt is measured differently according to who is doing the measuring and why.

For example, Standard & Poor's is a debt rating agency for businesses and investors. It only measures debt owed to commercial creditors. It doesn't measure what a government owes to other governments, the International Monetary Fund, or the World Bank. It also only measures national debt, not what is owed by states or municipalities within a country. But S&P does take into account the potential effects these obligations have on the country's ability to honor its sovereign debt.

The European Union has restrictions on the debt-to-GDP ratio a country is allowed to have. So, its measurements are roader. It includes state and local government debt, as well as future obligations owed to social security.

The U.S. debt separates public debt from intragovernmental debt, which is the debt owed by the federal government to itself. It does not include debt incurred by municipalities, states, and other non-national government bodies. Most states and cities aren't allowed to incur deficits.

How Debt Boosts Growth

Whether a government spends on social security, health care, or new fighter jets, it's pumping money into the economy. That boosts economic growth because businesses expand to meet the demand created by the spending. That usually results in new jobs, which has a multiplier effect in stimulating further demand and growth. Deficit spending is a powerful stimulant because the demand is being created now. The cost won't come due until sometime in the future.

As long as the sovereign debt remains within a reasonable level, creditors feel safe that this expanded growth means they will be repaid with interest. Government leaders keep spending because a growing economy means happy voters who will re-elect them. Basically, there is no reason for them to cut spending.

When Sovereign Debt Goes Wrong

All goes well until creditors start to doubt whether they will be repaid. These doubts start to creep in when sovereign debt reaches 77% of the country's annual economic output. For emerging market countries, the tipping point comes sooner, at the 64% debt-to-gross domestic product ratio.

Creditors first start to worry whether the country will default on the interest payments. This becomes a self-fulfilling prophecy because, as fears rise, so does the amount of interest a country must promise to pay to float new bonds. Countries must borrow at ever-more expensive rates to pay off the older, cheaper debt. If this cycle continues, the nation may be forced to default on its debt altogether.

Defaults

Debt crises have occurred for centuries, as a result of wars or recessions. In the 1980s, a wave of defaults occurred in East Europe, Africa, and Latin America. This was a result of a boom in bank lending in the 1970s. When the 1981 recession hit, interest rates rose, triggering defaults in the emerging market countries.

In the 1998 debt crisis, Russia defaulted after plummeting oil prices decimated its revenue. Russia's default led to a wave of defaults in other emerging market countries. The IMF prevented many debt defaults by providing needed capital.

Rankings 

The Good - Here are nine countries with debt that's less than 20% of their annual economic output or GDP. Some countries, like Brunei, have plenty of revenue to pay for government services. This revenue comes mostly from natural resources. They have a healthy GDP growth rate, so they don't need to boost economic growth through deficit spending. Others, like Afghanistan, still have traditional economies that rely on agriculture.

1. 0.0% — Macau
2. 0.0% — Faulkland Islands
3. 0.1% — Hong Kong
4. 2.8% — Brunei
5. 3.8% — Timor-Leste
6. 4.7% — Libya
7. 5.6% — Wallis and Futuna
8. 6.5% — New Caledonia
9. 7% — Afghanistan

The Bad - Here are 9 countries with public debt greater than their entire annual economic output. This means more than 100% of GDP. Most of them are in danger of default. Japan is the exceptions because it owes most of its debt to its citizens. They buy government bonds as a form of personal savings. During the Greek debt crisis, the EU saved the country from default.

1. 237.6% — Japan
2. 181.8% — Greece
3. 157.3% — Barbados
4. 146.8% — Lebanon
5. 131.8% — Italy
6. 131.2% — Eritrea
7. 130.8% — Republic of the Congo
8. 125.8% — Cabo Verde
9. 125.7% — Portugal

The Just Plain Ugly - These countries don't have the worst debt-to-GDP ratios, but it's causing problems for their economies. The United States has a public debt-to-GDP ratio of 122.5%.

The U.S. government borrows from the Social Security Trust Fund. It also borrows from federal retirement funds. They have been running surpluses for years. The federal government uses these surpluses to pay for operating other departments. As a result, the U.S. taxpayer is the biggest owner of the U.S. debt.

When that is included, the total U.S. debt is $29.2 trillion. This amount is larger than what any other single country owes. If the United States defaulted on its debt, it would bring the global economy to its knees. A monster debt that has any risk of default is uglier than a smaller debt with a higher likelihood of default.