The Growing Importance of Sovereign Debt

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, which is why it is often used interchangeably with public debt.

Sovereign debt is an accumulation of a government's annual deficits. Therefore it shows how much more a government spends than it receives in revenue over time.

Governments usually finance their debt through bonds, such as U.S. Treasury notes. These bonds have terms from three months to 30 years. The government pays interest rates to give bond buyers a return on their investment. The more likely it is the bond will be repaid, the lower the interest rate paid -- and the lower the cost of the sovereign debt. Governments can also take on loans directly from banks, private businesses/individuals or other countries.

When comparing sovereign debt between countries, you've got to be very careful what is actually included. That's because 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. Therefore, it only measures debt owed to commercial creditors. It doesn't measure what a government owes to other governments, the IMF, or the World Bank. It also only measures national debt, not what is owed by states or municipalities within a country. However, S&P does takes into account the potential effect these obligations have on the country's ability to honor its sovereign debt.

The European Union has restrictions on how much total debt a country is allowed to have to stay in the euro zone. Therefore, its measurements are broader, and includes state and local government debt, as well as future obligations owed to social security. (Source: Eurostat, Statistics Explained)

The U.S. debt separates public debt from debt owed by the Federal government to itself, known as intragovernmental debt. It does not include debt incurred by municipalities, states and other non-national government bodies. That's because most states and cities aren't allowed to incur deficits.

Whether a government spends on social security, health care or new fighter jets, it's pumping money into the economy. This boosts economic growth because businesses expand to meet the demand created by the spending. This usually results in new jobs, which has a multiplier effect in boosting further demand and growth.Deficit spending is a powerful stimulant because the demand is being created now, and 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 reelect them. Basically, there is no reason for them to cut spending.

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, or Gross Domestic Product (GDP). For emerging market countries, the tipping point comes sooner -- at 64% debt-to-GDP ratio.

Creditors first start to worry whether the country will default on the interest payments. This becomes a self-fulfilling prophecy because, as worries 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 country may be forced to default on its debt altogether. (Source: The World Bank, Finding the Tipping Point)

Debt crises have occurred for centuries, usually 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. However, the IMF prevented many debt defaults by providing needed capital. (Source: Federico Sturzenegger and Jeromin Zettelmeyer, Chapter 1, Debt Defaults and Lessons from a Decade of Crises, MIT Press: January 2007)

Here are 13 countries with debt less than 10% of their annual economic output (GDP). These countries have plenty of revenue, mostly from natural resources, to pay for government services. They have a healthy GDP growth rate, so they don't need to boost economic growth through deficit spending.

1. 9.6% -- Kuwait
2. 9.2% -- Chile
3. 9.0% -- Russia
4. 8.6% -- Qatar
5. 8.0% -- Uzbekistan
6. 7.5% -- Gibraltar
7. 6.6% -- Estonia
8. 6.6% -- Algeria
9. 5.6% -- Wallis/Futuna
10. 5.2% -- Azerbaijan
11. 5.1% -- Equatorial Guinea
12. 4.0% -- Oman
13. 3.5% -- Libya

(Source: CIA World Fact Book)

Here are 11 countries with debt greater than their entire annual economic output (more than 100% of GDP). Most of them are in danger of default. In fact, Iceland already defaulted in 2008. Japan and Singapore are the exceptions. Japan owe most of its debt to its own citizens, who buy government bonds as a form of personal savings. Most of Singapore's debt is held by its social security trust fund. In fact, Singapore hasn't borrowed to finance deficit spending since the 1980s.

1. 233.2% -- Zimbabwe
2. 199.7% -- Japan
3. 185.0% -- St. Kitts/Nevis
4. 142.7% -- Greece
5. 133.8% -- Lebanon
6. 126.3% -- Iceland
7. 126.2% -- Jamaica
8. 119.1% -- Italy
9. 105.8% -- Singapore
10. 102.1% -- Barbados
11. 100.7% -- Belgium

These countries don't have the worst debt-to-GDP ratios, but nevertheless have investors worried about default. The United States has a public debt-to-GDP ratio of 62.9%. This isn't so bad -- it's not in the top five -- but the total amount owed is $14.7 trillion, larger than any other single country. If the U.S. defaulted on its debt, it would bring the global economy to its knees. Therefore, a monster debt that has any risk of default is uglier than a smaller debt with a higher risk of default.

Most countries in Europe exceeded the self-imposed threshold debt limit, Investors are worried about default in Greece, one of the five-worst indebted countries in the world, as well as the other "PIGS"

• Portugal -- 93.0%
• Ireland -- 94.9%
• Spain -- 60.1%

However, the debt-to-GDP ratios of the European countries that are bailing out the "PIGS" are also high -- Germany's is 83.5% and France's is 84.2%. European banks are large holders of this debt, which could therefore export a European default to the global financial system. (Article updated January 17, 2012)