Definition of debt
Debt is a duty owed by a person who is the debtor to another person called the creditor.
In fact, debt is a sum of money owed by a borrower, which can be a company, a State, a community or an individual, to a lender, known as a creditor.
Thus, the debt can be contracted with a bank, but also with financial institutions, such as an investment fund, a credit institution, an insurer or an individual.
The different types of debt
In general, debt can be subdivided into three main forms:
- Multilateral debt : Debt that is owed to the World Bank, at International Monetary Fund to regional development banks such as the African Development Bank, and to other multilateral institutions such as the European Development Fund.
- Private debt : Loans taken out by private borrowers regardless of the lender.
- Public debt : All loans taken out by public borrowers.
Public debt : types and categories
Public debt is defined as all financial commitments made in the form of loans by the State, public authorities and the organizations directly dependent on them.
It is constantly evolving in line with the repayments of loans made by the State and public administrations and the new loans they contract to finance their deficits.
The different forms of public debt
Public debt can be presented according to several criteria :
According to its owner
- Domestic public debt held by the economic agents residents of the issuing state
- External public debt owned by foreign lenders.
According to its quality
On the one hand, we distinguish between virtuous debt, which would be good for the economy, and on the other, debt with more harmful effects.
- The good debt : would be linked to a reduction in the use of taxes, in particular to finance the war effort or, in peace time, fluctuations relating to business cycles, the stimulation of demand in crisis situations, the management of public assets or the failure of the private sector compensated by the public authorities, and in general the debt reserved for the financing of investments which will increase the collective heritage of the nation.
- Bad debt : only serves to continuously finance current public expenditure
Depending on its duration
Debt can be classified into two main categories: short-term debt and long-term debt.
- Short-term debt : It is a financial obligation that must be repaid within one year or less. It generally includes bank overdrafts, debts suppliers, short-term loans and accrued expenses.
- Long-term debt : It is a financial obligation that has a maturity of more than one year. It generally includes long-term bank loans, bonds issued by the company, and finance leases.
According to its nature
Public debt can also be subdivided into direct debt and indirect debt :
- Direct debt : is contracted directly by the public authorities (the State, a federated entity or a municipality, for example) to cover its own needs.
- Indirect debt : is contracted for the benefit of certain institutions or public services. The amortization and interest charges on this debt are borne by the State and charged to the budgets of the administrations which have supervision over the borrowing organizations
Recourse to debt: a choice or an obligation
The management of a country leads the State and public administrations to take charge of activities of general interest, called public services, for the areas considered to be exclusive responsibility of the State (sovereign functions) : justice, internal and external security. State intervention has gradually extended to the economic and social spheres : infrastructure (roads, ports, airports, etc), education, health.
Indeed, to implement its development policy, the government often has limited means to mobilize public revenue or private investments, and given the size of the funds it needs, recourse to debt becomes the only way to finance these investments.
Besides, debt financing plays a crucial role in development because borrowing can help the country accelerate its growth by financing productive investments and can also mitigate the effects of economic disruptions, provided that the debt is well managed, transparent and used as part of a credible growth strategy.
However, this is all too rarely the case. Unsustainable levels of public debt harm growth and will have detrimental consequences for the most vulnerable, as they can increase pressures on social and infrastructure spending and limit the government’s ability to implement reforms.
Therefore, policy makers in the borrowing country will need to have reliable debt data to make informed decisions. For their part, citizens must be clearly informed by their leaders of the conditions and purpose of the loans, in order to demand accountability.
Relationship between deficit and debt
The budget deficit is defined as the situation in which revenues are less than expenditures, so it is a negative balance.
Thus, if during a year, the State’s expenditure is higher than its revenue, there is a budget deficit, to finance it the State is obliged to borrow.
Public debt is therefore the sum of loans contracted by the State, year after year, and not yet repaid, the outstanding amount of which results from the accumulation of State deficits.
Generally speaking, the succession of deficits encourages the appearance of new deficits, because the interest charge thus borne leads to an increase in the deficit and therefore to a further increase in debt and the interest charge. In this sense, when a budget deficit appears, it is covered by the loan, which, accumulated over the long period, results in additional and growing debt.
Measuring public debt
If a state accumulates debts it cannot service, a debt crisis can erupt, with potentially high economic and social costs. Therefore, it is important to assess what level of debt an economy or state can safely accumulate, that is, what level of debt is sustainable for an economy and what level becomes excessive.
Thus, a debt can be considered sustainable if it is expected that the borrower will be able to continue to service it. Conversely, a debt becomes unsustainable when it continues to accumulate faster than the borrower’s ability to service it.
Debt sustainability assessment involves three steps:
- Forecast the evolution of commitments (in terms of revenue, expenditure, interest rate, growth rate and exchange rate) in relation to the economy’s capacity to pay ;
- Examining how the outlook would change under plausible shocks, in fact refers here to risks such as the increase in the cost of financing or a sharp depreciation of the currency which increases the burden of foreign currency-denominated debt ;
- Assess whether the results could lead to an unsustainable situation, i.e. the ability to repay debt service is evolving less quickly than debt accumulation.
Debt sustainability is generally measured by the debt-to-GDP ratio. This ratio provides an idea of the size of the debt relative to the size of the economy, as measured by the Gross Domestic Product (GDP).
The evolution of this ratio will depend on the growth rate of the economy. Thus, the debt ratio to GDP can decrease while the nominal outstanding debt increases: it is sufficient that the debt grows less quickly than the GDP.
On the other hand, this ratiois influenced by the difference between the interest rate paid on the debt and the growth rate of nominal GDP: if the interest rate is higher than the growth rate of nominal GDP, the share of debt in GDP tends mechanically to increase.
In general, debt is considered sustainable if its level remains within the limit of 60% of GDP.
Overall, and in addition to its amount, the level of public debt and its consequences is assessed by several equally important elements, such as : its evolution, the capacity to raise taxes, the quality of public spending, the rate of growth of the economy and especially its cost (which depends on interest rates), this last factor is largely determined by the rating that the country receives from rating agencies, namely : Moody’s Investor Service, Standard & Poor’s and Fitch Rating, which assess the State’s ability to repay its debt. Thus, the higher the risk, the lower the rating and the more the State will be obliged to apply high interest rates on its bonds to raise funds on the financial market.
Public debt management
Managing a country’s debt is not comparable to managing a household or a business: a state has an a priori infinite lifespan and is not intended to generate profits; its expenditure and revenue have a direct influence on the performance of the economy.
Public debt can thus be used to support the economy in periods of weak activity or to temporarily finance useful expenditure for the future (innovation, ecological transition, etc.). On the other hand, an uncontrolled accumulation of debt carries risks, insofar as it can make the situation of public finances unsustainable and contribute to the loss of confidence of lenders and other economic agents.
Moreover, the fundamental objectives of the debt management strategy are to provide the State with stable and sustainable financing, enabling it to cover all of its financing needs while ultimately reducing the cost of borrowing and limiting the exposure of the debt portfolio to financial risks.
In this context, debt management aims to :
- Minimize the cost of short, medium and long term debt. However, since the possibilities of acting on the cost of debt are all the more limited the shorter the horizon and all the more uncertain the longer the horizon, the medium term is in fact preferred. This cost is represented by flows of interest payments and repayments spread over time
- Minimize risks in the short and medium term, by ensuring that the State can meet its payment obligations including the repayment of capital and the payment of interest on the debt, that repayments are not concentrated in a particular month or year, etc. In theory, this should lead to zero risk of default.
Indeed, to address debt-related vulnerabilities, governments must take urgent action to reverse long-term debt trends, including through the establishment of a credible fiscal framework that could guide the process of better reconciling spending needs and debt sustainability. Furthermore, active management of external debt is mainly reflected in the adoption of a more global strategy, combining budgetary discipline and debt restructuring through debt conversions into investment, hedging operations of financial risks linked to the debt portfolio and the treatment of expensive debt through its repurchase by cheaper debt.
Conclusion
Throughout their history, states have used several financing methods, varying parameters such as the nature of the financial instruments used (direct loans, negotiable securities, etc.) or the investors they turned to (citizens, national banks, international banks, international investors, etc.). However, rising debt levels, combined with rising global interest rates, could increase the debt burden. Low-income countries spent an average of 7.5% of their budgets on debt service, an amount greater than their combined spending on health and education.