06/10/2022
Do countries usually borrow money when the taxes they collect aren’t enough to cover budgetary needs? We’ll explain when countries seek a loan, how they do it, and whom they borrow from.
Ever wonder where countries get the money they need to function? It may seem complicated; but actually, finance for both a country and a household is very similar. When our household income isn’t enough to buy something, hire a service or make some other kind of payment, we usually resort to taking out a credit facility, a loan, a mortgage and other types of financing.
With countries, the same thing happens when tax revenue (a country’s main source of income) falls short to cover government spending on public investment or welfare projects: they take out a loan. The money they borrow is called “sovereign (or government) debt”, and their negative financing balance is called “public deficit”.
How does sovereign debt work?
Who lends countries money and how does the loan work? To get funding, governments can issue debt securities. They are payment obligations to the investor who buys them, with terms and conditions for repayment. Securities can be issued at the local and national level and by public entities. People and private or public institutions in and outside the country can be an investor and buy them. These are the three main types of debt securities:
Treasury bills
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A treasury bill has the shortest term to maturity (3, 6, 12 and 18 months). In general, governments use it to get short-term financing at the lowest possible cost. It pays investors a fixed interest rate that is lower than other financing mechanisms. That's because its market price remains stable over such a short repayment period. A treasury bill is considered a low-risk investment.
Treasury notes
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A treasury note has a term to maturity of between two and five years. It requires its issuing government to return the investor’s money by its maturity date and give a set interest or coupon payment every year.
Treasury bonds
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Treasury bonds are similar to treasury notes. Both give the investor an annual interest or coupon payment. But a bond’s term to maturity is different: usually between 10 and 30 years. Bonds can usually indicate markets’ confidence in a country’s economy based on its ability to pay in the future.
The kind of debt security a government issues will depend on its financing needs. If a country doesn't have the funds it needs to build a system of motorways, it can issue 2-to-5-year treasury notes and promise to make interest or coupon payments until the note reaches maturity (the time by which the country expects it will have the amount it needs to pay back its debt).
How much sovereign debt is too much?
To understand how indebted a country is, we can compare its sovereign debt to its gross domestic product (GDP). If a country owes €70 million and its GDP equals €100 million, 70% of everything made from producing and selling goods and services can go towards paying down its debt. In theory, the smaller that percentage is, the greater its ability to pay will be. But if the ratio of debt to GDP is high, the country's risk of default will grow.
In each country, the economy and spending needs are different. So it’s impossible to set a good or bad level of debt. Large economies, like Japan (whose debt is 250% of GDP), can cope with high debt levels because financial markets have confidence in their ability to pay.
