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CFA Level I · CFA Level I Exam · Credit Analysis for Government Issuers

A sovereign's nominal GDP is expected to grow 4% a year, and the average interest rate on its debt is 6%. It currently runs a primary balance of zero, with debt at 80% of GDP. Holding other factors constant, the debt-to-GDP ratio will most likely:

The debt-to-GDP ratio will rise. With a zero primary balance, interest is financed by new borrowing, so debt grows at about 6% while GDP grows only 4%. Stabilizing the ratio requires a primary surplus when the interest rate exceeds nominal growth.

  1. Afall, because a zero primary balance means no new borrowing
  2. Bstay at 80%, because the primary balance is zero
  3. Crise, because interest growth exceeds GDP growth with no primary surplusCorrect

Explanation

With a zero primary balance, new borrowing equals interest. Debt grows at 6% while GDP grows at 4%, so the ratio rises by about (0.06-0.04)/1.04 x 80% = roughly 1.5 points in the first year. Stability would require a primary surplus. The first option wrongly ignores that interest must be financed with new debt.

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