External Debt

Loans raised through foreign lenders, such as foreign commercial banks, foreign governments, and international financial institutions.

What is External Debt?

External debt refers to the loans raised through foreign lenders, such as foreign commercial banks, foreign governments, and international financial institutions. In the case of external debt, all repayments must be made in the currency in which the debt was issued.

External debt is the portion of a country's debt that is borrowed from foreign lenders, including commercial banks, governments, or international financial institutions. These loans, including interest, must usually be paid in the currency in which the loan was made. To earn the needed currency, the borrowing country may sell and export goods to the lending country.

On the other hand, internal debt refers to the money owed to domestic financial institutions and commercial banks.

KEY TAKEAWAYS:

External debt is the portion of a country's debt that is borrowed from foreign lenders, including commercial banks, governments, or international financial institutions.
If a country cannot repay its external debt, it is said to be in sovereign debt and faces a debt crisis.
External debt can take the form of a tied loan, whereby the borrower must apply any spending of the funds to the country that is providing the loan.

Understanding External Debt

In addition to internal debt, external debt serves as one of the two primary sources of borrowing of individuals, organizations, and national governments.

Countries borrow from foreign creditors mainly to finance their own excess expenditures, build additional infrastructure, finance recovery from natural disasters, and even to repay its previous external debt.

Companies and governments generally do not prefer external debt, since they impose restrictions on the borrowing country and give the lender country some leverage over them. However, certain circumstances compel countries to borrow money from outside, some of which are as follows:

When domestic commercial banks and financial institutions lack sufficient money to lend
When available domestic funds need to be utilized in other important areas, such as healthcare and education
When international financial institutions and foreign governments offer lower interest rates and easier repayment schemes than the domestic debt market

External debt, or foreign debt as it is sometimes called, factors in both principal and interest and does not include contingent liabilities, which are debts that may be incurred at a later date based on the outcome of an uncertain future event. It is defined by the International Monetary Fund (IMF) as debt liabilities owed by a resident to a nonresident, with residence being determined by where the creditors and debtors are ordinarily located rather than their nationality.

In some cases, external debt takes the form of a tied loan, which means the funds secured through the financing must be spent in the nation that is providing the financing. For instance, the loan might allow one nation to buy resources it needs from the country that provided the loan.

External debt can take the form of a tied loan, obligating the borrower to spend the funds it's lent in the nation that's providing the financing.

External debt, particularly tied loans, might be set for specific purposes that are defined by the borrower and lender. Such financial aid could be used to address humanitarian or disaster needs. For example, if a nation faces severe famine and cannot secure emergency food through its own resources, it might use external debt to procure food from the nation providing the tied loan.

Likewise, if a country needs to build up its energy infrastructure, it might leverage external debt as part of an agreement to buy resources, such as the materials to construct power plants in underserved areas.

What Are the Types of External Debt?

External debt is money borrowed by a government or corporation from a foreign source. It can include:

Public and publicly guaranteed debt
Nonguaranteed private sector external debt
Central bank deposits
Loans from the IMF

What Are the Effects of External Debt?

High levels of external debt can be risky, especially for developing economies. It could, among other things, increase the risk of default and being in another country's pocket, ruin credit ratings, leave little funds to invest and spur growth, and expose the borrower to exchange rate risk.

Risks Associated with External Debt

There are several risks associated with foreign debt as well, which are as follows:

1. Affects economic growth

Economic growth occurs when governments and companies incur capital expenditures that boost production and increase output and income levels. If large amounts of external debt need to be repaid, then there is less money left for investment purposes. It hampers future economic growth.

2. Long gestation period

Gestation period is the interim period between the initial investment in a project and the time the project becomes productive. When external debt is used to fund infrastructure projects, it takes a few years for the project to start giving a return on the investment.

If the French government borrows money from the U.S. to set up a pharmaceutical factory, it will take time for the factory to become functional, start production, and earn money through sales. However, the debt will need to be repaid, along with interest, within one year of receiving the loan. The French government will face the pressure of repaying the loan even before the project starts yielding a stable return.

3. Unexpected devaluation of domestic currency

If the currency of the borrowing country depreciates with respect to that of the lending country, then the real value of interest (as denominated in the domestic currency) will rise.

For example, France borrows $100 million from the U.S. at an interest rate of 5% per year. When the euro-dollar ratio is 1:1, then the yearly interest payment is $5 million, or €5 million. If the euro suddenly depreciates and the euro-dollar ratio changes to 1.5:1, then the yearly payment denominated in euro increases to €7.5 million.

The Vicious Cycle of Debt

The most crucial disadvantage of external debt is that it often leads to a vicious cycle of debt for countries. The debt cycle refers to the cycle of continuous borrowing, accumulating payment burden, and eventual default.

When a government’s expenditure exceeds how much it earns in a year, it faces a fiscal deficit. In order to finance the adverse gap, the government borrows money from another country. In the next year, with the additional expense of interest payment and loan repayment, the government might face a deficit again and be forced to take another external loan. In subsequent years, there might be a situation where it borrows money in order to repay its previous loans.

A country with a high amount of external debt raises caution among prospective lenders, and they become unwilling to lend more money. Since it cannot raise further debt, the country might fail to repay external debt, a phenomenon known as sovereign default. Therefore, the debt cycle culminates in an almost bankrupt nation, and many other lender-nations facing bad loans.

To better understand a debt cycle, consider the following example. Country X incurs a fiscal deficit of $100 million in Year 1 and plans to invest $100 million in an infrastructure project. It borrows $200 million from Country Y at an interest rate of 5% per year. The loan must be repaid in 10 annual installments of $20 million each, starting from the following year.

Assume that all subsequent deficits arise out of loan repayments, and X takes further external loans to finance the deficits at the same terms as the first loan. Also, assume that the infrastructure project starts to yield an annual return of 10% on the initial investment from the third year.

Summary

External debt refers to the loans raised through foreign lenders, such as foreign commercial banks, foreign governments, and international financial institutions.

The most crucial disadvantage of external debt is that it often leads to a debt cycle – the cycle of continuous borrowing, accumulating payment burden, and eventual default.

The Bottom Line

Like any form of debt, borrowing money from foreign sources can be a good or a bad thing. It may be a useful, cost-effective way to access much-needed capital or trigger a vicious cycle of debt.

If it means procuring money for important investments at a cheaper rate than can be found domestically, then it can ultimately be viewed as a good thing. However, the same cannot be said when struggling economies are effectively forced to borrow from other countries on ridiculous terms just to stay afloat.