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. A country with a high amount of external debt raises caution among prospective lenders, and they become unwilling to lend more money.
External debt is broken down by instrument, original maturity and institutional sector. The example, though simplified, gives an accurate estimate of how damaging a debt cycle can be. X needs to take new loans every year in order to pay off its past deficits. The increasing burden of external debt can make Country X go bankrupt in a few years. Foreign debt as a percentage of a country’s Gross Domestic Product or GDP is the ratio between the amount owed by a country to foreign lenders and its nominal GDP. Secretary of State, pledged more funds to help Pakistan cope with the devastating flood that killed over 1,600 people.
A government or a corporation may borrow from a foreign lender for a range of reasons. For one thing, local debt markets may not be deep enough to meet their borrowing needs, particularly in developing countries. Moreover, the loan repayment leaves the borrower with little funds to invest in economic development. Besides this, the borrowing country’s exposure to interest rate risk increases when it takes on foreign debt. According to one estimate, the amount of money developing country governments are paying toward foreign debt nearly doubled from 2010 to 2018, as a percentage of government revenues.
- 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.
- The external debt statistics also include indicators of net external debt (i.e. gross external debt net of external assets in debt instruments).
- When a government’s expenditure exceeds how much it earns in a year, it faces a fiscal deficit.
- A government or a corporation may borrow from a foreign lender for a range of reasons.
- Therefore, the debt cycle culminates in an almost bankrupt nation, and many other lender-nations facing bad loans.
Usually, governments take on this debt to fulfill certain objectives like meeting additional expenses and boosting economic recovery after a natural disaster. International financial institutions like the IMF and the World Bank are the most common external debt sources. Besides these, governments may also avail financial assistance from foreign commercial banks to meet their financial objectives.
Understanding Foreign Debt
In addition to internal debt, external debt serves as one of the two primary sources of borrowing of individuals, organizations, and national governments. The most common indicator of external debt is gross external debt, which measures the total debt a country owes to foreign creditors, i.e. it considers only the liabilities of that country. The World Bank, in conjunction with the IMF, gathers short-term foreign debt data from the Quarterly External Debt Statistics (QEDS) database.
That said, one must note that a substantial debt increases the default risk, and failure to repay the loan significantly impacts the borrower’s credit ratings. Foreign debt, especially tied loans, might allow a borrower to fulfill certain purposes defined by the two parties. For instance, the borrower might only be able to utilize the funds to recover from a natural disaster by purchasing resources from the lender country. Per rules, countries taking on this debt must repay the loans in the currency in which the lender issued the loan. Foreign debt is of various types, like non-guaranteed private sector external debt and public and publicly guaranteed debt.
There are various indicators for determining a sustainable level of external debt. While each has its own advantage and peculiarity to deal with particular situations, there is no unanimous opinion amongst economists as to a sole indicator. These indicators are primarily in the nature of ratios—i.e., comparison between two heads and the relation thereon and thus facilitate the policy makers in their external debt management exercise. 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.
What are External Debt and Internal Debt?
If a nation is unable or refuses to repay its external debt, it is said to be in sovereign default. This can lead to the lenders withholding future releases of assets that might be needed by the borrowing nation. The borrower’s currency may collapse, and the nation’s overall economic growth will stall. Economic growth occurs when governments and companies incur capital expenditures that boost production and increase output and income levels.
What Is External Debt?
It is possible that countries that default on external debt may potentially avoid having to repay it. Assume that all subsequent deficits arise out of loan repayments, and X takes further what is external debt 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. Country X incurs a fiscal deficit of $100 million in Year 1 and plans to invest $100 million in an infrastructure project. The loan must be repaid in 10 annual installments of $20 million each, starting from the following year.
With the country already struggling to address its existing economic challenges and repay its external debt amid the diminishing cash reserves, the natural disaster certainly worsens things. The conditions of default can make it challenging for a country to repay what it owes plus any penalties that the lender has brought against the delinquent nation. Defaults and bankruptcies in the case of countries are handled differently from defaults and bankruptcies in the consumer market.
High levels of external debt can be risky, especially for developing economies. Among other things, it could 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. External debt, particularly tied loans, might be set for specific purposes that are defined by the borrower and the lender.
The Vicious Cycle of Debt
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. 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. The nations that follow the U.S. in the list are —- United Kingdom- France- Germany- Japan- The Netherlands, etc.
This is an external obligation of public debtors, like national governments, autonomous public bodies, etc. The borrower guarantees to repay the outstanding borrowings to the lender and fulfill the obligation. The external debt of an economy represents, at any given time, the outstanding actual (rather than contingent) liabilities (and assets) vis-à-vis non-residents.
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. The IMF is one of the agencies that keeps track of countries’ external debt. Together with The World Bank, it publishes a quarterly report on external debt statistics.
