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.
Defaulting on External Debt
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. External debt is the portion of a country’s debt that is borrowed from foreign lenders. Internal debt is the opposite, referring to the portion of a country’s debt incurred within its borders. Poor debt management, combined with shocks such as a commodity-price collapse or severe economic slowdown, can also trigger a debt crisis.
- It may be a useful, cost-effective way to access much-needed capital or trigger a vicious cycle of debt.
- The IMF and The World Bank produce an online database of external debt statistics for 55 countries that is updated every three months.
- Moreover, a country can utilize the funds received from a foreign lender to meet various expenditures.
- On the other hand, internal debt refers to the money owed to domestic financial institutions and commercial banks.
- If large amounts of external debt need to be repaid, then there is less money left for investment purposes.
- The borrowed money is known as Debt, and the modes of borrowing money can be classified into two categories – External Debt and Internal Debt.
External Debt: Definition, Types, vs. Internal 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.
This is often exacerbated because foreign debt is usually denominated in the currency of the lender’s country, not the borrower. That means if the currency in the borrowing country weakens, it becomes that much harder to service those debts. Foreign debt, also known as external debt, has been rising steadily in recent decades, with unwelcome side-effects in some borrowing countries.
Risks Associated with External 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.
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.
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.
Understanding Foreign Debt
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.
Hence, Country A takes on external debt from Country B to fulfill its requirement. Country A must fulfill its obligation in time to prevent what is external debt any impact on its credit ratings. First, they provide loans at non-concessional interest rates to high and middle-income countries. Like any form of debt, borrowing money from foreign sources can be good or bad. It may be a useful, cost-effective way to access much-needed capital or trigger a vicious cycle of debt. The external debt statistics also include indicators of net external debt (i.e. gross external debt net of external assets in debt instruments).
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.
In the case of external debt, all repayments must be made in the currency in which the debt was issued. Internal debt can be defined as money borrowed by the government from inside the country. Sources for internal debts can include citizens, the country’s banks, the country’s financial institutions, business houses, etc. Internal debts are mostly used by the government for the betterment of education and health within the country. External debt refers to liabilities governments usually owe foreign lenders, such as international financial institutions, foreign governments, and commercial banks. Nations may take on this debt for various purposes, like meeting additional expenses, building infrastructure, etc.
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.
