External Debt

What Is External Debt?

External debt, also known as foreign debt, is a nation's loans and borrowings from external sources monitored by the International Monetary Fund (IMF).

The sources are varied, including commercial banks, monetary and financial institutions, and external lending parties involved with the economy. 

These exchanges are derived from the interest and are paid in the currency agreed for trade in the formal agreement between the lending and borrowing parties. 

The external debt derived from the financial opportunities overseas can serve several benefits. In emerging economies, this has served the purpose of research & innovation, infrastructure activities, etc. Thus, it has led to employment generation, an increase in revenues, and a rise in per capita income. 

The risks and uncertainties associated with post-debt facilities remain under control and regulation. These include fluctuations in interest rates, post-loan compliance facilities, regulations and laws, and collateral issues. 

The major problem that arose after the creation of foreign debt was the scope of the creation of debt traps. The fiscal deficit burden has eventually led to the clash of the gross domestic product and debt burden issues. 

Understanding External Debt

The foreign debt of an economy is commonly represented by the proportions of the gross domestic product to the debt or the amount of foreign sources aspect in the total debt of the nation. 

The nation's aggregate external debt is defined as the aggregate liabilities of residents to non-residents. These sources of debt can be varied and are denominated in domestic or foreign currency. 

Numerically, 

External Debt = Debt of the nation owed to non-resident investors / Gross Domestic Product of the nation

Some Major Aspects:

1. The foreign debt holdings for a longer period take the form of a debt crisis. 

2. The economy runs into sovereign default if it cannot pay its debts.

3. The debt issues can further affect the solvency and liquidity capacity of the nation.

4. The net external debt equals the gross external debt less than the external assets.

5. Net foreign debt equates to net international investment, excluding financial derivatives, employee stock options, and equity and investment fund shares.

The Methodology 

It consists of the current and contingent liabilities. These are payments to be made on the interest on the principal. The IMF defines the key elements, which include various aspects. They include outstanding and actual current account liabilities, principal and interest, residence & current, and contingent liabilities. 

The classification can be divided into four or seven heads of classification. The large four heads of classification constitute:

• Guaranteed debts 
• Non-guaranteed debts
• IMF gives the Liabilities
• The central bank deposits 

The three heads added further into the structure, including

• Trade credits
• Currency debts, and
• NRI debts 

The sustainability of foreign debt arises from meeting the current debt needs. This is done to fulfill the evaluation of the medium-term scenarios. Therefore, the debt is evaluated using various variables and calculated based on several factors. 

The tied loans constitute the repayment either in capital repayment or divergence of the capital allocations in the source country, along with the IMF responsible for the regulation and control of foreign debt statistics. In addition, the World Bank generates quarterly reports on external debt. 

Foreign or external debt is the outstanding amount to those current liabilities. It does not include contingent liabilities, largely.

Foreign debt requires the debtor to pay the principal with interest or only interest at some point or period in the future.

The contingent or potential liabilities refer to the penalties that may occur in the future. These include pending lawsuits, honoring product warranties, etc.

Framework

In reality, the foreign debt facility in developing economies has led to various developmental activities and huge infrastructure. It leads to a chain reaction in the form of defaults leading to the debt crisis. However, the manner of response to defaults and bankruptcies varies in the consumer market than in the foreign debt crisis. 

The concept raised states that healthy debts amount to certain percentages of exports or revenues. 

The indicators of external debt are 

• The debt to GDP ratio, 
• Foreign Debt to Exports Ratio, and 
• Government Debt to Current Fiscal Revenue 

The structure of the outstanding debts constitutes a share of foreign debt, short-term debt, and concessional debt holdings. 

Purpose Of External Debt

A government or corporation that borrows money from a foreign source is said to have external debt. 

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 by their nationality.

Some of the purposes are:

Tied Loans 

The government or corporations can procure debt from foreign sources. This commonly occurs in the structure of tied loans, so it defines the nature of the debt's usage post-procurement in the lending nation. 

This exchange may be a barter exchange where the country buys the resources instead of repaying the loan. The debt may serve social welfare purposes. 

Development And Infrastructure Activities 

In developing economies, the lack of capital poses a major problem in development activities. It is a problem with the scope of the debt crisis, with the defaulters' chain reaction. Global disturbances to the international financial system cause turbulence and turmoil, creating a further need for capital.

The COVID-19 pandemic created the external debt stocks of developing economies, reaching US $ 10.6 trillion. It comes to around one-third of the GDP of developing economies.

Monetary And Financial Exchange 

The financial exchange facilitated the presence of foreign debtors. They are in the form of financial intermediaries, monetary institutions, and governments.  

This led to exchange and interaction between economies and financial institutions.

Capital Financing Serves Multilateral Purposes

This leads to the scope of vicious debt cycles. Moreover, the capital financed by the economies serves multilateral purposes, i.e., fulfilling excess expenditures, the finances from natural disasters, and recoveries from crises to the international financial system. 

Foreign debt facilitates the exchange of capital across nations. It largely constitutes capital repayments on the grounds of foreign reserves, foreign trade, and facilitating mechanisms drawn across the borders of the countries. 

A nation's capacity and overall image facilitate access to other economies and global cooperative institutions. However, repayment issues can create further debt and enlarge the encompassing burden issues and developmental and infrastructural activities. 

The development of emerging economies has a large capacity owed to foreign debt facilities. In a few economies, like India, remittance and the issue of debts from non-resident Indians settled overseas have played a large role in capital restructuring activities. 

External Debt Considerations

The debt facilities of the economies constitute the internal and foreign debt facilities. Foreign debt serves as the primary source of borrowing for individuals and corporations. 

The debt financed from external sources serves collateral purposes. These mainly constitute expenditures, construction and infrastructure activities, and recovery processes from disasters and crises.

The debt tied up creates imposing conditions causing restrictions and straining the leverages set by the lender. 

Operational circumstances create disadvantages during opportunities. These include the insufficient capital or capital inadequacy faced by monetary and financial institutions.

The inadequate allocation of resources to various crucial healthcare, hospitality, and education sectors and the major disadvantage lies in the lack of flexibility in interest rates and no ease of repayment schemes.

The risks associated with the economic growth faced due to foreign debt impose several conditions. However, these can create a spark of economic growth. 

This lack of recovery and repayment creates defaults. 

The gestation period is the interim period between the initial investment and the project's maturity. As a result, the temporary period created is often larger than the planned period. This results in the devaluation of domestic currency due to unforeseen delays and tardiness of the services.

Sustainability And Debt 

Foreign debt has been long associated with sustainability issues. These aren't confined to environmental recovery aspects. They are largely confined to the durability of the debt and non-confinement of the debt to burden. 

The major aspects of ensuring the sustainability of the debt are as follows: 

1. The rise in economic growth on a sustainable basis. 

2. The reduction in vulnerability in the sectors of exports of the nation. 

3. The increase in the quality of foreign capital. This is in foreign capital's availability, efficiency, transparency, and concessional.

Problems And Challenges 

The benefits offered are a disadvantage when the default swaps fall under the chain loop of operations, creating a vicious debt cycle. It refers to a continuous borrowing process, payment burden, and defaults.

This is the initial phase that creates a fiscal deficit. It happens when expenditures exceed earnings, leading to debt. 

The debts form loops and create a cycle of debts, further widening the debt burden—the further debt burdening continues until the repayment occurs, which creates a vicious cycle. As a result, the adverse gap widens due to the debt burden on the government to cover the fiscal deficits. 

The reputation worsens in the credit market, worsening the scope of further debts or the range of repayment. Moreover, it leads to a lack of capital.

Sovereign default occurs due to a lack of capacity to repay foreign debt, which continues in an almost bankrupt nation and leads to the creation of bad loans.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Assessing Debt Capacity
• Asset-Liability Committee (ALCO)
• Cost of Debt
• Debt Service Coverage Ratio
• Debt Settlement