External debt is the amount of money borrowed by a government, businesses, banks and other entities from lenders outside their country. These lenders can include foreign governments, commercial banks and other financial institutions.

External borrowing in developing economies can be a double-edged sword. While it can be a valuable source of financing, the borrowed amounts need to be returned and serviced. If a country is unable to service its debts, it will have adverse implications on the economy.

What Is External Debt?

External debt is basically a liability that arises when a domestic borrower takes a loan from a foreign creditor.

The main difference between external and domestic borrowing arises from the fact that external debt involves exposure to exchange rate risks. Fluctuations in the exchange rate can have an impact on the ability of the borrower to service its debt.

External debts become a problem when the country or the private sector does not have sufficient foreign exchange reserves to cover the service charges on the borrowed money. When the amount of debt exceeds the capacity of the borrower to return it, it leads to a sovereign debt crisis.

How Do We Know Whether External Debt Is Sustainable?

While determining whether or not a country’s debt is sustainable, it is important to understand that debt is a relative notion.

A country’s debt needs to be measured against its capacity to pay back the borrowed amount and the interest on it.

Indicators that help in understanding the capacity of a borrower to pay back a loan include:

1. Debt–Fiscal Revenue Ratio

This indicator helps in determining the ability of the government to pay back its debts. It indicates the fiscal stress that may exist if the government is unable to pay back the borrowed amount.

2. Maturity Structure

The maturity structure determines the extent to which a borrower’s liability comprises short-term and long-term debt.

A high concentration of short-term debt can adversely impact the ability of the borrower to pay back its liabilities. It can become a burden on the borrower.

3. Share of Concessional Debt

The share of concessional debt basically indicates the amount of debt relief provided to the borrower by the creditors.

4. External Debt–Exports Ratio

This ratio basically helps in determining the extent to which the borrower can service its foreign debt.

The foreign exchange earnings from exports are usually the biggest source of foreign exchange for most economies. This is why the ratio determines the country’s or borrower’s ability to pay back its liabilities.

5. Debt–GDP Ratio

The debt-to-GDP ratio helps in determining the debt burden of the economy.

6. Debt as a Percentage of Total Debt

This indicator determines the extent to which India’s total debt is owed to external creditors.

What Are the Major Types of External Debt?

External debts can be classified based on different criteria.

Based on maturity structure, external debt can be divided into long-term and short-term debt.

Long-Term Debt

Long-term debt basically refers to liabilities with original maturity of more than one year.

Short-Term Debt

Short-term debt refers to liabilities with original maturity of one year or less or those that are payable on demand.

External debts can also be classified on the basis of whether they are multilateral or bilateral in nature.

Multilateral Debt

Multilateral debts basically refer to external debts owed to international agencies like the International Development Association (IDA), International Bank for Reconstruction and Development (IBRD), and Asian Development Bank.

Other agencies include the European Bank for Reconstruction and Development and the French Development Agency.

Bilateral Debt

Bilateral debts refer to debts that are contracted between two countries.

For instance, bilateral creditors to India include Japan, Germany, the US and France.

External debts can also be classified as sovereign and non-sovereign debt.

Sovereign Debt

Sovereign debts basically include external borrowings taken by the Government of India under the external assistance program, government borrowing from the IMF and external debt of a non-commercial nature, including defence liability.

Non-Sovereign Debt

Non-sovereign debts basically include the remaining debt that is not classified as sovereign.

What Are Trade and Export Credits?

Trade or Export Credit refers to credit extended for trade purposes by overseas suppliers, banks and financial institutions.

Trade credits basically help importers finance their trade payments, thus facilitating international trade.

What Are External Commercial Borrowings?

External Commercial Borrowings (ECBs) basically refer to borrowings raised from external sources.

ECBs can be raised from commercial banks and financial institutions, as well as from external bonds and floating rate notes (FRNs).

They give borrowers an alternate avenue to raise funds from global sources.

How Can External Debt Affect an Economy?

While taking on debt is not necessarily a bad thing, it can have several adverse implications when it is not handled properly.

Some of the major adverse implications of debt include:

1. Sovereign Default

When a sovereign defaults on its debt payments, it can have adverse implications on the credibility of the borrower in the eyes of the lenders.

2. Reduced Access to External Financing

A sovereign default can make it difficult for a borrower to raise capital from external sources.

3. Exchange Rate Volatility

External debts can have an impact on the domestic currency of the borrowing country. If the currency appreciates against other currencies, it can increase the cost of repaying foreign liabilities.

4. High Interest Rates

High interest rates can make it difficult for the government as well as the corporate sector to service its debt.

5. Exchange Rate Risk

Exchange rate risk basically refers to the risk of a change in the domestic currency value of a foreign-currency liability.

6. Crowding Out Effect on Economic Growth

Debt can have an adverse impact on economic growth when a country has to allocate a significant amount of its resources towards servicing its debts.

Why Do Developing Countries Need External Debt?

Developing countries have large capital requirements that are not met out of their domestic savings. This necessitates the need for developing countries to take on external debt.

If the borrowed capital is put to development purposes, it will be helpful in promoting the growth of the economy as well as the capacity of the borrower to pay back the loan.

Why Is Foreign Exchange Important for External Debt?

The most important aspect of external debt is the fact that it needs to be serviced in a foreign currency. This implies that the borrower needs to have adequate foreign exchange earnings to be able to meet its obligation.

Foreign exchange earnings for most countries are largely generated out of exports.

This is why the level and rate of growth of exports are important in determining the capacity of a country to pay back its debts.

The external debt-to-exports ratio is an important indicator of how much debt a country can take.

External Debt in India

India’s external debt needs to be assessed keeping in mind its total economic size as well as the capacity of the country to generate foreign exchange earnings.

According to the passage, India’s external debt stood at US$571.3 billion at the end of June 2021, an increase of US$1.6 billion from the end of March 2021.

According to the passage, India’s external debt-to-GDP ratio decreased from 21.1% at the end of March 2021 to 20.2% at the end of June 2021.

External Debt vs Domestic Debt

How Can External Debt Be Managed Sustainably?

The basic objective of debt management is to keep external borrowing at a sustainable level as far as the repayment capacity of the borrower is concerned.

External debt can be managed sustainably in the following ways:

1. Keeping Borrowing Sustainable

External borrowing should be kept within manageable limits.

2. Keeping Exports Strong

A strong and healthy export sector can generate the foreign exchange needed to pay back external debts.

3. Avoiding Excessive Short-Term Borrowing

Excessive short-term borrowing can put an additional burden on the borrower to repay the debts.

4. Maintaining Fiscal Discipline

Fiscal discipline will help keep the debt-servicing burden of the government in check.

5. Making Sure Borrowed Funds Are Used Productively

The borrowed capital needs to be put to productive uses so that the growth and repayment capacity of the economy can be improved.

Conclusion

External debt is neither inherently good nor bad. Its impact is determined by the extent to which it is borrowed, for what purpose, and whether the borrower has the capacity to pay it back.

When used judiciously, external borrowing can help provide resources to fund the needs of the economy as well as its development. But when it is taken on recklessly or when it becomes difficult for the borrower to pay it back, it can have adverse implications for the economy.

FAQs

What is external debt?

External debt refers to money borrowed from external lenders like foreign governments, commercial banks and international financial institutions.

What are the main types of external debt?

The main types of external debt are short-term and long-term debt, multilateral and bilateral debt, and sovereign and non-sovereign debt.

What is bilateral debt?

Bilateral debt basically refers to external debts contracted between two countries.

What is multilateral debt?

Multilateral debt basically refers to external debts contracted by international agencies like the International Development Association (IDA), International Bank for Reconstruction and Development (IBRD), Asian Development Bank, etc.

What are External Commercial Borrowings?

External Commercial Borrowings (ECBs) basically refer to borrowings raised from external sources.

ECBs can be raised from commercial banks and financial institutions, as well as from external bonds and floating rate notes (FRNs).