External Debt

Updated on January 29, 2024
Article byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is External Debt?

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.

External Debt

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: External Debt (wallstreetmojo.com)

Also known as foreign debt, external debt includes principal and interest. However, it does not consider contingent liabilities. 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.  

Key Takeaways

  • External debt meaning refers to the amount that a country or company must repay a foreign lender. Usually, a nation takes on this debt to meet various expenses and fund investments in multiple sectors.  
  • Some common sources of external debt are foreign commercial banks and governments. Moreover, a nation can afford this type of debt from the World Bank, IMF, and other international financial institutions.
  • The common types of external debt are public and publicly guaranteed debt, non-guaranteed public sector external debt, and loans offered by the IMF.
  • Excessive foreign debt can obstruct economic growth over the long term.

External Debt Explained

External debt meaning implies a portion of a nation’s debt borrowed from foreign institutions. Typically, governments and companies do not prefer taking on this type of debt as it gives the lending country leverage over them. Nevertheless, specific reasons compel a country to avail of financial assistance from a foreign lender. Some of these reasons are as follow:

  • Domestic financial institutions, including commercial banks, do not have adequate funds to sanction a loan.
  • Foreign lenders offer loans at a lower interest rate than domestic financial institutions. Moreover, foreign financial institutions may offer better repayment terms.
  • A country must use the available domestic funds for specific purposes, such as healthcare and education.

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.

Sometimes, foreign debt may come in the form of a tied loan. This means that the borrower must utilize the loan amount to only make expenditures in the lender’s country. For example, a loan might only allow a country to purchase the required resources from the nation that sanctioned the loan.

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.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

Some popular types of external debt are as follows:

1. Public And Publicly Guaranteed Debt

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.

2. Loans Offered By IMF

The IMF may offer two types of financial assistance. First, they provide loans at non-concessional interest rates to high and middle-income countries. Secondly, they offer loans to low-income nations on concessional terms.

3. Non-Guaranteed Private Sector External Debt

This sub-type refers to private debtors’ long-term external obligations that a public entity does not guarantee to repay.

Effects

If governments lack the funds required for capital expenditures to boost income levels and out in the economy, they often take on foreign debt. 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.

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.     

Examples

Let us look at a few external debt examples to understand the concept better.

Example #1

In September 2022, Antony Blinken, the U.S. Secretary of State, pledged more funds to help Pakistan cope with the devastating flood that killed over 1,600 people. 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.

Besides pledging more funds, Antony Blinken urged Pakistan to look for debt restructuring and relief from China, its largest creditor. The loan amount Pakistan still must repay includes the balance of payments supports worth $6 billion.

Example #2

Suppose Country A requires significant capital expenditure to recover from a natural disaster. That said, the funds available domestically are not enough. Hence, Country A takes on external debt from Country B to fulfill its requirement. Country A must fulfill its obligation in time to prevent any impact on its credit ratings.

Advantages And Disadvantages

The advantages of foreign debt are as follows:

  • Enables governments to access capital that can help them meet various expenses and boost economic development
  • Promotes improved governance and macroeconomic policy in the borrowing country
  • Enables governments to access funds when domestic financial institutions cannot offer loans.

Let us look at some disadvantages of external debt.

  • It often leads to a vicious cycle of debt for nations.
  • Excessive foreign debt can hamper a nation’s ability to invest in different sectors, thus hindering long-term economic growth.  

External Debt vs Internal Debt vs Public Debt

Internal, external, and public debt might confuse an individual who is not familiar with these terms. All three are a source of financing for governments, companies, and individuals. However, they have some distinct features. The table below compares these three concepts to get a clear idea about them.

Basis Of ComparisonExternal DebtInternal DebtPublic Debt
MeaningThis refers to a country’s debt usually taken by a foreign lender.Internal debt refers to borrowings that a country, company, or individual owes domestic lenders.Also known as government debt, public debt refers to a country’s overall outstanding debt.
SourcesExternal debt sources are foreign commercial banks, governments, and international financial institutions. Some popular institutions are the World Bank and IMF. The sources of internal debt are domestic financial institutions, like commercial banks.The public debt sources are both domestic and foreign governments and financial institutions.
ComponentsUsually, the foreign debt components are private non-guaranteed credits, the debt payable to IMF, central bank deposits, and public and publicly guaranteed debt.   This form of debt consists of loans availed in the open market, compensation and other bonds, special securities issued to the central government, etc.Public debt comprises both internal and external debt.

Frequently Asked Questions (FAQs)

1. What is external debt to GDP ratio?

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.

2. Which country has highest external debt?

The U.S. has the highest amount of foreign debt. The country’s total external debt stood at $20.41 trillion in 2019. The nations that follow the U.S. in the list are —
– United Kingdom
– France
– Germany
– Japan
– The Netherlands, etc.

3. Is external debt good or bad?  

Foreign debt can be useful as it allows the country to fund investment in different sectors, thus improving economic growth. Moreover, a country can utilize the funds received from a foreign lender to meet various expenditures. That said, one must remember that it can lead to a vicious cycle of debt. This can thwart long-term economic development. Hence, companies and governments prefer internal debt to foreign debt.

4. What are the determinants of external debt?

Some of the main determinants of foreign debt accumulation are as follows:
– Unstable exchange rates
– Persistent budget deficits
– Low savings
– High-interest rates, etc.

This article has been a guide to What is External Debt. We explain its types, examples, advantages & disadvantages, & compare it with internal & external debts. You can also go through our recommended articles on economics –

Reader Interactions

Comments

  1. Ismail Muhammed says

    This article is very helpful and resourceful,it is indeed highly detailed.

Leave a Reply

Your email address will not be published. Required fields are marked *