External Debt

What is External Debt?

External debt refers to the loans raised through foreign lenders, such as foreign commercial banks, foreign governments, and international financial institutions. In the case of external debt, all repayments must be made in the currency in which the debt was issued.

On the other hand, internal debt refers to the money owed to domestic financial institutions and commercial banks.

Understanding External Debt

In addition to internal debt, external debt serves as one of the two primary sources of borrowing of individuals, organizations, and national governments.

Countries borrow from foreign creditors mainly to finance their own excess expenditures, build additional infrastructure, finance recovery from natural disasters, and even to repay its previous external debt.

Companies and governments generally do not prefer external debt, since they impose restrictions on the borrowing country and give the lender country some leverage over them. However, certain circumstances compel countries to borrow money from outside, some of which are as follows:

• When domestic commercial banks and financial institutions lack sufficient money to lend
• When available domestic funds need to be utilized in other important areas, such as healthcare and education
• When international financial institutions and foreign governments offer lower interest rates and easier repayment schemes than the domestic debt market

Risks Associated with External Debt

There are several risks associated with foreign debt as well, which are as follows:

1. Affects economic growth

Economic growth occurs when governments and companies incur capital expenditures that boost production and increase output and income levels. If large amounts of external debt need to be repaid, then there is less money left for investment purposes. It hampers future economic growth.

2. Long gestation period

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.

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.

3. Unexpected devaluation of domestic currency

If the currency of the borrowing country depreciates with respect to that of the lending country, then the real value of interest (as denominated in the domestic currency) will rise.

For example, France borrows $100 million from the U.S. at an interest rate of 5% per year. When the euro-dollar ratio is 1:1, then the yearly interest payment is $5 million, or €5 million. If the euro suddenly depreciates and the euro-dollar ratio changes to 1.5:1, then the yearly payment denominated in euro increases to €7.5 million.

The Vicious Cycle of Debt

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.

When a government’s expenditure exceeds how much it earns in a year, it faces a fiscal deficit. In order to finance the adverse gap, the government borrows money from another country. In the next year, with the additional expense of interest payment and loan repayment, the government might face a deficit again and be forced to take another external loan. In subsequent years, there might be a situation where it borrows money in order to repay its previous loans.

A country with a high amount of external debt raises caution among prospective lenders, and they become unwilling to lend more money. 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.

To better understand a debt cycle, consider the following example. Country X incurs a fiscal deficit of $100 million in Year 1 and plans to invest $100 million in an infrastructure project. It borrows $200 million from Country Y at an interest rate of 5% per year. The loan must be repaid in 10 annual installments of $20 million each, starting from the following year.

Assume that all subsequent deficits arise out of loan repayments, and X takes further 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. The amounts in the following table are in million dollars.

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.

Additional Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Commercial Loan Agreement
• Default Rate
• Financial vs. Non-Financial Covenants
• Senior and Subordinated Debt
• See all economics resources