Foreign Debt
The money that a government, an organization, or a household borrows from the government or private lenders of another country
What is Foreign Debt?
Foreign debt refers to the money that a government, an organization, or a household borrows from the government or private lenders of another country. The obligations to organizations such as the World Bank and the Asian Development Bank (ADB) are also categorized as foreign debt. The short-term debt can be used in combination with long-term debt to form foreign debt.
Foreign debt has gradually risen in recent decades, with unexpected side-effects for some borrowing countries. Including slower economic growth, especially in low-income countries, crippling debt problems, stock market instability, and even secondary consequences such as rising human rights abuses. Foreign debt can also be referred to as external debt.
Summary
- Foreign debt refers to the money that a government, an organization, or a household borrows from the government or private lenders of another country.
- The IMF and the World Bank maintain that foreign debt sustainability can be achieved if a country meets its current, as well as future, obligations of foreign debt.
- Various metrics exist to assess a sustainable degree of foreign debt.
Impacts of Foreign Debt
A government or a company will want to borrow from an overseas lender for a variety of reasons. One reason is that local debt markets may not be capable of meeting their financing needs, especially in developing countries. Additionally, foreign lenders may simply offer more favorable terms. For countries with low income, in particular, borrowing from foreign institutions is a necessary choice since it will provide financing that it would otherwise not be able to obtain at competitive rates and flexible periods of repayment.
Excessive amounts of foreign debt will hinder countries’ capacity to invest in their financial prospects, whether through education, infrastructure, or health care, because their small income is spent on repayment of loans. It is a challenge to economic development in the long term.
Ineffective debt management, coupled with shocks such as a fall in oil prices or an extreme economic recession, may also cause a debt crisis. This is also compounded by the fact that foreign debt is generally denominated in the currency of the nation of the issuer, not that of the borrower. This means that if the economy of the borrowing country weakens, it becomes even harder to pay off such debts.
Indicators of Foreign Debt Sustainability
The International Monetary Fund (IMF) and the World Bank maintain that foreign debt sustainability can be achieved if a country meets its current, as well as future, obligations of foreign debt without debt rescheduling and comprising growth. According to the IMF and the World Bank, reducing the net present value of foreign public debt to around 150% of the export of a country or 250% of the taxes of the country would help to overcome the obstacle.
Various metrics exist to assess the sustainable degree of foreign debt. Although each offers its own benefit and uniqueness in dealing with particular circumstances, there is no consensus opinion among economists on a single indicator. Both metrics – solvency and liquidity – are largely based on the essence of the ratios and thereby make it possible for decision-makers to practice proper debt management.
The above metrics can be viewed as indices of the solvency of the government where they regard the debt stock at a given point in relation to the capacity of the country in generating resources for repaying the outstanding debt amount.
Debt-to-GDP, government debt-to-fiscal revenue, and foreign debt-to-export are some of the ratios that can be used as metrics for managing foreign debt burden. The metrics also contain the composition of outstanding debt, including short-term debt, foreign debt portion, and concessional debt in overall debt stock.
The second group of metrics reflects the short-term liquidity needs of a country for its debt repayment obligations. The metrics are not only helpful early warning signals of debt repayment issues, but they also illustrate the effect of inter-temporal choices emerging from previous borrowing decisions. Debt service-to-GDP, government debt service-to-actual fiscal revenue, and foreign debt service-to-export are some ratios used for tracking liquidity.
Another set of metrics exists that shows the change in debt burden over time, considering the interest rate and the pool of data currently available. They are forward-looking indicators that indicate how debt-burden metrics would change when new disbursements or repayments are absent.
Related Readings
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
Financial Analyst Certification
Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!
