External Debt | Types, Effects, Merits and Demerits

External Debt can be defined as money borrowed from outside the country from sources like foreign governments, International Monetary Funds (IMF), Foreign Direct Investments (FDI), Foreign Portfolio Investments (FPI), etc. As people and businesses sometimes need to borrow money to pay their expenses, the same goes for the government of any country. The government sometimes may need to borrow money from either inside the country or outside the country. The borrowed money is known as Debt, and the modes of borrowing money can be classified into two categories – External Debt and Internal Debt.

What are External Debts?

External debt can be defined as the debt borrowed by the government from outside the country. Sources for external debts can include foreign governments, International Monetary Funds (IMF), World Bank, Foreign Direct Investments (FDI), Foreign Portfolio Investments (FPI), etc. The government is forced to borrow funds from external sources when the internal sources do not have adequate funds to support the operations of the government. External debts are voluntary in nature. The nature of External debts is more complex as compared to Internal debts as it uses the concept of foreign currency. The government offers money from external sources to boost its economy after facing any economic crunch, to invest in multiple sectors, etc.

Key Takeaways from External Debts:

• External debts are the debts that the government needs to borrow from external sources to fund its operations.
• Lack of availability of funds from internal sources forces the government to borrow funds from external sources.
• External debts are more complex as they use the concept of foreign currency and the involvement of people outside the country.
• Interest rates on external debts are generally lower than it is on internal debts but may offer better repayment terms.

Examples of External Debts

• At the end of March 2023, India’s external debt amounted to USD 624.7 billion and it was USD 5.6 billion more than the year March 2022.
• In case, country A needs funds to recover from the effects of natural disasters, and country B is ready to help, then country A should take the loan and repay it timely to avoid the negative impact of external debts.

Types of External Debts

External debts are generally of three types, namely Public and Publicly Guaranteed Debts, Loans offered by IMF, and Non-Guaranteed Private Sector External Debt. These three are explained below:

1. Public and Publicly Guaranteed Debts: These debts are long-term external debts borrowed from the government of another country and/or their representatives to meet the required obligation.

2. Loans offered by IMF: The International Monetary Fund (IMF) provides financial assistance to its member countries through various types of loan programs. Stand-by arrangements, Extended Fund Facilities, Flexible Credit Lines, Rapid Financing Instruments, etc. are some of the loan forms offered by the IMF.

3. Non-Guaranteed Private Sector External Debt: These debts are long-term external debts borrowed from the government of another country and/or their representatives where the debtors do not guarantee repayment.

4. Central Bank Deposits: Central bank deposits are more of a country’s international reserves. International reserves are assets held by the country’s central bank, often in foreign currencies and other internationally recognized assets, that can be used to stabilize the country’s economy.

Effects of External Debts

External debts are debts borrowed from external sources and use the concept of foreign currency. External debts affect the level of a country on a deeper level. Countries heavily reliant on external debts are more vulnerable to economic downturns. A sudden drop in revenue or an increase in interest rates can worsen their debt situations. Further, If a country borrows in foreign currencies, fluctuations in exchange rates can lead to increased debt servicing costs, especially if depreciation of currency takes place. High levels of external debt can lead to lower credit ratings, making it more expensive for a country to borrow in the future.

Significance of External Debts

1. Investment in Infrastructure and Development: External debts can provide a country with the necessary funds to invest in infrastructure projects, such as building roads, bridges, and power plants, which can drive economic growth.

2. Budget Gaps: Borrowing externally can help governments cover budget deficits, allowing them to continue providing essential; services like healthcare and education.

3. Economic Growth: When used wisely, borrowed funds can boost economic activity, create jobs, and enhance productivity, leading to overall economic development.

Limitations of External Debts

1. Debt burden: Excessive external debts can become a burden on a country’s finances. Interest payments and principal repayments can strain government budgets, diverting resources away from essential services.

2. Economic Shocks and Interest rates: Countries heavily reliant on external debts are more vulnerable to economic downturns. A sudden drop in revenue or an increase in interest rates can worsen their debt situations.

3. Exchange Rate Risks: If a country borrows in foreign currencies, fluctuations in exchange rates can lead to increased debt servicing costs, especially if depreciation of currency takes place.

4. Credit Rating Risks: High levels of external debts can lead to lower credit ratings, making it more expensive for a country to borrow in the future.