External Debt: Definition, Types, vs. Internal Debt

What Is External Debt?

External debt is the portion of a country’s debt that is borrowed from foreign lenders, including commercial banks, governments, or international financial institutions. These loans, including interest, must usually be paid in the currency in which the loan was made. To earn the needed currency, the borrowing country may sell and export goods to the lending country.

Understanding External Debt

External debt, or foreign debt as it is sometimes called, factors in both principal and interest and does not include contingent liabilities, which are debts that may be incurred at a later date based on the outcome of an uncertain future event. It is defined by the International Monetary Fund (IMF) as debt liabilities owed by a resident to a nonresident, with residence being determined by where the creditors and debtors are ordinarily located rather than by their nationality.

In some cases, external debt takes the form of a tied loan, which means that the funds secured through the financing must be spent in the nation that is providing the financing. For instance, the loan might allow one nation to buy resources it needs from the country that provided the loan.

External debt, particularly tied loans, might be set for specific purposes that are defined by the borrower and the lender. Such financial aid could be used to address humanitarian or disaster needs. For example, if a nation faces severe famine and cannot secure emergency food through its own resources, it might use external debt to procure food from the nation providing the tied loan.

Likewise, if a country needs to build up its energy infrastructure, it might leverage external debt as part of an agreement to buy resources, such as the materials to construct power plants in underserved areas.

Defaulting on External Debt

A debt crisis can occur if a country with a weak economy is not able to repay the external debt due to an inability to produce and sell goods and make a profitable return.

The IMF is one of the agencies that keeps track of countries’ external debt. Together with The World Bank, it publishes a quarterly report on external debt statistics.

If a nation is unable or refuses to repay its external debt, it is said to be in sovereign default. This can lead to the lenders withholding future releases of assets that might be needed by the borrowing nation. Such instances can have a rolling effect. The borrower’s currency may collapse, and the nation’s overall economic growth will stall.

The conditions of default can make it challenging for a country to repay what it owes plus any penalties that the lender has brought against the delinquent nation. Defaults and bankruptcies in the case of countries are handled differently from defaults and bankruptcies in the consumer market. It is possible that countries that default on external debt may potentially avoid having to repay it.

The Bottom Line

Like any form of debt, borrowing money from foreign sources can be good or bad. It may be a useful, cost-effective way to access much-needed capital or trigger a vicious cycle of debt.

If it means procuring money for important investments at a cheaper rate than can be found domestically, then it can ultimately be viewed as a good thing. However, the same cannot be said when struggling economies are effectively forced to borrow from other countries on ridiculous terms just to stay afloat.