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.

Key Takeaways:

  • External debt is the portion of a country's debt that is borrowed from foreign lenders through commercial banks, governments, or international financial institutions.
  • If a country cannot repay its external debt, it faces a debt crisis.
  • If a nation fails to repay its external debt, it is said to be in sovereign default.
  • External debt can take the form of a tied loan, whereby the borrower must apply any spending of the funds to the country that is providing the loan.

Understanding 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 International Monetary Fund (IMF) is one of the agencies that keeps track of countries' external debt. The World Bank 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 the lender has brought against the delinquent nation. Defaults and bankruptcies in the case of countries are handled differently than defaults and bankruptices in the consumer market. It is possible that countries that default on external debt may potentially avoid having to repay it.

How External Debt Is Used by the Borrower

Sometimes referred to as foreign debt, corporations, as well as governments, can procure external debt. In many instances, external debt takes the form of a tied loan, which means 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 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. 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.