What it means
Foreign debt has a public part and a private part. Public external debt is borrowed by the government and state entities, while private external debt is borrowed by banks and companies, and a crisis in either can quickly spill into the other because the government often ends up supporting failing banks.
Borrowing abroad is not automatically bad. It brings in capital that a domestic savings pool cannot supply, which can fund infrastructure, industry and imports of capital equipment, and countries at an early stage of development routinely rely on it.
The vulnerability comes from the terms. Analysts track external debt as a share of gross domestic product, the debt service ratio comparing annual repayments with export earnings, and the level of foreign exchange reserves relative to short-term external obligations falling due within a year.
The specific problem economists refer to as a currency mismatch is the reason external debt is treated differently from domestic debt. A government can always create more of its own currency, but it cannot create dollars, so debt in a foreign currency turns an exchange rate movement into an immediate solvency question.
For companies the practical relevance is indirect but sharp. When a country's external position deteriorates, local borrowing costs rise, credit ratings fall, capital controls become possible, and multinational groups can find it difficult to move cash out of a subsidiary in that market.
In practice
Real-world examples.
Example
A cement producer in an emerging market borrows in dollars because the rate is three percentage points below the local alternative. Its revenue is entirely in local currency, so when that currency weakens by a fifth, its interest bill in local terms rises sharply while its sales are unchanged.
Example
An exporter of processed food in the same country experiences the opposite. Its dollar receipts translate into more local currency, its dollar borrowing is naturally matched by dollar revenue, and the weaker currency actually improves its competitive position abroad.
Example
A regional bank funds long-dated local lending with short-term foreign currency borrowing from overseas banks. When those lenders decline to roll the facilities during a period of stress, the bank faces a funding gap that no amount of good local loan quality can close.
Formula
Calculation
External debt to GDP = total external debt / gross domestic product. Debt service ratio = annual external principal and interest payments / annual export earnings.
Worked example. A country has external debt of $180 billion against a gross domestic product of $450 billion, so the ratio is $180 billion / $450 billion = 40%. Its annual external debt service is $14 billion against exports of $70 billion, giving a debt service ratio of $14 billion / $70 billion = 20%. Now suppose the local currency loses 20% of its value, so the exchange rate moves from 50 to 62.5 units per dollar. The external debt was worth 180 x 50 = 9,000 billion local units and is now worth 180 x 62.5 = 11,250 billion local units, an increase of 25%, while domestic output measured in local currency is unchanged at 450 x 50 = 22,500 billion units. The external debt to GDP ratio has therefore jumped from 40% to 11,250 / 22,500 = 50% without the country borrowing a single extra dollar.Case study
Seen in the real world.
Solvane Cement is a fictional manufacturer, operating in an equally fictional country called Marovia, used here only as an illustration. Marovia's external debt sat at about 38% of gross domestic product, a level widely regarded as manageable, and dollar borrowing was cheap, so Solvane funded a new kiln with a $60,000,000 dollar loan while selling every bag of cement domestically.
A commodity price shock hit Marovia's export earnings and the currency fell by roughly a quarter against the dollar over eight months. Solvane's loan principal was unchanged in dollars, but in local currency terms both the principal and the interest cost rose by about a third, and its interest cover fell from 4.1 times to 2.4 times.
The illustrative lesson is about matching rather than pricing. The three percentage point saving that made the dollar loan attractive was wiped out many times over by a currency move, and after the episode the fictional company adopted a simple policy of borrowing only in the currency in which it earns.
Watch out
Common mistakes.
- Judging foreign debt purely by its size rather than by its currency, maturity profile and the reserves available to service it.
- Assuming that only governments carry external debt, when private sector foreign borrowing is often the larger and faster-moving part of the total.
- Treating a low interest rate on foreign currency debt as a saving, when the rate difference frequently reflects the exchange rate risk being transferred to the borrower.
Questions
People also ask.
What is the difference between foreign debt and sovereign debt?
Foreign debt is defined by who the lender is, meaning anyone outside the country, while sovereign debt is defined by who the borrower is, meaning the government, and a bond can be one, both or neither.
Why do foreign exchange reserves matter so much here?
Reserves are the buffer that allows a country to keep meeting foreign currency obligations when export earnings dip or lenders refuse to refinance maturing debt.
How should a company operating in a high external debt country protect itself?
Match borrowing currency to revenue currency where possible, keep shorter payment terms with local customers, and plan for the possibility that moving cash out of the country becomes restricted.
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