External debt is defined as part of a country’s debt that is borrowed from various foreign lenders such as commercial banks, governments, or international financial institutions. External Debt is borrowed from foreign lenders and is mostly paid in the currency in which the loan was made. In case of non-payment of external debt, a country could get embroiled in a debt crisis. In this article, we will study about external debt which is important for UPSC preparation.

What is External Debt?

• External debt can be regarded as one of the forms of a tied loan, where the borrower needs to apply any spending of the funds to the country which has provided the loan.
• In case of an inability of the borrower country to produce and sell goods so as to make a profitable return to repay the loan, there arises a debt crisis.
• As of June 2021, India’s external debt was placed at US$ 571.3 billion, recording an increase of US$ 1.6 billion over its level at the end-March 2021.
• India’s external debt to GDP ratio declined to 20.2 per cent at the end-June 2021 from 21.1 per cent at end-March 2021.
• External debt sustainability can be measured based on the following parameters:

1. Government’s debt and current fiscal revenue ratio.
2. The overall share of short and long-term debt in the total debt burden.
3. Share of concessional debt.
4. Foreign debt to exports ratio
5. Debt to GDP ratio
6. The share of external debt to the total debt of the country.

Types of External Debt

Long and Short Term Debts

Long term debt is debt with an original maturity of more than one year and short term debt is defined as debt repayments on-demand or either with an original maturity of one year or even less.

Multilateral and Bilateral Debt

• Multilateral institutions such as the International Development Association (IDA), International Bank for Reconstruction and Development (IBRD), Asian Development Bank (ADB) etc are regarded as multilateral creditors.
• Whereas nations that engage in sovereign and non-sovereign arrangements such as one-to-one loan arrangements are bilateral creditors. India’s bilateral creditors are Japan, Germany, the United States, France, etc.

Sovereign (Government) and Non-Sovereign (Non-Government) debt

• External debt on account of loans received by the Government of India under the ‘external assistance’ programme, government’s debt comprising borrowings from IMF, defence debt component of Rupee debt and foreign currency defence debt together constitute sovereign debt.
• Non-Sovereign debt is constituted by the rest of the components of external debt.
• Trade/Export Credits
• It is when the loans and credits are extended for imports by overseas suppliers, banks and financial institutions to sovereign and non-sovereign entities.
• External Commercial Borrowings (ECB)
• It includes borrowings from commercial banks, financial institutions, money that is raised through issuing securitized instruments such as bonds, floating rate notes (FRN), securitized borrowing of commercial banks etc.

Impact of External Debt

• In the case of non-payment sovereign default can occur which can lead to lenders withholding future releases of assets that might be needed by the borrowing nation.
• Due to sovereign default, the borrower’s currency can collapse leading to the deterioration of economic growth.
• It can sometimes cause erratic changes in the interest rate which can lead to greater default by borrowers.
• Increased changes in the exchange rates of different foreign currencies can occur.

Conclusion

External debt is a component of total government debt owed to foreign individuals. Failure to repay external debt can lead to a sovereign debt crisis which is detrimental for the economic growth of the nation. It is also necessary to provide stimulus to various economic activities, especially in a developing nation. Hence, external debt should be complemented by strong fiscal measures so as to prevent a debt crisis.

FAQs

MCQs

1. What is the main purpose of external debt for a developing country?

A) Financing luxury imports
B) Stabilizing foreign exchange reserves
C) Supporting infrastructure and development projects
D) None of the above

2. Which of the following institutions is NOT a key source of external debt for India?

A) World Bank
B) IMF
C) NITI Aayog
D) Bilateral loans from other countries

3. Which of the following is considered short-term external debt?

A) Debt due in 5 years
B) Debt due within 1 year
C) Debt from international banks
D) All of the above

4. How does an increase in external debt affect a country’s economy?

A) It always boosts economic growth
B) It increases the debt servicing costs
C) It reduces inflation
D) It leads to a higher GDP growth rate

5. What is the external debt-to-GDP ratio?

A) A measure of total debt owed by a country
B) A ratio comparing a country’s total external debt to its Gross Domestic Product (GDP)
C) The total amount of foreign direct investment in the country
D) A measure of foreign exchange reserves

GS Mains Questions and Answers

Q1: What are the main challenges in managing India’s external debt? Discuss with relevant examples.

Answer: Managing India’s external debt poses several challenges, including currency fluctuations, rising debt servicing costs, and external shocks like global financial crises. India has a diversified source of external debt, with a mix of multilateral, bilateral, and commercial borrowings. However, excessive dependence on external commercial borrowings (ECBs) can lead to high costs if currency depreciation occurs, increasing the burden of repayment.

The government must focus on maintaining a manageable debt-to-GDP ratio, ensuring that debt is sustainable in the long term. Managing foreign reserves and adopting prudent fiscal policies are critical to mitigating the risks associated with external debt. For example, during the 2013 currency depreciation crisis, India's external debt burden rose, highlighting the need for careful monitoring of external borrowing and debt servicing costs.

Q2: Explain the role of external debt in India’s economic growth. Is it a boon or a bane?

Answer: External debt plays a dual role in India’s economic growth. On the one hand, it provides critical resources for financing infrastructure, industrial growth, and developmental projects, which stimulate economic progress. On the other hand, excessive external debt can lead to debt servicing burdens, currency depreciation, and balance of payments crises if not managed properly.

For instance, India has successfully utilized external debt for development projects, such as power plants and highways, fostering growth in key sectors. However, during times of global economic instability or sharp currency depreciation, the costs of repaying this debt can outweigh the benefits, making external debt a potential burden. Therefore, the key lies in maintaining a balanced external debt strategy that supports growth while mitigating risks.

Q3: Evaluate the significance of multilateral borrowing in managing India’s external debt. What are the advantages and risks?

Answer: Multilateral borrowing, from institutions such as the World Bank and the IMF, plays a critical role in managing India’s external debt. These loans typically come with lower interest rates and longer repayment periods, making them less risky compared to commercial borrowings. Additionally, multilateral loans often come with technical assistance and policy advice, supporting effective project implementation.

However, relying too much on multilateral institutions can also lead to policy conditionalities, which may constrain domestic policy flexibility. For instance, IMF loans often come with macroeconomic stipulations that can affect national sovereignty in economic decision-making. Balancing multilateral loans with other forms of borrowing is essential to ensure sustainable debt management.

Previous Year Questions on External Debt

1. UPSC CSE Prelims 2018:

Question: Which of the following is considered part of India’s external debt?

A) Domestic borrowings
B) Sovereign bonds issued to international investors
C) Loans from the Reserve Bank of India
D) Treasury bills issued in Indian rupees

Answer: B

Explanation: Sovereign bonds issued to international investors are part of India’s external debt as they represent obligations owed to foreign creditors.

2. UPSC CSE Mains 2021 (GS Paper 3):

Question: "External debt is a double-edged sword for developing economies." Analyze this statement with reference to India.

Answer: External debt is essential for developing economies to finance infrastructure projects and meet fiscal deficits, but it can also lead to financial vulnerabilities if not managed carefully. In India's case, external debt has been crucial in funding development, but challenges such as rising debt servicing costs and currency depreciation have raised concerns over long-term sustainability. The external debt-to-GDP ratio remains a key indicator of the country's ability to manage these obligations. Proper debt management strategies, including diversifying the debt portfolio and controlling the fiscal deficit, are vital to ensure that external debt does not become a financial burden.