Problems and Prospects of External Debt Management - Essay Example

Problems and Prospects of External Debt Management When a country requires financial resources in excess of what it already has, it is compelled to borrow finances from other sources. These creditors can be financial institutions located within the domestic country or situated outside the geographical boundaries of the nation. External debt (or foreign debt) is the part of a country’s total debt which it owes to creditors outside its economy. The International Monetary provides a more formal definition of the External Debt. “Gross external debt, at any given time, is the outstanding amount of those actual current, and not contingent, liabilities that require payment(s) of principal and/or interest by the debtor at some point(s) in the future and that are owed to nonresidents by residents of an economy.” (IMF, 2012) The Importance of External Borrowing A nation always tries to borrow its required amount of resources from the domestic financial institutions first. However, these indigenous institutions may not always have sufficient amount of resources to fulfill all the requirements of the country. In that case, it is forced to resort to international commercial banks or international lending institutions like the IMF of the World Bank. It can also request for financial aid from the Government of its ally nations. The debtors of a country can include the national Government, the private corporations or even the individual households. Usually, external debt is borrowed in two ways: by taking loans from the lending institutions or by selling the country’s securities to acquire the required amount of funds. After the country accomplishes its projects with the help of the borrowed resources, it is required to repay the external debt along with its interest payments. Thus, external debt is actually a liability of the nation. For this reason, it is recorded under the Debit Account in the Balance of Payments (BOP) of the country. The BOP is a statement of accounts of the nation including its assets and liabilities and the outstanding credit and debit of the economy. The BOP gives an indication of the country’s position with respect to the international market. If the country has borrowed a large amount of financial resources from abroad, this will automatically add to the Debit account of the BOP. A huge burden of external debt does not reflect a good financial position of the domestic nation. Instead it indicates that financial resources generated within the economy are not sufficient to fulfill the requirements of the national Government, the private firms and the individual households. That is why; the country has to depend on external sources to finance its multifarious requirements. Economists and financial experts always advise countries to keep their external debt burden down to a minimum. Nations are expected not to borrow extra resources unless and until it becomes absolutely necessary (The World Bank, 2012). Indicators of a Country’s External Debt Burden Apart from the Balance of Payments Statement, there are other variables which give an indication of the external debt burden of a particular country. These are: a. The Ratio of External Debt to GDP: A high value of this ratio reflects a high external debt burden of the nation. This shows that the country’s external borrowings are greater than the value of its Gross Domestic Product produced within its geographical boundaries. The financial resources generated in turn from the GDP are not being able to meet all the financial requirements within the economy. Therefore, the country has to borrow extra resources from external creditors b. The Foreign Debt to Exports Ratio: When an economy has a high ratio of foreign debt to exports, this also indicates a high external debt burden of the country. It exhibits that the nation’s borrowing from external sources is more than the value of the goods exported by the country. This may also reflect that the nation’s external debt liabilities are greater than its external credit earnings. The export earnings are the main source of external revenues for a nation. (It also receives interest payments on loans that the country itself has lent to other countries). Thus, if the external borrowings turn out to be more than the export earnings, this shows that the nation owes more to the international economy in comparison to what it is expected to receive from there. c. The Ratio of Debt Service Payments to Exports: A high value of this ratio again reflects a high burden of external debt for the economy. The debt service payments are actually the interest payments that a nation is required to pay on its external borrowings. A high ratio of debt service payments to exports indicates that the country’s external debt interest payments are greater than its export earnings. In other words, the nation spends more resources as the interest payments on its external debt compared to the revenue earned from its export of goods and services. (IMF, 2011) The Management of External Debt The external debt burden of a country is a measure of its external liability towards the international economy. Thus, it should always devise efficient methods of the management of its external debt. This would serve a twin purpose. On one hand, efficient debt management helps the country to utilize the borrowed resources effectively to suit the purposes of its economy. On the other hand, it also ensures the timely repayment of the external loan along with the interest payments. The Management Strategy of External Debt can be formulated keeping in mind the three basic principles in this respect: 1. Reducing the Costs of Borrowing External Resources: The country must ensure that the international institutions provide them with the necessary financial resources at a moderate rate of interest. The interest rate varies according to the different external lending sources. Sometimes, the nation will also be able to bargain for a lower interest rate than is the stipulated norm for the institution. This can be obtained in exchange of a promise of early repayment of the loan. The nation must ensure an affordable rate of interest on the external loans which it would find easier to service. Borrowing external resources at high interest rates makes it more difficult for nations to repay the loans. 2. Efficient Utilization of the Borrowed Resources: It goes without saying that the nation must always make sure that the borrowed resources are used efficiently within its economy. Countries are forced to resort to external borrowing for a variety of purposes. After the loan is secured from the international creditors, the national Government should ensure that it is utilized for the right purposes. Any sort of wasteful allocation of these external funds is to be strictly avoided. Sometimes, the borrowed resources can be utilized to generate among other things, the interest payments required to service the loan. 3. Making Provisions for Timely Repayment of the Loans: Countries must always ensure that they adhere to the timelines stipulated for the repayment of the loans. As soon as it decides to resort to external borrowing, it must formulate an effective debt management strategy. This would help it to utilize the borrowed resources properly and also make arrangements for the timely repayment of the loans. The reputation of a nation in the international financial market depends upon all these factors. If a country is not able to repay its external borrowings in time, this could hamper its chances of securing further resources in future (The World Bank, 2011) India’s Debt Management Strategy The external debt position of India can be seen from the following table: Country Amount of External Debt (in USD) Percentage of GDP India US $ 305.9 billions 17.3 % (India’s Foreign Debt, 2011) According to the data of the Reserve Bank of India, the country’s external debt burden amounted to US $ 305.9 billion in 2011. This constituted 17.3 per cent of the nation’s GDP. During the last financial year, India’s external borrowings increased by 17.2 per cent which totaled & 45 billion in figures. In this domain, the country has had to service external commercial loans, short-term trade credits, and external borrowings from a single nation as well as a consortium of nations. On the other hand, India’s foreign exchange reserves stood at US $ 319 as of July 29, 2011. Since the majority of the country’ external loan exposure was in US $, it was evident that the nation would require almost all its foreign reserves to service its external debt of USD $ 305.9 billion. The country depended heavily on external earnings to replenish its foreign exchange reserves. While some economists were concerned about the situation, others were not so worried. They argue that since India is required to service this external over a period of time, the country has some time to formulate its debt servicing strategies and implement them to good effect. (India’s Foreign Debt, 2011) However, there remains one cause of concern for the country. Beginning from 2008, India’s external debt burden has been increasing. On the other hand, the nation has not been able to devise appropriate methods to increase its foreign exchange earnings, which are required to service the external loans. It has to address this area of concern before it is too late. Otherwise it could run into an external debt crisis in future. Conclusion It is evident from the above discussion that the area of external debt is a serious area of strategy for most countries. Nations resort to borrowing funds from external sources when their own domestic resources fall short of fulfilling their requirements. However, countries should be careful of formulating an effective strategy of managing external debt based on three basic principles. The Strategy should state the methods of utilizing the borrowed resources effectively. It would also facilitate the provisions for timely repayment of the loans. Countries should always attempt to borrow external resources at an affordable rate of interest, which would make the debt service obligations easier to handle. India’s external debt burden has been moderate for the last few years. As of 2011, it stood at US $ 305.9 billion, which amounted to 17.3 per cent of the GDP. The country has relied on external sources of revenue to service its debt obligations. However, since 2008, it has not been able to discover new opportunities of earning foreign exchange revenues. This remains a cause of concern for the country. Unless it is able to discover new ways of earning external revenues, its foreign exchange reserves may soon get depleted in trying to repay external debt. References 1. Reinhart, C.M & Sbrancia, M.B (2011). The Liquidation of Government Debt, Bank for International Setlements, available at http://www.bis.org/publ/work363.htm (accessed on January 6, 2012) 2. Klein, T.M, (1994), External Debt Management: an introduction: Volumes 23-245, USA, World Bank Publications 3. European Bank for Reconstruction and Development (2011), available at http://www.ebrd.com/pages/homepage.shtml (accessed on January 6, 2012) 4. The Economist (2011), available at http://www.economist.com/business-finance (accessed on January 6, 2012) 5. 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