External Debt Essay ⋆ Business Essay Examples ⋆ EssayEmpire

External debt, in its most general sense, denotes a payment obligation in which the debtor (entity that obtained resources) and the creditor (entity that supplied the resources) are separate and in essence distinct units. The offshoot of this perspective is that creating or terminating the debt generates a corresponding change in aggregate wealth or resources on the part of both units involved in the transaction.

The entities involved can be corporations, individuals, or countries. For corporations, the debt would then be referred to as corporate debt. Debts always entail a liability that has to be eventually paid back on agreed terms. In the case of relatively small businesses, debt is usually in the form of loans or lines of credit obtained from banks.

Corporate Debt

With respect to relatively large corporations, a major portion of debt takes the form of financial instruments, usually bonds of one form or another. Bonds are borrowing arrangements whereby an issuer or borrower sells an IOU to an investor or lender. By this arrangement, the issuer is obligated to make stated payments to the bondholder on specific dates. A coupon bond obligates its issuer to make fixed nominal payments called coupon payments over the life of the bond. In addition, the issuer pays the lender the bond’s face value at the time of expiration (maturity date). The coupon rate then is the coupon payment expressed as a percent of the bond’s par value. The terms of the issue, including the coupon rate, par value, the maturity date, and any other legal rights and responsibilities of the issuer and the holder are spelled out in a contract, called an indenture. Sometimes coupon payments are set to zero so that the buyer pays a price below the par value to get a return equal to the price difference when principal is repaid at maturity in the amount of the bond’s face value.

Usually firms issue four types of corporate debt, namely debentures, notes, mortgage bonds, and asset-backed bonds. Notes in this context are generally bond issues whereby all obligations are due less than 10 years from the date of issue. A more common maturity for corporate bonds is 20 to 30 years.

Debentures, like notes, are not secured by any specific pledge of property. They do, however, have claim to the issuer’s property and earnings because they share the claim of general creditors on all assets owned by the issuer but not specifically pledged to secured debt elsewhere. They also have a claim on pledged assets whenever such assets exceed what is needed to satisfy secured lenders.

Secured debt is that whereby particular assets are pledged as collateral so that investors in bonds have direct claim to the assets given bankruptcy. This type of debt is also referred to as asset-backed bonds. Mortgage bonds are an example of asset-backed bonds secured by real property. The process of raising capital through debt financing is analogous to the initial public offering (IPO) for stocks.

Country Debt

When the entities involved include countries, external debt is defined as the outstanding amount of actual, current, and noncontingent payments of principal and interest by the debtor country that are owed to nonresidents by the residents of the borrower country. The liability has to exist and be outstanding. It is important to establish whether the creditor actually owns a claim on the debtor. The debt liabilities in this case are created through provision of economic value, i.e., financial and nonfinancial assets including goods, services, or transfers by one institutional entity, the creditor to another unit, the debtor, usually under some contractual arrangement. Liabilities can also accrue in this type of borrowing, from legal action such as when taxes, penalties, or judicial awards are imposed by force of law. Liabilities from external debt at the country level also include arrears of principal and interest charges.

Where commitments are made for provision of economic value at a future date, corresponding debt liabilities are not established unless services are rendered, items change ownership or some form of income accrues to the borrower. For example, the components of an agreed loan arrangement that have yet to be disbursed to the beneficiary or export credit commitments not utilized are not part of a country’s gross external debt position.

The country-level definition of external debt makes no distinction between required principal payments and interest payments. As a result, interest-free loans are treated as debt instruments even though no interest is paid. Perpetual bonds are likewise considered debt instruments although principal is not repaid on them. The form of payment can be deposits of funds or provision of goods and services. Here future obligations to make payments, rather than the form of payments, determine whether or not a given liability is a debt instrument. Similarly, the timing of payments is irrelevant in this regard.

In order to be considered external debt, the liabilities must be owed by a resident of the borrower country to a nonresident. Residence status in this instance is based on where the debtor and creditor have their centers of economic interest. Thus, what matters is their ordinary location, not their official nationality. Also excluded from the definition of external debt are contingent liabilities. These refer to arrangements whereby one or another specific condition must be fulfilled prior to a financial transaction. This does not imply that guaranteed debt, for example, is excluded. The guaranteed debt is attributed to the debtor rather than the guarantor—until the guarantee is called.

The historical experience of developing countries with external debt highlights benefits and risks entailed in reliance on debt as a major source of capital. In the aftermath of World War II during the rapid economic expansion of the developed countries, less developed countries also enjoyed relatively fast growth rates. However, on account of their domestic savings and foreign exchange gaps, less developed countries increased their external debts to sustain their economic growth. Following the sudden oil price increases of the 1970s and the accompanying episodes of inflation, industrial countries implemented restrictive monetarist policies to stabilize their economies. This led to higher interest rates, which in turn raised costs of debt servicing.

A combination of costly debt service and easy availability of debt from oil surpluses of exporting countries contributed to a buildup of unsustainable debt among less developed countries. Most of this debt was underwritten by governments of industrial countries and multilateral institutions like the World Bank and the International Development Association (IDA). The debt problem deteriorated to a point at which more debtor defaults were likely among nations before debt forgiveness by multilaterals and governments provided bail-outs for highly indebted poor countries. The literature documents cases of default in the past with little consequence to debtors.

Bibliography:

Alvarez-Plata and T. Bruck, “External Debt in Post-Conflict Countries,” World Development (v.36/3, 2008);
Efraim Benmelech and Nittai K. Bergman, Collateral Pricing (National Bureau of Economic Research, 2008);
Laurence Booth and Sean Cleary, Introduction to Corporate Finance (John Wiley, 2008);
R. Graham and C. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics (v.60, 2001);
Aart Kraay and Vikram Nehru, “When Is External Debt Sustainable?,” World Bank Economic Review (v.20/3, 2006);
S. External Debt and Power (Council on Foreign Relations, 2008);
Winkler, Foreign Bonds: An Autopsy (R. Swain, 1933);
Wynne, State Insolvency and Foreign Bond Holders: Case Histories, 2nd ed. (Yale University Press, 1951).

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