External Debt Essay

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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:    

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

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