Countries often borrow from foreign lenders, i.e. take on external debt, to meet their expenditure needs. These loans are usually paid in the currency in which the loan was made. While an efficient use of debt finance can generate sustainable economic growth, high levels of external debt can be especially risky for developing countries.

First, the evidence. Data suggests that external (or foreign currency denominated) debt has approximately doubled in Asia’s developing countries in the last few decades. The source of the upward trend in debt in most Asian economies since the onset of the 2008 global financial crisis seems to be caused by low interest rates, which make it easier and more attractive for corporations, individuals and governments to borrow. While not a problem per se, the deterioration in the external debt to export ratio suggests that many regions in Asia may be trending towards higher risk of future debt repayment difficulties.

Second, the impact. Against this backdrop, policy makers and government officials need to understand the impact of external debt on economic growth. In a recently published paper, we study the long-term economic consequences of external debt. We use a comprehensive dataset comprising more than a hundred developing and advanced economies from 1990 to 2015, of which more than a quarter are ADB members. To understand the costs of external debt at a more granular level, we examine the relationship between external debt and growth across different categories, such as public and private external debt. We pay close attention to whether the underlying empirical relationships are conditional on the income level of a country, institutional development, the fiscal framework and the degree of openness, among other factors.

Our main finding suggests that higher levels of external debt seem to generate persistently low growth for a significant number of years. This is especially relevant when we limit our focus to the sample of developing countries. ​The breakdown in external debt further reveals that the negative relationship between total external debt and growth seems to be driven primarily by one of its components, public external debt. Considering these findings, the study suggest that external debt buildup should be closely monitored.

We also study the channels through which external debt affects growth. Our results suggest that public external debt reduces savings and “crowds out” investment, which translates into a low level of capital, such as machinery and equipment. For instance, in their consolidation efforts, governments tend to cut expenditure allotted for public investment, including maintenance of public infrastructure, which tends to have a persistently negative impact on economic growth.

When is the debt level too high? It is important to think carefully about the sustainable level of external debt. Policy makers are often concerned only with the negative impact on growth at high debt levels (typically, over 60% of GDP), but do not worry too much at lower levels of external debt. Instead, our study suggests that the threshold level beyond which public external debt negatively affects economic growth may be as low as 30% of GDP for countries in the lowest income bracket. One suggestion borne out of these findings is that even low levels of external debt should serve as an early warning sign since it raises the debt risk profile of a country.

 

The policy options can be derived based on cross-country evidence with successful debt management experiences. First, countries – especially low- and middle-income countries – should continue efforts to develop technical capacity on public management frameworks that enable them to closely monitor debt buildup and adopt better fiscal management practices. This could include more stringent screening and monitoring policies that can be introduced at the implementation level. This can help ensure that borrowed funds are wisely allocated and could enable a more careful management of the opportunities, costs and risks of different sources of borrowing.

Second, well-developed financial markets that leverage domestic savings in low-income countries can provide fiscal space by providing financial resources that encourage economic growth and development of these countries. Third, increasing accountability and transparency of debt and spending may incentivize better debt management practices. Finally, repayment vulnerabilities may be reduced through export diversification especially in countries that are exposed to changes in commodity prices.

In many low-income economies, the ability to borrow from abroad is a valuable source of finance, enabling governments to invest in critical sectors such as infrastructure, energy and human capital. However, external debt increases the exposure to exchange rate fluctuations, making economies vulnerable to sudden-stops in capital flows and sharp capital outflows.

And there are far too many examples of external debt exposures that precipitated a banking or currency crisis for us to take this issue lightly.

This blog is based on the research paper titled “The long-term consequences of external debt: Revisiting the evidence and inspecting the mechanism using panel VARs” published in the Journal of Macroeconomics authored by Irfan Qureshi (ADB) and Zara Liaqat (University of Waterloo).