External debt

External debt

Subject: Economy

Section: External Sector

Context:

Private long-term external debt outstanding of countries identified by the World Bank as belonging to the low and middle income category more than doubled from $1.04 trillion in 2012 to $2.18 trillion in 2020.

Details:

• Overall, the share of governments in foreign currency bond issues across emerging market and developing economies (EMDEs) has fallen from 65 to 48 per cent between 2002 and 2021—
  • The share of government issuance has fallen in developing Europe (from 85 to 66 per cent) and Latin America and the Caribbean (from 76 to 51 per cent).
  • The share of government issuance has risen in Africa and the Middle East (from 39 per cent in 1996 to 64 per cent in 2021) and in developing Asian and the Pacific (from 14 to 24 per cent over the same years).

Cause:

• Low interest rates in advanced economies and
• Low global risk aversion leading to portfolio reallocation in search of risk-adjusted yields and diversification opportunities.

Why risky?

• Decline of forex reserves-Foreign borrowing requires debt service commitments to be covered in foreign currency.
• Prone to external shocks-Any external shock that affects foreign currency earnings or receipts, can precipitate debt distress.
• Affected by depreciation-In the event of any unexpected depreciation of the domestic currency, the debt servicing cost in local currency would spike and add to the servicing burden.
• Capital flight-When debt takes the form of bonds, it becomes easily tradable leading speculative investors to exit at the slightest sign of uncertainty.
  • Example- the ongoing effort of developed country central banks to hike interest rates and limit or draw out excess liquidity from money markets is triggering an exit of bondholders from less developed countries.
    • This pushes down bond prices and raises interest rates, worsening debt stress.
    •  It also raises the cost of contracting new debt, often needed to service past debt.
    • The presence of multiple bondholders in the community of creditors delays or prevents resolution.

Foreign Currency Bonds:

• In addition to issuing bonds in domestic markets and local currencies, governments and companies can also issue bonds in other markets and different currencies. 
• It is an alternative to issuing debt in its own currency, a government may issue debt in a foreign currency to calm investor fears of currency devaluation eroding their earnings.
• Issuing debt in a foreign currency exposes a nation to exchange rate risk because if their local currency drops in value, paying down international debt becomes costlier.
• Foreign Currency Convertible Bonds (FCCBs) mean a bond issued by an Indian company expressed in foreign currency, and the principal and interest in respect of which is payable in foreign currency.
  • A convertible bond is a mix between an equity and debt instrument. Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution.