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Context

• India's external debt has been a focal point of economic analysis, with recent data from the Reserve Bank of India revealing significant developments as of March 2024.
• The country's external debt has witnessed notable changes, reflecting both economic dynamics and global financial conditions.

'External Debt'

Definition:

• It refers to money borrowed from a source outside the country. External debt has to be paid back in the currency in which it is borrowed.

Description:

• External debt can be obtained from foreign commercial banks, international financial institutions like IMF, World Bank, ADB etc and from the government of foreign nations.
• Normally these types of debts are in the form of tied loans, meaning that these have to be used for a predefined purpose as determined by a consensus of the borrower and the lender.
• Government and corporations are eligible to raise loans from abroad. These are in the form of external commercial borrowings.
• The interest rate on foreign loans is linked to LIBOR (London Interbank Offer rate) and the actual rate will be LIBOR plus applicable spread, depending upon the credit rating of the borrower.

Effects of External Debts

• Economic Vulnerability: Countries heavily reliant on external debts face significant economic risks. The dependence on foreign capital makes them more susceptible to financial instability.
• Impact of Economic Shocks: Economic downturns can severely impact these countries, as a sudden drop in revenue (e.g., from exports or tourism) can make it difficult to meet debt obligations.
• Interest Rate Risks: An increase in global interest rates can escalate debt servicing costs, making it more challenging for these countries to manage their debt.

Exchange Rate Volatility

• Foreign Currency Borrowing: When countries borrow in foreign currencies, they are exposed to exchange rate risks.
• Exchange Rate Fluctuations: Changes in exchange rates can increase the cost of debt servicing. For example, if a country's currency depreciates against the currency in which the debt is denominated, the amount required to service the debt increases.
• Increased Debt Servicing Costs: Depreciation of the local currency leads to higher repayments in terms of local currency, putting additional strain on the country's financial resources.

Significance of External Debts

Infrastructure and Development Investment

• Funding for Infrastructure: External debts provide the necessary funds for significant infrastructure projects, such as roads, bridges, and power plants.
• Economic Growth: These investments are critical for driving economic growth, as they improve the efficiency and capacity of the economy.
• Long-term Benefits: Infrastructure development can lead to sustained economic benefits by enhancing productivity and connectivity.

Bridging Budget Deficits

• Covering Budget Shortfalls: Governments can use external borrowing to cover budget deficits, ensuring the continuity of essential public services.
• Essential Services: This includes funding for healthcare, education, and social welfare programs that are vital for the well-being of the population.

Economic Growth Catalyst

• Boosting Economic Activity: When used effectively, borrowed funds can stimulate economic activity by funding projects that create jobs and enhance productivity.
• Job Creation: Investment in various sectors through external debts can lead to the creation of employment opportunities, thereby reducing unemployment rates.
• Enhanced Productivity: By improving infrastructure and investing in key sectors, external debts can help enhance the overall productivity of the economy, leading to higher economic growth.

Limitations of External Debts

Financial Burden

• Strain on Government Finances: Excessive external debts can place a heavy burden on a country's finances. The need to service these debts can divert resources away from other essential services.
• Debt Servicing Costs: Interest payments and principal repayments consume a significant portion of the government budget, limiting the funds available for other critical areas.

Vulnerability to Economic Shocks

• Susceptibility to Downturns: Countries that rely heavily on external debts are more vulnerable to economic downturns. A sudden drop in revenue, such as a decline in export earnings or tourism, can exacerbate their debt situation.
• Interest Rate Sensitivity: An increase in global interest rates can significantly worsen the debt situation for these countries, as it increases the cost of borrowing and debt servicing.

Exchange Rate Risks

• Exposure to Currency Fluctuations: Borrowing in foreign currencies exposes countries to the risk of exchange rate fluctuations.
• Increased Repayment Costs: If the local currency depreciates, the cost of servicing foreign-denominated debts increases, placing additional strain on the country's financial resources.

Credit Rating Impact

• Lower Credit Ratings: High levels of external debt can lead to lower credit ratings for a country. Credit rating agencies may downgrade the country's rating, reflecting the increased risk associated with its debt levels.
• Higher Borrowing Costs: A lower credit rating makes it more expensive for a country to borrow in the future, as lenders demand higher interest rates to compensate for the increased risk.
• Financial Constraints: Reduced access to affordable credit can limit a country's ability to finance important projects and respond to economic challenges.

Overview of External Debt Growth

• According to the Reserve Bank of India's latest report, India's external debt stood at $663.8 billion by the end of March 2024.
• This figure marks an increase of $39.7 billion from the previous year, highlighting a steady growth trajectory in external borrowing.

Adjusted Growth Figures

• Adjusting for valuation effects, the actual increase in external debt amounts to $48.4 billion, indicating the impact of currency fluctuations and other valuation adjustments on the reported figures.

External Debt to GDP Ratio

• Despite the increase in absolute terms, India's external debt to GDP ratio showed improvement, declining to 18.7% by March 2024 from 19% recorded in March 2023.
• This metric underscores the relative stability in managing external debt relative to economic output.

Composition by Sector

• The composition of external debt reveals insights into its distribution across different sectors.
• Government external debt accounted for 4.2% of GDP, while the non-government sector's external debt comprised 14.5% of GDP, indicating varying levels of exposure and borrowing strategies.

Currency Composition

• US dollar-denominated debt remains predominant, comprising 8% of India's external debt portfolio.
• This is followed by debt denominated in Indian rupees (31.5%), yen (5.8%), SDR (5.4%), and euro (2.8%), reflecting a diverse currency risk management approach.

Components of External Debt

• Loans constitute the largest component of India's external debt, comprising 33.4% of the total.
• Currency and deposits account for 23.3%, trade credit and advances make up 17.9%, and debt securities represent 17.3%, illustrating the varied sources and forms of external borrowing.

Long-Term vs Short-Term Debt

• Long-term debt (with maturity exceeding one year) reached $541.2 billion, marking a substantial increase of $45.6 billion from the previous year.
• Conversely, short-term debt (maturity up to one year) decreased to 18.5% of total external debt by March 2024, down from 20.6% in March 2023, indicating a shift towards longer-term financing.

Debt Sustainability Indicators

• The ratio of short-term debt to foreign exchange reserves declined to 19.0% by March 2024, down from 22.2% in the preceding year, suggesting improved liquidity and resilience in managing short-term debt obligations relative to available reserves.
• This comprehensive overview provides a detailed analysis of India's external debt position, highlighting key trends, ratios, and sectoral compositions as of March 2024, based on the latest data released by the Reserve Bank of India.

PRACTICE QUESTION Q.   Discuss the current status of India's external debt situation, highlighting the key components and trends. Analyze the potential risks and implications for the Indian economy, and suggest measures that could be adopted to manage and mitigate these risks.

SOURCE: Economic Times