What Is the Meaning of an Internal Debt Trap?

A nation in a debt trap must spend a large portion of its income on debt repayment instead of construction and other projects.

An internal debt trap, also known as a public debt trap, is a situation where a nation incurs a large amount of debt in comparison to its total income. The interest payments on the debt require the nation to reduce spending on other government services, such as road construction, highways, power plants and employment of civil service workers. The nation's infrastructure deteriorates, reducing its income, which makes it even more difficult to make interest payments on its debt.

Foreign Investment

Internal debt traps reduce foreign investment. Foreign investors who wish to start an enterprise in a nation desire to build factories and offices in a location with reliable public services such as water and electricity. Since the nation can no longer reliably afford to provide these services, foreign investors stop constructing businesses in the nation and sell off their existing facilities.

Credit Rating

A nation's credit rating declines when it is in an internal debt trap. Credit rating firms such as Moody's rate a nation's credit, according to the United States Fiscal Commission. Since the definition of the debt trap is that the nation holds more debt than it can afford to pay, lenders are not willing to loan the nation additional funds unless the nation pays much higher interest rates because of the increase in risk. The value of the nation's outstanding bonds declines, so investors sell the bonds to limit their loss.

Export Focus

Since the debt is often denominated in foreign currencies, the nation focuses its efforts on earning foreign currencies to pay off the debt. This means changing production to crops which can be sold in world markets and reducing investments in products which the nation's citizens demand. The nation may be forced to export foods while its own citizens do not have enough food to eat, according to the National Institutes of Health.

Inflation

A debt trap affects inflation in a country. When investors sell their assets in a nation and purchase foreign assets, the value of the foreign currency increases proportionally to the nation's currency, according to the United States Fiscal Commission. The cost of imports increases. A weaker currency does allow the nation to sell cheaper exports in comparison with other nations, although it is much harder to produce exports when the investors are pulling their funds out of the country.

Foreign Aid

Foreign aid can produce a debt trap. A wealthy nation may provide aid to a poorer nation in the form of loans for development. If the poorer nation does not successfully use the money to develop its resources, it will still owe the wealthy nation money. The poorer nation may need to receive additional aid from the wealthy nation to make its loan payments, including loan payments to other nations. A wealthy nation can forgive the debt of a poorer nation to reduce or eliminate a debt trap.

References

• USAID: An Aid Exit Strategy for African Countries
• US Fiscal Commission: China's Billion Consumers are the Key to Reducing the Trade Deficit
• National Institutes of Health: Third World Debt