The simple distinction between external and internal debt is that the former is debt held by foreign banks, while the latter designates debt held by domestic banks. This may prove too simple, however. Globalization has led to an integrated world economy where, for better or worse, distinctions between “internal” and “external” have become blurred. Differences between the two forms of debt still exist, but they have become closely integrated.
When a country borrows from bankers abroad, the debt is considered “external.” More specifically, external debt exists when the debt is contracted in a foreign currency. This distinction leaves the option open for US banks operating in Latin America, for example, to lend money in the local currency.
Debt owed to locally owned banks in the local currency is “internal” debt. Foreign banks operating in Brazil lend the government money in Reals, which is considered “internal” debt as well. The major distinction in an age of globalization is the vulnerability to foreign interest rates. Speaking generally, internal debt is basically immune to changes in international or other foreign rates. The Brazilian currency, the Real, is controlled by local banks. The Chinese Yuan is controlled by the state. Therefore, if local rates are low, then internal debt will increase. If they are high, and foreign rates are lower, external debt will increase.
Integration of Debt
In general, there is a close interrelation between the two types of debt that can often make the distinction between them obsolete. Development economist Michael Carlberg argues that there is a clear connection between external debt and high domestic rates. High domestic rates encourage foreign borrowing and therefore, external debt increases. Lower domestic rates encourage local borrowing and hence, local investment. The payoff here is that low domestic debt leads to an exporting strategy, while high debt leads to an importing strategy. Therefore, internal debt leads to balance of payment issues and vice versa. Low debt means that the country earns hard currency through exports, since more cash is available to finance domestic industry. High debt means that the country must import needed items, since less money is available due to debt servicing. Therefore, high domestic debt is a downward spiral. If this connection is true, then the distinction between internal and external debt is largely a matter of semantics, since both types of debt are mutually connected.
Significance of Debt
Debts contracted in foreign currency often mean that local interest rates are high. External debt also means that the borrower is in thrall to foreign powers, since foreign interest rates will directly affect the economy of the borrower. Internal borrowing means the country maintains more of its economic sovereignty. The distinction between internal and external debt is important only in the sense that the currency in which the debt is contracted is the main variable. Local currency is easier for local banks and governments to control than foreign currency.