Gross external debt/GDP

Gross external debt/GDP

This solvency indicator is often confused with the public debt ratio, but gross external debt/GDP is distinct on two key criteria. First, it includes both private and public debt – individuals and private firms as well as the public sector, with the private debt stock often being the larger category in more developed economies. Second, it only considers all liabilities, principal and interest owed to nonresidents (private foreign banks, other governments and multilateral institutions) by residents of a country. This ratio is useful in revealing how much of a country’s debt is exposed to cross-border risk and particularly currency fluctuation. The currency issue is not as important for US entities that nearly exclusively issue debt in US dollars. However, the majority of countries issue at least some debt in US dollars, yen, or euros, particularly emerging and developing economies. This adds a layer of currency risk to their profiles, which can be a particularly volatile category during times of crisis.

Table 1

While euro-denominated Euro-zone debts were once assumed to be free of currency risk within the ‘zone, it is dawning on investors that risks vary significantly across the Euro-zone. German debt and Greek debt, while issued in the same currency and from the same economic bloc, each possess distinct risk factors. Complicating the Euro-zone situation is very significant levels of cross-border holding of sovereign and banking debt by Euro-zone and wider-EU banks. According to the Institute of International Finance (IIF), for most of the sixteen Euro-zone sovereigns, non-domestic investors hold more than 50% of the outstanding government debt. Some 65% of Greek government debt is held by non-residents in the rest of the Euro-zone and, according to Bureau of International Statistics data, the largest creditors to Irish public- and private-sector debt are banks based in the UK and Germany.
External debt is particularly important when assessing the debt stocks in Latin America, Africa and other emerging economies where a history of poor credibility precluded countries from issuing international debt in their home currency. As countries develop their capital markets they are dependent on borrowing from outside sources, and currency risk becomes one of the most important factors weighing on overall external debt ratios.

Chart 3

Japan is an example of a developed economy with a high public sector debt ratio but low external debt relative to GDP – i.e., most of its public sector debt is domestically held. With the bulk of the nation’s public and private debt denominated in yen, repayment is not held hostage to the exchange rate, but rather to the Bank of Japan. This minimizes the risk of a public debt default as the central bank could always print more yen as a last resort. And as the debt is mainly domestically held, the country would not experience a massive outflow of funds that could destabilize the external balances. These factors offer Japan some protection from a debt crisis, setting it apart from countries with severe cross-border risk.