There is a long history of conflicting views on the role of external financing and sovereign debt in shaping economic development and sociopolitical conditions. The fall of the Soviet Union in 1989, the global recession in 2008, and the COVID-19 pandemic altered the views and introduced new dimensions in external financing.
The development and modernization of physical infrastructure in developing countries during the Soviet regime were largely dependent on subsidized external debts and grants from the superpowers. These grants and long-term public sector debts had been considered a major source of finance for infrastructure development in the bipolar regime. These facilitations were based on political ideology and alliances with the big powers. This regime encouraged the developing countries to depend on the superpowers for their development financing.
Since 1990, developing countries have realized that dependency on subsidized external loans and grants is no longer a feasible option for their development in the changed scenario.
So, the higher dependency on long-term debt from international financial institutions, bond markets, and borrowing at competitive commercial rates has become a common global phenomenon.
A significant jump in the external debt after the fall of the Soviet Union was observed. Similarly, the growth in short-term financing and IMF lending after 1990 was also observed. The largest increase in debt financing in developing and emerging economies was noted in the 2nd decade of the 21st century.
The share of debt financing for development projects was 70 percent in 2017. This debt financing can be further classified into international and local participants: 55 percent of the debt was financed by international investors (25 percent by development finance institutions, 24 percent through bilateral sources, and 6 percent by the multilateral institutions), while 15 percent was financed by local investors.
Since 2010, the total debt of developing countries rose by 60 percentage points of GDP to a historic peak of more than 170 percent of GDP in 2019. Sovereign debt was the most popular source of financing before COVID-19, and the repayment of unhistorical debt had become a critical issue. Some new dimensions of external financing have been unleashed during the Covid-19 crisis.
A further rapid increase in debt financing after the COVID-19 pandemic to avoid the serious adverse consequences of COVID-19 added to the risk of widespread debt distress in the world economy.
The history of the global debt crisis unleashed some important facts. First, a pleasurable trend in the global economy is the increasing share of middle-income countries in World GDP.
The share of high-income countries was 81.5 percent in World GDP, which has now dropped at 64.3 percent. The share of middle-income countries was 17.3 percent in 1980. It was dropped to 13.7 percent after the fall of the Soviet Union, but started to regain swiftly. Now, it is 35.1 percent. It indicates that globalization has reduced the gap between the countries; however, it enhanced the rich-poor gaps within the countries.
During the liberalization, privatization, and free trade regimes, a large part of the responsibility of economic development has been shifted to the corporate sector from the public sector.
Now, the infrastructure development through public sector organizations is not a proper option. This change introduced the ‘Public-private partnership’ in infrastructure development projects. Several modes of financing have been invented to attract the private sector in gigantic developmental activities.
Now, global debt volume has arrived at USD 251 trillion, which is 235 percent of global GDP. Out of this global debt, USD 152 trillion is a liability of the private sector, while USD 99 trillion belongs to the public sector debt.
The debt to the private sector in 2025 is the lowest since 2015, reflecting a reduction in household liabilities and a slight change in non-financial sector corporate debt. The lower borrowing by companies due to subdued growth prospects, strong balance sheet positions, and cash holdings are the factors that are responsible for lowering private sector debt.
Furthermore, the heavy public borrowing limits the credit availability or raises its cost for the private sector. High fiscal deficit is the main driver of rising public debt. Public and private sector debt are further classified into external debt and domestic debt (or credit in broader terms).
In this way, Pakistan’s public debt is 70 percent of its GDP. (33 percent of this is external public debt, and the remaining is domestic debt). Pakistan’s private sector external debt is around 6 percent of GDP, and domestic credit to the private sector is 13 percent.
The unhistorical rise in debt financing pushed a re-thinking of the role of external debt. The economic impact of external debt involves the eventual outflow of real goods and services. Other than this outflow of resources, debt financing is associated with the risk of sovereign default. This sovereign default may not be declared officially, but the indicators of inability to pay back the debts on due dates are considered a sovereign default.
The Greek crisis had its origin in the external borrowing to finance its aggressive GDP growth. This borrowed money was not used to develop its production capacity. There are many severe consequences of default, including barriers or complete stoppage in the imports of necessities, highly expensive borrowing in the future, and domestic chaos. If foreign banks, institutional investors, pension funds, and multilateral institutions have invested their money in a default country, the crisis may spread to global markets.
The sociopolitical crisis in Sri Lanka in 2023 is one of the worst examples of the severe effects of a sovereign default.
There is no defined level to assess the unsustainability of debt financing. Generally, it is assessed through a debt-to-GDP ratio, which is not a realistic way in a real-world scenario. A 1.0 percent increase in interest rate or 1.0 percent decline in GDP growth can badly affect the debt-to-GDP ratio or the cost of debt to tax revenue ratio.
A cross-country comparison of the debt-to-GDP ratio is absolutely a misleading approach. The government of a country issues sovereign debt to borrow money, which is different from national debt.
The corporate debt is also included in the national debt. External public debt can be further classified into long-term debt and short-term debt. Long-term debts are usually utilized for development projects, while short-term debt is required to manage the immediate cash requirement.
The debt-to-GDP ratio of Pakistan is not comparable with the debt-to-GDP ratios of Turkey, India, China, or the USA. In the case of Pakistan, almost all the external debt is payable by the government, while in the case of other countries, a significant part of the external debt is a liability of the private sector.
The withdrawal of subsidies, cuts in development expenditures, and higher taxes are the sources of paying public debt. There are no such dire consequences in the case of private debts.
The important concern is the impact of growing external debt on economic growth. Debt sustainability is eventually related to the cost of debt and the benefits from the utilization of incremental debt.
The external financing will remain a viable option if the cost of capital (interest on debt and dividends on foreign investment) is less than the incremental GDP growth. External financing includes foreign investment, short-term borrowing, and long-term borrowing by the public and private sectors of a country.
The external capital will become a problem only if its cost cannot be recovered through incremental growth, and the government has to generate funds from the public to pay the cost of external capital. It is a wrong perception that external liabilities should tend to be zero. If external financing improves the earning power of domestic assets, it will always be a good option.
The policymakers must consider this aspect in external financing and its utilization. A negative relation between the cost of external debt and GDP growth rate in problematic countries has been envisaged in the IMF data.
The top 10 borrowers from the IMF show that their interest on lending (a proxy of the return on investment) or cost of services on external debt was less than their GDP growth rate.
The utilization of external debt for unproductive projects creates such a problematic situation. The external debts may be used for politically motivated popular projects that are not feasible for long-term and perpetual economic growth. To finance unviable projects through external debt is more common in proportional voting systems and coalition governments.
Similarly, an outgoing political party can raise more debt and cut taxes unmanageably just before it leaves office. Such political conditions and irrational decisions to gain popularity create economic risks for the future of a country.
It is a global phenomenon that external financing affects tax collection negatively. In the presence of external financing, governments avoid tax collection. All the modes of external debt are commonly used to provide subsidies to the private sector and provide a substitute for taxes.
Long-term external debt, short-term external debt, and even debt through sovereign bonds help the government to provide subsidies to its private sector businesses and the general public.
It was noted that the direct, immediate effect of external long-term debt on GDP growth is significantly negative.
Long-term debt is commonly utilized for long-term projects, which provide benefits in the future. Such long-term debts can engage the national resources for future development and growth. So, the negative impact of long-term debt in the short term is understandable.
However, the positive effects of external debt to the private sector on GDP growth and per capita income corroborate the positive effect of external debt to the private sector on GDP in the real term.
Similarly, foreign direct investment and external short-term debt are good options for GDP growth. The short-term external borrowing is an effective mode of financing that improves the quality of trade and transport-related infrastructure.
Short-term external borrowing is identified as the most effective mode of financing, which may help countries to maintain the liquidity position for the perpetuity of developing projects and survival of the institutions.
In case of short-term debts, the economic managers cannot shift their faults, shortcomings, and responsibilities to future governments.
Copyright Business Recorder, 2026
The reviewer is a professor at Iqra University Karachi