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6.1 Nature and Kinds of Public Debt

• To finance its expenditure, government collects its

income from tax and non–tax revenues
• When public expenditure exceeds its revenue, there is
budget deficit
• The total amount owed by the government to creditors
(accumulated deficits over time) is public debt
• Public debt (also called government debt or national
debt) refers to the total obligations of a government—
central, state, or local—to repay borrowed funds plus
any accrued interest
• It is financed through borrowing from domestic or
foreign sources rather than immediate taxation or
money creation
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Classical view (Adam Smith, David Ricardo, Thomas
Malthus)
• Public debt is generally harmful
• It represents a transfer of resources from productive
private uses to (often) unproductive government
spending
• Debt crowds out private investment and burdens
future generations
Keynesian view (John Maynard Keynes and post–WWII
developments)
• In periods of recession, deficit–financed spending
(increasing public debt) can boost aggregate demand,
output, and employment
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• Debt is not inherently a burden if it finances productive
investments or stabilizes the economy
• It can even act as a "national asset" by raising incomes
• Putting the two views side by side, debt has both
demand–side benefits (short–term stimulus) and
supply–side costs (long–term crowding out)
• Its core characteristics (nature) include:
1. Contractual obligation: public debt represents a legal
promise to repay principal with interest at a future
date
2. Non–compulsory revenue source: unlike taxation,
borrowing is generally voluntary, except in rare
compulsory cases
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2. Instrument of fiscal policy: governments use debt to:
• Finance deficits
• Stabilize the economy during recessions
• Support development projects
4. Intertemporal transfer mechanism: public debt shifts
financial burden across time (present to future
taxpayers)
5. Dual nature (productive vs burdensome): it can
promote growth (via infrastructure investment); or
become unsustainable liability if excessive

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Classification of Public Debt
• Public debt is classified along several dimensions
o By source:
• Internal debt: borrowed from domestic residents, banks,
or institutions (paid in local currency)
• External debt: borrowed from foreign governments,
institutions, or markets
o By maturity:
• Short–term (floating debt): up to 1 year
• Medium–term debt:1–5 years
• Long–term (funded debt): more than 5 years

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o By Repayment Nature:
• Redeemable debt: repayable after a fixed period
• Irredeemable (perpetual) debt: no fixed maturity
o By Purpose/Productivity:
• Productive (reproductive) debt: finances infrastructure,
education, or projects generating returns
• This may offset burden through higher future
growth
• Unproductive: for war, consumption, etc.
• This imposes net burden

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6.2 Effects of Public Debt
• Public debt has multidimensional effects
 Positive Effects
 Economic development
• Financing infrastructure, education, health
• Enhances long–term productive capacity
 Stabilization role
• Supports aggregate demand during recession
• Enables counter–cyclical fiscal policy
 Resource mobilization
• Transfers idle savings into productive use
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 Negative Effects
 Crowding–out of development spending
• Government borrowing may reduce private
investment via higher interest rates
 Inflationary pressure
• If financed through monetary expansion
 Reduced growth (long–run)
• High debt can lower capital accumulation and
growth
 Fiscal rigidity
• High debt limits government flexibility in future
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policies
6.3 Burden of Public Debt
• Debt burden refers to the economic sacrifice imposed
on society due to debt servicing
• It is measured by the loss of economic welfare in terms
of consumption of goods and services foregone for the
repayment
 The debt burden can be:
 External: the sum of money that a borrowing country
repays to a foreign creditor
• Direct money burden: the debtor country has to pay to
the creditor country every year large sums of money in
terms of foreign exchange
• In order to earn this foreign exchange, the country has
to make exports
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• Indirect money burden: sometimes, the debtor country
has to pay interest in terms of the goods and services to
the creditor country
• In other words, the debtor country has to export goods
and services on a large scale to the creditor country
• This inevitably results in a rise in the prices of these
goods and services in the domestic market of the debtor
• As a consequence, there will exist a fall in the economic
welfare of the society
• This fall in community’s welfare shows the indirect
money burden of the external public borrowings
• Direct real burden—the government usually imposes
new taxes on the people to pay the debt
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• Indirect real burden—as a result of imposition of new
taxes to pay the debt, the capacity of the people to
work, save and invest declines
• The extent of external debt burden can be measured by
the following methods:
𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆
𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
• This measure indicates the extent to which the burden
of debt service has raised or declined over a given
period of time

𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆

𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 − 𝑺𝒂𝒗𝒊𝒏𝒈 𝑹𝒂𝒕𝒊𝒐 =
𝑺𝒂𝒗𝒊𝒏𝒈
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• It captures the effect of external debt service imposed
on saving & in turn on capital formation of the country
𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆
𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 − 𝑬𝒙𝒑𝒐𝒓𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑬𝒙𝒑𝒐𝒓𝒕 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔
• It indicates how much of the export earning is used for
repaying the interest on external loan
𝑬𝒙𝒕𝒆𝒓𝒏𝒂𝒍 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆
𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 − 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑻𝒐𝒕𝒂𝒍 𝑻𝒂𝒙 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
• It indicates the proportion of tax revenue that is
directed for repaying external debt
 Internal: the sum of money that a government repays
to a domestic creditor
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• Direct money burden: it will redistribute resources without
resulting in any change in the total resource of the
community
• Therefore, internal debt does not impose direct money
burden on the country because the tax collected for
repaying the debt redistributes resources from one
section of the society to another
• Indirect money burden: however, internal debt may cause
indirect money burden
• When the government spends the loan on development
projects, it results in the creation of demand for several
commodities and services
• Consequently, the prices of these goods and services rise,
imposing additional burden on the society
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• The extent of debt burden can be measured by the
following methods:
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑷𝒂𝒚𝒎𝒆𝒏𝒕
𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
• It indicates the extent to which government must tax
national income so as to raise enough revenue to pay
the interest on debt
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑷𝒂𝒚𝒎𝒆𝒏𝒕
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 − 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑻𝒂𝒙 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
• It indicates the effect of public borrowing on the
budget of the country
• Debt Trap: refers to a situation of a vicious circle of
borrowing when the government must borrow so as to
service old debts (pay the interest and the principal)
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• This means, the fresh loans raised are not used for
investment or capital formation rather for repaying
earlier debts
• Conversion: is a debt management technique where the
government replaces old debt with new debt on more
favorable terms, usually to reduce the interest burden
• High–interest–bearing loans or bonds are converted
into new lower–interest loans or bonds (often with
longer maturity)
• It is typically done before maturity when market
interest rates have fallen or the government's
creditworthiness has improved

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6.4 Redemption of Public Debt
• Redemption of public debt refers to the actual repayment
or retirement of the principal amount of government debt
• It reduces the outstanding debt stock and eases the long–
term burden on future budgets and generations
• Unlike refunding (replacing old debt with new debt) or
conversion, redemption involves a net reduction in
liabilities
• Redemption of public debt = extinguishing (repaying) the
principal obligation
Key distinction:
• Servicing → paying interest
• Refunding → replacing debt
• Redemption → eliminating debt
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Main Methods of Redemption
• Here are the primary techniques in public finance:
 Budgetary Surplus (or Surplus Revenue): the
government generates a primary budget surplus and
uses the excess to repay principal
 Sinking Fund: the government sets aside funds
annually from its revenue into a dedicated sinking
fund
• This fund accumulates over time (with compound
interest) to repay the debt at maturity or through
periodic redemptions
• Annual contributions + interest on the fund = enough
to retire the loan when due
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Sinking Fund vs. Refunding vs. Conversion
• Sinking Fund → Actual accumulation for repayment
(true redemption tool)
• Refunding → Issue new debt to pay off old debt
(postpones or reshapes burden; no net reduction)
• Conversion → Replace high–interest debt with low–
interest debt (reduces servicing cost but principal
remains)
 Terminal Annuities: debt is repaid through fixed
annual installments that include both interest and a
portion of principal (similar to a mortgage or
installment loan)
• It ensures gradual redemption over the loan's life
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 Asset Sales or Privatization: sell government assets
(state–owned enterprises, land, etc.) and use proceeds
for redemption
• This method provides one–off revenue without raising
taxes
 Buybacks: the government repurchases its own debt
in the open market, often at a discount if market
prices are below par (face value)
• Useful when debt trades at a discount due to high
yields

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Redemption itself creates economic costs:
(i) Tax Burden: higher taxation reduces
consumption/investment
(ii) Opportunity Cost: funds used for debt repayment
could be used for development
(iii) Deflationary Pressure: large repayments reduce
aggregate demand
Overall, redemption is essential for long–term
sustainability but must be gradual and supported by
growth and prudent fiscal policy
A well–managed sinking fund, combined with
revenue–enhancing reforms and buybacks when
opportunities arise, offers a balanced path
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6.5 Public Debt in a Developing Economy
• Public debt in developing nations differs markedly from
debts in advanced economies in structure, scale,
composition, and impacts
• While global public debt reached record levels (around
$102 trillion in 2024, with developing countries
accounting for about $31 trillion), debt has grown faster
in developing nations since 2010—according to UN
Structural Features and Composition
 Higher Reliance on External Debt (compared to advanced
economies, which mostly borrow domestically in their
own currency):
• A large portion is denominated in foreign currencies
(especially USD), creating currency mismatch and
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• When local currencies depreciate, the real debt burden
rises sharply
 Changing Creditor Landscape: decline in traditional
Paris Club creditors
• Paris Club creditors provide concessional debt (low
interest, long maturity and sometimes cancellation)
• The share of external public debt held by commercial
and non–Paris Club creditors nearly doubled since 2010
• This makes debt more expensive (higher interest rates,
shorter maturities) and harder to restructure due to
diverse, profit–oriented creditors and lack of
standardized clauses
 Rising Domestic Debt:
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