Understanding Public Debt: Causes, Types, and Redemption Methods

Every time the government spends more than it earns in a year, someone has to bridge that gap. That someone is usually the public, both at home and abroad, through the government’s borrowings. This borrowing, accumulated over the years, is what economists call public debt. It funds everything from highways and hospitals to defence equipment and pandemic relief. But like any loan, it comes with interest, repayment schedules, and limits on how much a government can safely owe. Understanding how this debt is created, classified, and eventually repaid is central to understanding how a country manages its finances.

What is public debt and why do governments borrow 🔗

Public debt refers to the total outstanding liabilities of the government, built up through past borrowing, that must be repaid with interest in the future. Governments rarely borrow for one single reason. A budget deficit, where expenditure exceeds revenue, is the most common trigger. Development spending on roads, railways, and social schemes is another. Historically, wars and national emergencies have also pushed governments into heavy borrowing, since taxation alone can rarely cover sudden, large expenses.

In the Indian context, the power to borrow is constitutionally defined. Article 292 of the Constitution allows the Union government to borrow amounts sanctioned by Parliament, while Article 293 restricts state governments to borrowing only from internal sources unless the Centre permits otherwise. This is why the central government carries both internal and external debt, while states rely almost entirely on domestic borrowing.

What causes public debt to rise 🔗

Three broad forces typically drive up a government’s debt stock.

Persistent budget deficits 🔗

When tax and non-tax revenue fall short of planned spending year after year, the shortfall is financed through fresh borrowing. Since interest on old loans itself becomes a recurring expense, deficits tend to feed on themselves unless revenue growth keeps pace.

Development and capital expenditure 🔗

Building infrastructure such as ports, power plants, and highways requires large upfront capital that tax revenue alone cannot fund in a single year. Governments borrow to spread this cost over time, betting that the resulting economic growth will make repayment easier later.

Emergencies, wars, and shocks 🔗

Unplanned events force sharp increases in borrowing. Healthcare and welfare spending during the Covid-19 pandemic is a recent example that pushed up central government debt considerably, while historically, wartime spending has been one of the biggest single drivers of public debt across countries.

Types of public debt: internal and external 🔗

Public debt is broadly split into two categories based on where the money comes from.

Internal debt: borrowing at home 🔗

Internal debt is money the government borrows from lenders within the country, such as banks, insurance companies, provident funds, and individual investors. It is raised mainly through government securities, dated bonds, and treasury bills, along with instruments like the National Small Savings Fund. According to the Indian Economic Service’s Arthapedia, internal debt also includes securities issued to international financial institutions such as the IMF and World Bank for India’s contributions to them, though these are still classified as internal liabilities since they are serviced in rupees.

Internal debt makes up the overwhelming majority of India’s public debt stock. As per the government’s own budget documents, the outstanding internal and external debt and liabilities of the central government were estimated at close to ₹197 lakh crore by the end of 2025-26, with projections crossing ₹214 lakh crore by the end of 2026-27, and internal borrowing continues to account for the bulk of this figure.

External debt: borrowing from abroad 🔗

External debt covers money owed to non-resident lenders, including foreign governments, multilateral institutions like the World Bank and Asian Development Bank, and international commercial banks. This debt is usually denominated in foreign currency, which means repayment costs can rise or fall with exchange rate movements, adding a layer of risk that internal debt does not carry.

India’s reliance on external debt has fallen sharply over the decades. A status report from the Department of Economic Affairs shows that the share of external liabilities in the central government’s total debt dropped from over 25 per cent in the early 1990s to under 5 per cent by 2025, a shift that has meaningfully reduced the country’s exposure to currency risk. That said, external debt in absolute dollar terms has still been rising steadily. Reserve Bank of India data puts the country’s total external debt (government and non-government combined) at over 736 billion dollars at the end of March 2025, an increase of more than 67 billion dollars over the previous year, driven largely by higher commercial borrowings.

Fiscal rules that keep debt in check 🔗

Unlimited borrowing is not an option for any responsible government. India’s main legal safeguard is the Fiscal Responsibility and Budget Management Act, enacted in 2003 after the country’s foreign exchange crisis of the early 1990s exposed the dangers of unchecked deficit financing. The FRBM Act sets targets for reducing fiscal and revenue deficits and generally prohibits the central government from borrowing directly from the RBI, a rule designed to stop the central bank from simply printing money to finance government spending. This separation between fiscal policy and monetary policy is meant to protect the economy from runaway inflation caused by excessive debt monetisation.

How does the government redeem public debt? 🔗

Redemption is the process by which the government repays or otherwise clears its outstanding debt. Since debt cannot keep growing indefinitely without straining public finances, several methods have evolved to manage repayment.

Conversion: swapping old debt for cheaper debt 🔗

Conversion is not repayment in the strict sense; it is an exchange of one loan for another. When market interest rates fall, the government can offer to convert older, high-interest bonds into new bonds carrying a lower rate. This eases the interest burden on taxpayers, but it requires the government to maintain a strong enough credit position to make the swap attractive to bondholders, as explained in this overview of redemption methods.

Sinking fund: saving up for repayment 🔗

The sinking fund method is widely regarded as the most systematic and disciplined approach to debt redemption. A fixed percentage of annual revenue is set aside every year and invested safely, so that by the time the debt matures, sufficient funds have accumulated to clear it without a sudden shock to public finances. Because the burden is spread evenly over several years rather than concentrated at maturity, this method also tends to boost investor confidence in the government’s creditworthiness.

Other redemption methods 🔗

Refunding, terminal annuities, and the use of budget surpluses are commonly used alongside conversion and sinking funds. Refunding is particularly popular with developing economies since it avoids the need for one large lump-sum repayment, instead rolling debt forward through fresh borrowing. Capital levies and additional taxation are rarely used in normal times, as they tend to reduce public confidence and can push domestic capital towards safer destinations abroad.

Why public debt matters: the double-edged sword 🔗

Public debt is not inherently harmful. It allows governments to fund large, productive investments today and repay them gradually as the economy grows, spreading the cost across future taxpayers who will also benefit from that infrastructure. Used well, it supports development that would otherwise be impossible within a single year’s tax collections.

The risk lies in excess. A rising debt stock means a growing share of the budget goes towards interest payments rather than productive spending, a phenomenon that reduces fiscal space for education, healthcare, or new investment. High and rising debt can also crowd out private investment, since heavy government borrowing competes with private businesses for the same pool of domestic savings and can push up interest rates economy-wide. If debt grows faster than the economy’s ability to service it, a country risks sliding into a debt trap, where fresh borrowing is needed merely to pay interest on old debt rather than to fund anything new. This is precisely why frameworks like the FRBM Act exist, aiming to anchor debt to a sustainable share of GDP rather than letting it expand without limit.

What do you think? If a government must choose between funding new infrastructure through fresh borrowing or slowing down spending to keep debt levels low, which trade-off do you think serves long-term economic growth better? And do you think methods like the sinking fund are disciplined enough to handle the scale of borrowing modern governments undertake?

References

1. https://ies.gov.in/arthapedia/concept/public-debt
2. https://www.indiabudget.gov.in/doc/rec/annex9.pdf
3. https://www.dea.gov.in/files/external_debt_documents/Ex%20Debt%20Report%202024-25.pdf
4. https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=60729
5. https://ies.gov.in/arthapedia/concept/fiscal-responsibility-and-budget-management-frbm-act
6. https://www.economicsdiscussion.net/india/public-debt/top-9-methods-for-redemption-of-public-debt-economics/26195