Risk premium and external debt sustainability: Thrilwall’s law and a stock-flow consistent model for a small globalized developing economy

External debt sustainability is critical for countries that cannot borrow in domestic currency. Borrowing costs rise nonlinearly as the external debt-to-exports ratio increases. The first objective is to enhance Thirlwall’s model by incorporating the relationship between external debt, foreign reserves, foreign borrowing costs, and risk premiums. The second objective is to analyze the repercussions of a sudden decline in risk-taking behavior in financial centers on the economy within a stock-flow-consistent model. First, we demonstrate that the long-run balance-of-payments constrained output is lower than that obtained from a model with a fixed borrowing rate. The gap between the two is substantial at high external debt ratios. Second, two equilibrium debt ratios exist. The higher one is unstable, and beyond this level, the debt ratio exhibits explosive characteristics, making it a plausible candidate for the threshold level at which lenders cease lending. Conversely, fixed interest rate models have a unique equilibrium external debt ratio. Above this level, no explosive debt dynamics exist, suggesting a downside in defining it as the threshold level of debt. Third, the simulations of the stock-flow consistent model demonstrate how elevated levels of foreign debt before a sell-off event can be fatal for a highly indebted economy. Fourth, real depreciation is contractionary when external debt is high. These results highlight the importance of avoiding an increase in the external debt ratio to high levels. Policies restricting foreign borrowing, particularly those that lead to currency mismatches, are crucial.