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How Does National Debt Affect The Foreign Exchange Rate?

By Peter Lavelle

Do you intend to transfer money abroad? If so, you’re probably aware that one of the things affecting the foreign exchange rate is economic sentiment. For instance, if the UK enters recession, that sends a pessimistic signal about how Britain is doing economically. That then tends to weaken the pound.

Conversely, if people in the Eurozone spend more than economists forecast on the high street on a given month, that tells us they’re feeling upbeat on the continent. That in turn will boost the euro. So far so good. But how does national debt come into this? Does it have a lasting effect on the foreign exchange rate? In this article, I intend to answer that question.

1. National debt is a factor on the foreign exchange market.

First of all, national debt has a definite impact on the foreign exchange rates. If a country is perceived to have a high national debt, without a credible plan for dealing with it, that can have a negative impact on the value of its currency.

For example, Spain recently accepted a €100 billion loan for its banking sector from the European Commission. This adds about 10.0% to Spain’s national debt, because the loan must be guaranteed by the Spanish state. Theoretically this should be fine, because Spain is a $1 trillion economy, and so can handle a large loan without difficulty.

The problem though is that Spain is in the midst of a depression, with Gross National Product expected to shrink over the next three years. Spain therefore has no credible plan for paying back this loan. It could default, which would cause immense problems for the Eurozone because, again, Spain’s economy is so big. That in turn has had an adverse impact on the value of the euro.

Hence, in this way, national debt has a direct impact on the foreign exchange rates.

2. National debt needn’t always have a negative impact on the foreign exchange rate.

However, just because Spain’s high national debt has weighed on the euro, doesn’t mean it always works like this.

For instance, the Australian government is expected to enter surplus this year, meaning it spends less than it takes in from taxes. That means from 2013 onwards Australia will begin cutting its national debt, which is already much lower than countries like the UK, United States or Japan.

The expectation of this, and the perception of the Australian government as fiscally responsible, is therefore raising the value of the Australian dollar. Australia’s low national debt makes the country look stable and secure, which makes its currency more attractive.

In short, national debt cuts both ways where the foreign exchange rates are concerned. If a country’s national debt is high, that can limit the value of its currency. But equally, a country with low national debt will likely be favoured with a rising pound or dollar.

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