Debt is a big issue recently. Given the western world’s inability to manage the expenditure side of their balance sheets, debt is likely to continue to be a big issue for the foreseeable future.
The question here is: why do currency investors care about debt?
DEBT
As some background, take a look at what debt has done in Europe and the United States since the 1970s.
In the 1970s, debt in both countries was relatively subdued, floating in the 40% to 50% range for most of the decade.
The magnitude of debt has grown since then, with the largest growth acceleration beginning in 2009. At the end of 2012, debt in Europe had grown to around 103% of GDP, while debt in the United States stood at about 105%.
The spectacular growth in debt in the western world (and most other areas as well) raises questions like: how long can this type of debt level be sustained and why does debt matter?
WHY DOES DEBT MATTER?
Why does debt matter for currency investors?
The simple answer is risk.
Various factors influence the value of a currency, including trade balances, government policy, inflation, interest rates, export and import prices, and debt.
Government debt influences the value of a currency in many ways. Two of the most common are inflation and money printing to pay off debt signals.
The first signal, inflation, is an ever-present risk. Essentially, although debt can finance high domestic expenditures, it also puts upward pressure on inflation relative to price levels in other countries. Higher inflation rates are generally associated with a depreciating currency because the purchasing power of that currency is weakened relative to other currencies.
The second signal or investor concern is money printing. If a government is unable to pay for its high debt levels with current revenue streams, governments may, in a direct or round-about-way, print money to pay off debt. This concern is exactly the concern investors have with the Federal Reserve’s financing of U.S. Treasury expenditures. The U.S. Treasury will never be able to pay back the debt owed.
WHEN WILL DEBT AFFECT THE EURO, POUND, AND DOLLAR CURRENCIES?
With this background in mind, one might ask (as do economists and other professional analysts): when will the high debt levels in Europe and the United States cause massive currency depreciation in countries with no ability to pay off its debt?
This trillion dollar question, of course, has no exact answer. All analysts and market observers can do is look at when bonds need to be renewed or debt limits are scheduled to be increased and guess if investors will accept certain rates at the given exchange rate.
Among the upcoming events, elected officials in the United States are currently debating whether to continue with a federal budget that keeps funding levels where they are now (i.e. ignore unsustainable expenditure levels) and, in a few weeks, whether to increase its debt limit. Should elected officials decide to get serious about unsustainable debt levels, elected officials in Congress may reduce the costs of government (i.e. spending) by an amount equal to the increased debt levels. Depending on how these two situations play out, exchange rates with the dollar may see increased volatility in either direction.
In contrast to urgent issues in the United States, public debt issues will likely take center stage early next year.
Overall, public debt influences exchange rates, with high debt levels associated with lower currency values due to inflation and money printing risks. Eventually, high debt levels in European countries and the United States will put downward pressure on euro and dollar exchange rates.
