Foreign Currency & Local Currency Defaults


Foreign Currency Defaults: 

The risk of a country defaulting on its debt is one indicator of its risk. There are two sorts of sovereign debt: foreign currency debt (such as the US dollar) and domestic currency debt.

Global banks and other international lenders prefer debt issued in a foreign currency. However, the risk for the issuing country is that it will be unable to service the debt simply by creating more money.

Local Currency Defaults:

Some currencies have defaulted on debt in their own and foreign currency.

Examples of Foreign Currency and Local Currency Defaults:
Foreign Currency Defaults: 

To illustrate, the United States government can repay the debt it has issued in USD by printing more USD. This is referred to as increasing the money supply, and it may lead to inflation. A country such as Argentina, however, cannot do this.

Local Currency Defaults:

Two examples of this include the defaults of Brazil and Russia in 1990 and 1998 (respectively). Research from Moody indicates that countries are increasingly defaulting on both types of debt simultaneously. Why would countries default on debt denominated in their own currencies when they could simply print more money? There are several reasons:

  • In the decades before 1971, currencies had to be backed by gold reserves. Therefore, these reserves limited a country's ability to print more money.
  • Greece and other members of the European Union use the Euro as their domestic currency. However, they do not have the right to print Euros (this is the responsibility of the European Central Bank). This means that Greece could not have solved its debt problems in 2012 by printing money.

Topics: ACCA, CIMA, CPD, AAT, FRM