In recent days, yields on Portugal government bonds have risen sharply and have once again raised the issue that Eurozone governments face insolvency risk. If, for example, Portugal was to leave the Eurozone and in re-establishing its own floating currency, it re-denominated all euro liabilities into this new currency, then they would eliminate that risk on all future liabilities.
Answer: False
The answer is False.
This question focuses on whether the floating own currency is a sufficient condition for fiscal policy independence. The answer is that it is not.
The answer would be true if the sentence had added (on all future liabilities) ... in its own currency. The national government can always service its debts so long as these are denominated in domestic currency.
The answer is false because there is a possibility that the government may borrow in foreign currencies in addition to its own currency.
It also makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case - by crediting bank accounts.
The situation changes when the government issues debt in a foreign-currency. Given it does not issue that currency then it is in the same situation as a private holder of foreign-currency denominated debt.
Private sector debt obligations have to be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate.
Private sector debts are always subject to default risk - and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the "market solution".
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
The solvency risk the private sector faces on all debt is inherited by the national government if it takes on foreign-currency denominated debt. In those circumstances it must have foreign exchange reserves to allow it to make the necessary repayments to the creditors. In times when the economy is strong and foreigners are demanding the exports of the nation, then getting access to foreign reserves is not an issue.
But when the external sector weakens the economy may find it hard accumulating foreign currency reserves and once it exhausts its stock, the risk of national government insolvency becomes real.
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