Question #2317

When a nations exchange rate appreciates, the debt servicing payments for debt denominated in a foreign currency

• (a) Fall in local currency terms.
• (b) Rise in local currency terms.
• (c) Are unchanged in local currency terms because the payments are fixed by contract.
• (d) Rise because foreign governments require higher payments.

Answer #11592

Answer: (a) Fall in local currency terms.

Explanation

Answer: Option (a)

You can work out the correct answer from the previous discussion on interpretations of exchange rate changes.

If a nation is using the Australian dollar ($A) and borrows in euros, then the interest payments will be set in euros per period as per the contract.

Say a nation has to pay 100 euros per month and the exchange rate is currently 1:1, meaning that in local currency terms, it must exchange $A100 in the foreign exchange markets to get the 100 euros to service its debt under the contract.

Now, say the Australian dollar depreciates to 0.80, which means that it takes $A1.25 to buy one euro or 80 euro cents to buy $A1.

So now the debt servicing obligations under the loan contract would require the debtor to exchange $A125 in the foreign exchange markets to get the 100 euros necessary to service the debt.

Alternatively, when the Australian dollar appreciates to 1.25, which means it takes only 80 cents Australian to buy one euro (or 1.25 euros to buy one Australian dollar), the debt servicing obligations in Australian dollars fall to $80 per month.

Thus, Option (a) is correct.