Lack of confidence in countries ability to manage budget -> Expectation that the worsening fisscal outlook would continue in the near future increases (see bond yields) -> Currency depreciates relative to other countries who are are able to manage their budget better it better.
If I recall, the increasing debt increases the probability of monetization of the debt. Expanding the money supply to support the debt would cause a rise in the (foreign/country with lots of debt) inflation rates, which would cause this currency to depreciate vis a vis another country’s, ceteris paribus.
I think you can also take the view point that country A can only utilize more debt if other countries are willing to hold it. If the other countries don’t want to hold the debt denominated in country A’s currency (since so much is already outstanding), demand for country A’s currency will decline, and the currency will depreciate.
It’s late for me, though. If someone can double check what I’ve said, that would be great.
Hope this helps!
Edit: I just realized that you were asking about the portfolio rebalancing approach (don’t know how I missed that in the title)…
The real interest rate would go up due to more government borrowing, this will lead to inflation and a deprecation of the local currency, but only if it is a continual fiscal deficit. Otherwise, a fiscal deficit may have an opposite effect and appreciate its currency’s value.
Government borrowing is a result of an expansionary fiscal policy. So more growth will lead to inflation. As the government continues to borrow over the long run, it would need to increase the real interest rate on debt, beacause their leverage ratios are already high. One of two things happen from there.
Capital inflows stop coming in due to the high amount of external debt and fear of default, while putting pressure on the current account, leading to a rapid devaluation of the domestic currency when the inflows cannot offset the trade imbalance, but this is a long term and critical scenario, and usually the second option happens before it gets to that stage.
The government attempts to counter their increasing balance sheet by a contractionary fiscal policy, thereby increasing taxes, reducing spending, and reducing reducing direct investment, which also leads to devaluation of the domestic currency, this also assumes high capital mobilty.
Yes, sorry. As I said, it had been a long day for me. I meant it would cause a rise in inflation (which you could use PPP to see how the currency depreciates). Expanding the money supply typically does drop interest rates, but can spur inflation.
Fiscal deficit -> government borrows money. Suppose that US government is running deficits (it is) and that x represents the % that is funded by foreign investors. If the deficits continue, the foreign investors may find their portfolios dominated by USD treasuries. Hence they will rebalance the portfolio to achieve optimal diversification - rebalancing means that they are selling USD and hence leads to depreciation of USD.
Think of it this way: When you have a current account decifit, you will have an offsetting capital account surplus. That surplus is accompanied by foriegn investors holding assets of the country which holds the deficit. Investors need to exchange their currencies for the deficit currency in order to purchase assets. This leads to appreciation of currencies in the short and medium term (think of supply and demand). However, in the long run it is different.
When the decifit continues to grow due to increased spending with fiscal policy, the borrowing by the deficit country will continue to build up debt. In the short/medium term, this will lead to appreciaition of the deficit currency for a significant amount of individuals holding the currency of that country thinking the economy is growing and is safe (going long the deficit currency in order to purchase assets, etc.). In the long term, the borrowing will become unsustainable thus leading to depreciation from skepticism that the deficit country has borrowed too much. This will lead the original foriegn investment to retreat and go somewhere safer (selling off the currency).
As you read through the material, you will notice that currency depreciation under PPP conditions should occur when interest rates of the price currency are high (In the long run). If a country is unsustainable in the long-run, interest rates will increase because of the risk that investors will require. Understanding of this theory will connect the two (high interest rates lead to currency depreciation in the LONG RUN).
I agree with you . According to open macro part in the principle of econ written by Gregory Mankiw , he states that fiscal deficit will lead to currency appreication. Although he didn’t mention whether this is short term or long term , I reckon it is short term because most of the Keynesian model emphasise the short term effect . When investors are anxious about oceans of debt afflicting the coutry , they will sell off the country’s assets , which is current Greece’s situation .