Saturday, November 19, 2011

another example of Forex-IR interdependency

When a government (Argentina,Greece...) is facing escalating borrowing cost ...

It can devalue currency by printing lots of money (Germany in 1923)

It can default (and also devalue currency), like Argentina did around 2002

It can tighten its belt, increase taxes, reduce gov spending like welfare, increase productivity, endure increasing unemployment ...

When Argentina's new bond's interest rate hits 700bps, why would existing bonds devalue on the secondary market? (Let's put aside the factor of default risk.) I already discussed this on my blog, but now i feel invariably it's related to currency depreciation. Rational Investors feel the supply of this currency has to increase and therefore devalue, because the government must print more of this currency to service debt.

But events in late 2011 are different. I'm not sure if currency is even a factor. When Italy's new bond hits 700bps, we know the Italian government can't print more euro as ECB is now in control. I would say the main reason for the escalating borrowing cost is default risk. Secondary bond market is unrelated to issuer's borrowing cost, but here bond yield also increased, probably due to default risk.

One thing for sure -- exchange rates, interest rates and credit risk affect each other in many ways.

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http://www.linkedin.com/in/tanbin