Why National Debt Affects Sterling

Many factors affect exchange rates, the traditional factors we teach in economics are:

• Interest rates - higher UK rates attract hot money flows and demand for sterling rises.
  
• Competitiveness - a higher UK inflation rate than our competitors makes our goods less competitive so demand for sterling falls
• Confidence in Economy and exchange rate. A lot of demand is speculative.
• Economic cycle. A recession tends to weaken the Pound because in a recession interest rates are cut.
• Balance of Payments. A large current account deficit can cause a depreciation, especially if it becomes difficult to finance the current account through capital inflows.

How Government Debt Affects the Exchange Rate

• A rapid increase in national debt means the government have to borrow more from the private sector. If markets have 100% confidence in the UK's ability to repay debt - foreigners will be happy to buy some of our debt (through buying bonds and gilts).
• If markets start to worry borrowing is getting too high / unmanageable, then investors will not be keen to hold UK government bonds. They will invest abroad i.e. many sterling assets will be sold. This will reduce demand for sterling on foreign exchange markets and cause a depreciation.

Basically when investing (especially in turbulent times) it makes sense to invest in the safest countries. If markets start to price in a risk of debt default, it will be more more difficult for that country to attract capital flows.

Although UK public sector debt has increased, the headline rate still looks manegable (44% of GDP). The problem is that the government's decision to underwrite unlimited bank losses, means we have large liabilities and potentially huge debt requirements in the future. (far greater than this 44% of GDP)

It is not certain that these liabilities will be exercised and the government will have to borrow, but, if it did it would lead to a huge increase in the governments borrowing requirement that the markets may be unwilling to finance. This is when sterling would really fall.

• It is worth noting that the UK is not alone in having large public sector debt. Nor is it alone in having a fragile banking sector. But, the bailout for banks in the UK have been one of the biggest as a % of GDP.
• It is also worth noting that although government liabilities will increase, they will also be matched by an increase in assets - in theory triple A safe asset backed loans. Liabilities tend to count towards net debt, but assets don't.
• It is not inconceivable the government could even make a profit as many of these assets already have the possibility of default priced in so the market prices are cheap. However, the fall in gilt prices suggests the markets think a loss is far more likely. It will be interesting to see how markets treat Sterling and gilt yields in the coming week.