How Is Debt Handled With Currency Devaluation?

Written by michael wolfe
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Sometimes a currency will lose a significant portion of its value. This process, known as inflation, can occur for a number of different reasons. In some cases, investors will decide as a group to sell off the currency, creating a large amount of supply relative to demand and causing its value to drop. In other cases, the country's central bank may decide to devalue the currency. This can lead to several effects on debt.

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Currency Devaluation

Sometimes, a country's central bank will decide to devalue a unit of currency. This may happen for several reasons -- for example, a country may wish to increase the money supply and encourage lending -- but the effect on debts is relatively consistent. Debts that are denominated in that currency are often easier to pay back as they are worth less. This is, of course, contingent on salaries rising along the level of inflation.

Outstanding Debt

Lenders often take a hit when a currency is devalued. This is because the money that the lender will receive when he is paid back for the loan is, in an inflationary atmosphere, worth less than it was when the loan was issued. However, inflation is good for borrowers, in that the borrowers will be better able to pay back the money they owe, as the money they pay back will be less value in real world terms.

National Debt

Currency devaluation will not only affect consumer debts, but it will affect how a country pays back its national debt. If a loan is denominated in the devalued currency, then the debt will be easier to pay off, as the country will have to spend less money paying back foreign investors. However, if the loan is denominated in another currency, it may be more difficult, as the debtor country's money is not worth less.

Interest Rates

Another effect of currency devaluation, if it is ongoing, is for lenders to raise interest rates steeply. This is because lenders will want to do their best to ensure that the money they receive when they are paid back the loan will be more valuable than the money was when they issued it. Often, the rise in inflation rates will create greater economic problems, only exacerbating the level of inflation and creating an inflationary spiral.

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