When people think of national deficits, they often imagine government overspending or tense budget debates. The periodic drama that plays out in the US between Congress and the President comes to mind.
Terms like “debt ceiling” and “fiscal cliff” are now common as governments worldwide – especially in the West – get deeper into debt.
But one factor that works quietly in the background is the exchange rate. We’ve seen big moves in the US dollar in the first half of 2025 already, and that’s influenced a lot of policymaking.
For countries everywhere, though, the local currency (and its strength/weakness) can impact its national deficit. Let’s break down why that’s the case.
Budget Deficits Vs. Current Account Deficits
First off, let’s define what a “deficit” actually is because there are two types. A budget deficit is when a government spends more than it collects in revenue over a year.
Then there’s a current account deficit, which measures the difference between what a country earns from exports and what it spends on imports and other foreign obligations.
Both can be influenced by the exchange rate but in vastly different ways. Budget deficits are shaped by domestic revenue and spending, while current account deficits are tied to trade and investment flows.
The two can still overlap. A weaker currency, for example, can make imports more expensive, pushing up inflation and, in turn, this can raise government spending or debt-servicing costs.
Read Also: 4 Key Statistics That Showcase Singapore & The U.S. Trade Partnership
How Currency Movements Affect Trade Balances
In theory, a weaker currency makes exports cheaper for foreign buyers and imports more expensive for those living in the country, improving the trade balance. But this works best when imports are optional.
For countries that depend heavily on imported essentials, such as energy, food staples, industrial machinery, the higher import bill can outweigh any export gains.
The 1997-1998 Asian Financial Crisis is a prime example of this playing out. Versus the US dollar, the Indonesian rupiah fell over 83%, the Malaysian ringgit nearly 50%, and the Thai baht about 40%.
The sharp rise in import costs and debt repayments pushed several economies into deep recessions, despite their goods becoming more competitive abroad.
Exchange Rates And Debt Servicing
For national governments with debt that’s denominated in foreign currency (often US dollars), exchange rate shifts can change repayment costs dramatically.
Mexico’s peso crisis (also dubbed the “Tequila Crisis”) in 1994 saw the currency devalue 13–15% in one day, and nearly 50% in the following months.
Inflation surged to 52%, and the rising cost of servicing dollar-denominated debt deepened the fiscal crisis. The upshot of all this was a forced international bailout.
Past traumatic episodes like these, with many countries in ASEAN having held high levels of US-denominated debt in 1997-1998, is one reason why local-denominated debt is a lot more common now in emerging markets (EMs).
That’s done to ensure debt servicing costs don’t spiral out of control if their currencies become untethered from the US dollar.
Read Also: Complete Guide To Getting The Best Foreign Exchange Rates At The Money Changers In Singapore
How Inflation Influences Deficits
A weaker currency makes imports costlier, which feeds into inflation. Higher inflation often prompts central banks to raise interest rates. Those rate hikes increase the cost of rolling over government debt, which can worsen budget deficits.
The reverse can also happen. A stronger currency can keep inflation low, allowing interest rates, as well as debt costs, to stay manageable.
However, that currency strength may erode export competitiveness, thereby reducing trade revenue.
History Lessons
The 1985 Plaza Accord is often cited as a success story in managing currency and deficit dynamics. Coordinated intervention weakened the US dollar, and by 1987, the US trade deficit had shrunk to roughly a third of its GDP share.
Yet much of that improvement also came from domestic policy: the Federal Reserve cut interest rates from 12% to 6%, and the US budget deficit shrank by almost 40%.
In contrast, Greece’s experience after joining the euro shows how losing currency flexibility can compound deficit problems.
Between 1999 and 2009, Greece’s budget deficit ballooned from under 5% of GDP to nearly 15%, culminating in a debt crisis. Without the ability to devalue its currency, competitiveness eroded and deficits soared.
The Butterfly Effect
It’s tempting to assume a weaker currency always worsens deficits or that a stronger one always helps.
The truth is far more dependent on a country’s economic structure, trade mix, and debt profile. These all have an impact on the end result and a reverberation in one area can cause knock-on effects.
Many studies have found the link between deficits and exchange rates to be inconsistent, highlighting the complexity of the relationship.
So how can governments reduce the impact of volatile currency fluctuations? There are measures, including intervening in currency markets, issuing more debt in domestic currency, or adjusting subsidies and tariffs to protect consumers from import price shocks.
However, all these are often partial fixes rather than permanent solutions. At the end of the day, global market forces still dominate.
How To Think About Currencies And Deficits
Exchange rates and currency strength can play a crucial role in the outcomes of the government’s deficits. But it also depends on a number of other factors like trade patterns, debt structure, and inflation dynamics.
While a weaker currency might help exporters but raise import and debt costs, a stronger currency can keep inflation in check but hurt competitiveness. In other words, there’s always a trade-off.
Finding that right balance, in the interests of the national deficit, is the hard part for policymakers and governments worldwide.
Read Also: US Tariffs To Remain At 10% For Singapore. How Local Workers & Businesses Will Be Affected
