What does the valuation effect refer to?

The valuation effect refers specifically to changes in the value of foreign debt that occur due to fluctuations in currency exchange rates. When the value of the Australian dollar (or any domestic currency) increases relative to foreign currencies, the dollar amount of foreign debt, when converted back to the domestic currency, decreases. This can provide a favorable impact on the balance sheet of entities holding foreign liabilities, as it effectively means they owe less in their domestic currency.

When considering the other options, an increase in the value of foreign investments typically correlates with foreign currency strength but doesn't directly illustrate the valuation effect, which is about debt value changes rather than investments. A sustained increase in the value of domestic currency could suggest stronger purchasing power, yet it doesn't capture the specific impact on foreign debt valuation. Finally, while changes in currency values can influence local interest rates indirectly, the valuation effect is not defined by a direct impact on interest rates.