Devaluation is an unconventional monetary policy tool by which the value of a country’s currency is officially lowered within a fixed exchange rate system, where the authority formally sets a new fixed rate with respect to a foreign reference currency. It is often confused with depreciation, which is a decrease in a currency’s value due to market forces of supply and demand under a floating exchange rate system, not by government or central bank policy actions.
For example, a country A has a fixed exchange rate of let’s say 5 units of their currency for US$1. After officially announcing and lowering the exchange rate, it can go for any number greater than 5.
Why do countries devalue their currency?
To Boost Exports
Export is something a country manufactures and sells to another country. Let’s take an example of two countries A and B with the fixed exchange rate equals to 1 unit of A = 1 unit of B. The country A can make enough bricks and has set the value of 1 brick = 1 unit of A while B can make a lot of rice and has set 10 bags of rice = 1 unit of B.
Let’s say that the A’s economy is export-driven economy and exports bricks to country B at a price of 1 unit of B (both currencies are same right now) because the country B is going through a bad season. After few months when the bad season ended, B started making bricks and same price and they don’t require A’s bricks. Now if the country A has to export their bricks to the other country, they have to lower the price, so they devalue their currency by 50% such that 2 units of A = 1 unit of B or the price of bricks fell by 50% than previous and now A can export more to boost their economy.
This is how countries boost exports by devaluing their currencies. In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged.
To correct balance of payments
Also known as trade deficits which occur when net exports are negative, meaning that country imports more than it exports. Many countries can bear trade deficits without devaluing their currency because their productivity is so high that it more than compensates the trade deficits. Persistent deficits are not uncommon today, with the United States and many other nations running persistent imbalances year after year. Economic theory, however, states that ongoing deficits are unsustainable in the long run and can lead to dangerous levels of debt which can cripple an economy. By devaluing the home currency, exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favors an improved balance of payments as exports increase and imports decrease, shrinking trade deficits.
To Reduce Sovereign Debt Burdens
A government may be incentivized to encourage a weak currency policy if it has a lot of government issued sovereign debt to service on a regular basis. If debt payments are fixed, a weaker currency makes these payments effectively less expensive over time.
A central bank can make the conscious effort to make its currency less valuable. If Country XYZ’s currency is set at a fixed exchange rate of 2:1 to the U.S. dollar and, due to a weak economy, XYZ cannot afford to pay the interest rate on its debt outstanding, XYZ may devalue their currency. This means the central bank of XYZ will declare their fixed exchange rate to be 10:1 to the U.S. dollar. This makes their debt outstanding is now worth five times less. It’s a very tricky maneuver with grave economic consequences.
What are the consequences of each objective?
Boosting Exports. First, as the demand for a country’s exported goods increases worldwide, the price will begin to rise, normalizing the initial effect of the devaluation. The second is that as other countries see this effect at work, they will be incentivized to devalue their own currencies in kind in a so-called “race to the bottom.” This can lead to tit for tat currency wars and lead to unchecked inflation. Lastly, if exports are being boosted, the weaker currency also leads to costly imports thereby increasing inflation in the home country.
The balance of payments. There is a potential downside to this rationale, however. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like India or Argentina which hold lots of dollars- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.
Sovereign Debts. This tactic should be used with caution. As most countries around the globe have some debt outstanding in one form or another, a race to the bottom currency war could be initiated. This tactic will also fail if the country in question holds a lot of foreign bonds since it will make those interest payments relatively more costly.
How do countries devalue currency?
Since we are talking about devaluation and not depreciation, we will see how a government changes the fixed exchange rate i.e. how do they devalue their currency?
Print Money. The first thing a government can do is to print more money. See this way, if there are fewer millionaires in a country, a million of that currency would be a very valuable asset but if there are many millionaires, then the value of that million would not be same as the previous one relative to another currency. So, if a country starts printing more money and dumps it into the foreign exchange market, while the other country’s amount of money is fixed, the value of the currency can be decreased or currency becomes weaker.
Sells/releases their own currency. There are two parts in it; unsterilized intervention by the government, and sterilized intervention.
- Unsterilized Intervention – In this case, the central bank buys, or sells, foreign currency securities using the domestic currency that it issues. For example, the Federal reserve can buy euros and sell dollars, which puts a downward pressure on the dollar and depreciates it against the euro. In other words, if the Fed is buying euros, then the demand of euros is increased thereby decreasing the value of the dollar in the market.
- Sterilized Intervention – It is like an unsterilized intervention but with a twist in order not to change the monetary base (central banks would want to keep the same monetary base in order to not influence the inflation levels). The first stage is conducting an unsterilized intervention. After this, the central bank will turn around to the private sector and “sterilize” the effect of the intervention by either selling domestic currency securities (in the case that it bought foreign currency securities) or buy domestic currency securities (in the case that sold foreign currency securities). If the ECB wants to depreciate the euro but it is scared about inflation it will perform a sterilized intervention. The ECB will buy dollars with euros depreciating the value of the euro, but at the same time will sell euro-denominated securities to private institutions in order to keep the same amount of money available.
In order to be able to perform these activities, central banks need to have sufficient foreign currency reserves in order to stand ready to keep the value. For example, if the dollar was pegged to the euro at 2 dollars per euro, and the euro was seeing appreciation against the dollar, due to one of the reasons above-mentioned, the FED should be ready to sell euros and buy dollars in order to defend the value of its currency. However if it runs out of euro reserves, it will not be able to defend the peg.
We have come a long way and have seen about a very interesting concept of devalution, its objectives, its effects and how can countries devalue the currency. I hope this helps you get an understanding about devaluation.
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