What is a Currency Devaluation?

A currency devaluation is a deliberate downward adjustment of a country’s currency value, relative to another currency, group of currencies, or standard. It’s a monetary policy tool that is typically employed by nations with fixed or semi-fixed exchange rate systems, in order to address internal economic challenges or meet economic goals.

How Currency Devaluation works in detail

Currency devaluation happens in a fixed or semi-fixed exchange rate system, when the government or country’s central bank deliberately lowers the official value of its currency relative to another currency, the gold standard, or a basket of currencies.

This process typically follows a series of deliberate steps aimed at achieving specific economic outcomes:

1. Government or Central Bank decision

Currency devaluation begins with a decision by policymakers or central bankers to adjust the official exchange rate. This decision is usually made to address macroeconomic issues like trade imbalances, high unemployment, or excessive national debt.

For example, a country facing a large trade deficit may choose to devalue its currency to make its exports more competitive while also discouraging imports. The government will announce a new, lower exchange rate for the currency – for instance, if the old exchange rate was 1 USD = 5 Local Currency Units (LCU), a devaluation might reset this to 1 USD = 6 LCU.

2. Adjustment of the Exchange Rate

In practical terms, devaluation means the central bank increases the amount of local currency required to purchase one unit of a foreign currency. They do this by reducing the official fixed value of the local currency in the forex market.

Looking at the supply-demand mechanics:

• When the currency is devalued, the cost of foreign goods increases for domestic consumers, because more local currency is needed to buy them.
• At the same time, the country’s exports become cheaper and more attractive to foreign buyers, thus boosting international demand for locally produced goods.

If, for example, a devaluation occurs, a product that previously cost $10 to a foreign buyer might now only cost $8 due to the reduced value of the local currency, and this price adjustment will encourage higher export demand.

3. Impact on Exports and Imports

Devaluation is often used to address trade imbalances, because by making exports cheaper for foreign buyers, a country hopes to increase the overall volume of goods sold internationally. Simultaneously, imports become more expensive for domestic consumers, potentially reducing import demand.

The broad outcomes expected are that the devaluation will:

• Boost export industries by making their products more competitive globally.
• Encourage consumers to buy locally produced goods, stimulating the domestic economy.

There can also, however, be unintended consequences, because if a country relies heavily on imported goods (like food, energy, or machinery), devaluation can lead to higher costs for essential goods, fueling inflation.

4. Role of Central Bank Intervention

Central banks play a crucial role in implementing and managing devaluation, as they might actively buy or sell foreign currencies to maintain the new fixed rate and/or prevent speculative attacks on the local currency.

Key tactics to manage a successful currency devaluation include utilizing foreign reserves (the central bank might use foreign currency reserves to stabilize the local currency) as well as adjusting monetary policies (interest rate adjustments may accompany devaluation to control inflation and/or attract foreign capital).

During Argentina’s 2002 economic crisis, for example, the government abandoned the peso’s peg to the U.S. dollar – something that led to a significant devaluation – whereupon the central bank intervened by setting new monetary policies to stabilize the economy.

5. Market Reactions and Ripple Effects

Currency devaluations will not only affect the domestic economy, but also impact international markets to a greater or lesser extent. Investors, businesses, and trading partners react to the changes, which can amplify or diminish the desired outcomes of the devaluation – devaluation doesn’t always have a clear, linear effect.

Local export-oriented industries will benefit from increased global demand, potentially leading to economic growth, but at the same time investors might begin to lose confidence in the economy, leading to capital flight, or at least reduced foreign investment.

Moreover, if neighboring countries perceive the devaluation as a threat to their trade balance, it can trigger “currency wars,” where other nations devalue their currencies in response.

6. Inflationary Pressures after Devaluation

One major consequence of devaluation is inflation, because as imports become more expensive, the cost of goods and services in the domestic market inevitably rises. Imported goods, especially fuel or food, see price increases due to the weaker currency, and businesses that rely on imported raw materials thus face higher production costs, which are passed on to consumers.

This inflationary effect can erode the purchasing power of citizens and reduce the benefits of increased export competitiveness if it’s not managed properly.

As a still painful example, Venezuela’s repeated devaluations of the bolivar circa 2010 led to hyperinflation, completely devastating the economy and eroding public trust in the currency.

In summary, a currency devaluation is a government or central bank decision to devalue the currency to achieve specific economic objectives. The official exchange rate is then altered, increasing the amount of domestic currency required to purchase foreign currency, making domestic goods and services cheaper for foreign consumers, potentially boosting exports.

Conversely, imports become more expensive for domestic consumers, which may reduce import volumes, and also force consumers to spend more within the local economy to fulfill their needs.

Pros and Cons of Currency Devaluation

The pros of devaluing currency include:

• Enhanced export competitiveness. Devaluation lowers the price of domestic goods in foreign markets, potentially increasing export volumes.
• Reduction of trade deficits. By boosting exports and discouraging imports, devaluation can help to narrow trade deficits.
• Economic stimulus. Increased demand for exports can lead to higher production, job creation, and overall economic growth.

The cons of devaluing the currency:

• Inflationary pressures. More expensive imports can lead to higher overall price levels, contributing to inflation.
• Reduced purchasing power. Citizens may find that their currency buys less abroad, diminishing their real income and household status.
• Potential retaliation. Trading partners may respond with their own devaluations or trade barriers, leading to “currency wars”.
• Developing economies. Devaluation can boost export-led growth, but might also exacerbate inflation and increase the burden of foreign-denominated debt.
• Advanced economies. While devaluation can aid in economic recovery, it may lead to reduced investor confidence and capital flight if it’s seen as a sign of economic weakness.

Why Countries Devalue their Currencies

There are a number of common reasons for a devaluation of currency, and one or more of them are always in the mix when currency devaluations occur:

• Boosting exports. Making domestic goods cheaper abroad stimulates economic growth.
• Addressing trade imbalances. Countries can reduce trade deficits by encouraging exports and discouraging imports.
• Managing debt. A devaluation can also ease the burden of domestic debt denominated in foreign currencies.
• Combating unemployment. A devaluation theoretically stimulates the demand for domestic goods, leading to job creation.

Historical Examples of Currency Devaluations

Some notable examples of currency devaluations include:

• UK (1967). The British pound was devalued by 14.3% to address a trade deficit and economic challenges.
• The Mexican Peso Crisis (1994). In December 1994, Mexico devalued the peso by about 15% against the U.S. dollar, a decision made to address a growing trade deficit and dwindling foreign exchange reserves. The devaluation triggered a financial crisis, however, as investors panicked and pulled their money out of the country, leading to a further depreciation of the peso by over 50% in the following months.
• The Russian Ruble Crisis (1998). In 1998, Russia devalued the ruble during a severe economic crisis caused by low oil prices, high debt levels, and a loss of investor confidence. The government defaulted on its domestic debt and allowed the ruble to fall sharply against foreign currencies.
• The Indonesian Rupiah Crisis (1997-1998). During the Asian Financial Crisis, the Indonesian rupiah lost more than 80% of its value against the U.S. dollar. This began with speculative attacks on the Thai baht but quickly spread to other Asian currencies. Indonesia’s central bank attempted to defend the rupiah by using foreign reserves, but the efforts failed, and the government eventually allowed the currency to devalue significantly.
• Argentina (2002). Abandoning the peso’s peg to the U.S. dollar led to a significant devaluation amid the ensuing economic crisis.
• Venezuela (2010). The bolivar was devalued to address fiscal deficits, unfortunately and most notably leading to high inflation and economic instability.
• China (2015). The People’s Bank of China devalued the yuan by nearly 2% in order to boost exports amid slowing economic growth.
• Kazakhstan (2015). The tenge was devalued by 19% to enhance export competitiveness, succeeding to some extent, but also impacting consumers’ purchasing power.

Conclusion

Currency devaluation is a complex policy tool with potential benefits, and also significant risks, and it’s the terrible failures that unfortunately remain the most memorable.

Its success depends on a number of factors, including underlying economic conditions, the structure of the economy, and the responses of international trading partner – all difficult considerations to manage at times.

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Frequently Asked Questions on Currency Devaluation