What Is Devaluation?
Devaluation is the deliberate downward adjustment of the value of a country’s money relative to another currency, group of currencies, or currency standard. Countries that have a fixed exchange rate or semi-fixed exchange rate use this monetary policy tool. This article will discuss why does devaluation happen.
Why Does Devaluation Happen?
As Investopedia states here are three top reasons why a country would pursue a policy of devaluation:
1. To Boost Exports
On a world market, goods from one country must compete with those from all other countries. Carmakers in America must compete with carmakers in Europe and Japan. If the value of the euro decreases against the dollar, the price of the cars sold by European manufacturers in America, in dollars, will be effectively less expensive than they were before. On the other hand, a more valuable currency makes exports relatively more expensive for purchase in foreign markets.
In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged. There should be some caution, however, for two reasons. 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 initiate 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 unchecked inflation.
2. To Shrink Trade Deficits
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. 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. Devaluing the home currency can help correct the balance of payments and reduce these deficits.
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 holds lots of dollars- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.
3. To Reduce Sovereign Debt Burdens
The government has the option of encouraging a weak currency policy if it has large debts that must be paid off regularly. If the debt payment is resolved, a weaker currency makes these payments effectively cheaper over time. Take for example a government that has to pay $1 million each month in interest payments on its outstanding debts. But if that same $1 million of notional payments becomes less valuable, it will be easier to cover that interest.
