There have been debates about the value of our rupee against the Dollar. The same is true in India. The piece today presents a few basics on the topic.
Ever since world currencies abandoned the gold standard and allowed their exchange rates to float freely against each other, there have been many currency devaluation events that have hurt not only the citizens of the country involved but have also rippled across the globe. If the fallout can be so widespread, why do countries devalue their currency?
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 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.
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.
Take for example a government who 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. In our example, if the domestic currency is devalued to half of its initial value, the $1 million debt payment will only be worth $500,000 now.
There are, however, some negative effects of devaluations.
1. Exports become cheaper and more competitive to foreign buyers. Therefore, this provides a boost for domestic demand and could lead to job creation in the export sector.
2. A higher level of exports should lead to an improvement in the current account deficit. This is important if the country has a large current account deficit due to a lack of competitiveness.
3. Higher exports and aggregate demand (AD) can lead to higher rates of economic growth.
4. Devaluation is a less damaging way to restore competitiveness than ‘internal devaluation‘. Internal devaluation relies on deflationary policies to reduce prices by reducing aggregate demand. Devaluation can restore competitiveness without reducing aggregate demand.
5. With a decision to devalue the currency, the Central Bank can cut interest rates as it no longer needs to ‘prop up’ the currency with high interest rates.
Disadvantages of devaluation
1. Inflation. Devaluation is likely to cause inflation because:
* Imports will be more expensive (any imported good or raw material will increase in price)
* Aggregate Demand (AD) increases – causing demand-pull inflation.
* Firms/exporters have less incentive to cut costs because they can rely on the devaluation to improve competitiveness. The concern is in the long-term devaluation may lead to lower productivity because of the decline in incentives.
2. Reduces the purchasing power of citizens abroad. e.g. it is more expensive to go on holiday abroad.
3. Reduced real wages. In a period of low wage growth, a devaluation which causes rising import prices will make many consumers feel worse off. This was an issue in the UK during the period 2007-2018.
4. A large and rapid devaluation may scare off international investors. It makes investors less willing to hold government debt because the devaluation is effectively reducing the real value of their holdings. In some cases, rapid devaluation can trigger capital flight.
5. If consumers have debts, e.g. mortgages in foreign currency – after a devaluation, they will see a sharp rise in the cost of their debt repayments. This occurred in Hungary when many had taken out a mortgage in foreign currency and after the devaluation, it became very expensive to pay off Euro denominated mortgages.
* The elasticity of demand. A devaluation may take a while to improve the current account because demand is inelastic in the short term. However, if demand is price elastic, then it will cause a relatively bigger increase in demand for exports. (See: J-Curve effect)
* If the country has lost competitiveness in a fixed exchange rate, a devaluation could be beneficial in solving that decline in competitiveness.
* Type of economy. A developing economy which relies on the import of raw materials may experience serious costs from a devaluation which makes basic goods and food more expensive.
Ever since world currencies abandoned the gold standard and allowed their exchange rates to float freely against each other, there have been many currency devaluation events that have hurt not only the citizens of the country involved but have also rippled across the globe. If the fallout can be so widespread, why do countries devalue their currency?
To Boost Exports
On a world market, goods from one country must compete with those from all other countries. Car makers in America must compete with car makers 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 make 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 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.
To Shrink Trade Deficits
Exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favours an improved balance of payments as exports increase and imports decrease, shrinking trade deficits. Devaluing the home currency can help the correct 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.
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.Take for example a government who 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. In our example, if the domestic currency is devalued to half of its initial value, the $1 million debt payment will only be worth $500,000 now.
The Bottom Line
Currency devaluations can be used by countries to achieve economic policy. Having a weaker currency relative to the rest of the world can help boost exports, shrink trade deficits and reduce the cost of interest payments on its outstanding government debts.There are, however, some negative effects of devaluations.
Advantages and disadvantages of devaluation
Advantages of devaluation1. Exports become cheaper and more competitive to foreign buyers. Therefore, this provides a boost for domestic demand and could lead to job creation in the export sector.
2. A higher level of exports should lead to an improvement in the current account deficit. This is important if the country has a large current account deficit due to a lack of competitiveness.
3. Higher exports and aggregate demand (AD) can lead to higher rates of economic growth.
4. Devaluation is a less damaging way to restore competitiveness than ‘internal devaluation‘. Internal devaluation relies on deflationary policies to reduce prices by reducing aggregate demand. Devaluation can restore competitiveness without reducing aggregate demand.
5. With a decision to devalue the currency, the Central Bank can cut interest rates as it no longer needs to ‘prop up’ the currency with high interest rates.
Disadvantages of devaluation
1. Inflation. Devaluation is likely to cause inflation because:
* Imports will be more expensive (any imported good or raw material will increase in price)
* Aggregate Demand (AD) increases – causing demand-pull inflation.
* Firms/exporters have less incentive to cut costs because they can rely on the devaluation to improve competitiveness. The concern is in the long-term devaluation may lead to lower productivity because of the decline in incentives.
2. Reduces the purchasing power of citizens abroad. e.g. it is more expensive to go on holiday abroad.
3. Reduced real wages. In a period of low wage growth, a devaluation which causes rising import prices will make many consumers feel worse off. This was an issue in the UK during the period 2007-2018.
4. A large and rapid devaluation may scare off international investors. It makes investors less willing to hold government debt because the devaluation is effectively reducing the real value of their holdings. In some cases, rapid devaluation can trigger capital flight.
5. If consumers have debts, e.g. mortgages in foreign currency – after a devaluation, they will see a sharp rise in the cost of their debt repayments. This occurred in Hungary when many had taken out a mortgage in foreign currency and after the devaluation, it became very expensive to pay off Euro denominated mortgages.
Evaluation of the impact of the devaluation
* It depends on the state of the business cycle – In a recession a devaluation can help boost growth without causing inflation. In a boom, a devaluation is more likely to cause inflation.* The elasticity of demand. A devaluation may take a while to improve the current account because demand is inelastic in the short term. However, if demand is price elastic, then it will cause a relatively bigger increase in demand for exports. (See: J-Curve effect)
* If the country has lost competitiveness in a fixed exchange rate, a devaluation could be beneficial in solving that decline in competitiveness.
* Type of economy. A developing economy which relies on the import of raw materials may experience serious costs from a devaluation which makes basic goods and food more expensive.
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