Currency Devaluation Definition
Currency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies and such a mechanism is used by economies that have a semi-fixed exchange rate or fixed exchange rate and it must not be confused with depreciation.
Top 3 Causes / Reasons of Currency Devaluation
#1 – To Boost Exports and Discourage Imports
The trade war is a common happening in the world market nowadays. In the world market, every country wants its products to be in demand and to be traded across nations. Every country wants its products to be able to compete with the products of other countries. For example, Laptop makers in Europe may compete with Laptop makers in America. If the Euro devalues against the dollar, the European car in America which was earlier available at $ x will now be available at $ x-y. Hence its price will go down making imports for America from Europe cheaper. On the contrary, if a currency gains in value, it makes the export more costly thus affecting the demand for the goods negatively. In other words, the devaluation of the currency makes exports more lucrative and discourages imports.
To continue with the above example: Say a European car as on April 20, 2018, was sold at 12000 Euro in America. As on April 20, 2018, the exchange rate for Euro to Dollar was:
1 Euro = 1.2 US Dollar
On April 25, 2018, as a part of monetary policy, Euro is devalued in comparison to the dollar. Thus the effect of devaluation on European car would be:
Thus the European car in America will become cheaper by $ 1,800 thereby making it more lucrative to buyers which would lead to an increase in demand thus driving the exports for the European country.
#2 – To Narrow Down the Trade Deficit
The trade deficit is the difference between exports and imports of the company.
Trade Deficit = Imports – Exports
Negative trade deficit may have negative impacts on the economy of the country and may lead to huge debt levels thereby crippling the economy. Thus currency devaluation can help boost exports by making exports cheaper and reduce imports by making them more costly for the residents of the country. Thus a balance of trade can be achieved by currency devaluation.
#3 – Reduce Sovereign Debt Burden
If a country has issued multiple Sovereign bonds to raise money, they may be incentivized by devaluing the currency. In other words, a devalued currency helps reduce the regular service burden for Sovereign Debt issued by a country if investments are high from FIIs and interest to be paid are fixed amounts.
For Example: If a US Government issued Sovereign debt the majority of which was purchased by European investors. Suppose the US government has to pay $ 500 per month to these investors on a monthly basis and the interest charges are fixed at $ 500 per month.
Thus say Dollar is devalued in comparison to Euro, Monthly service burden will reduce as mentioned below:
Limitations/Downside of Currency Devaluation
There are many downsides to currency devaluation like rising in Inflation, more costly foreign debts servicing. It further reduces the confidence of foreign investors in the country’s currency as well.
Further, deliberate currency devaluation may go wrong at multiple points:
- Though currency devaluation helps boost exports, some caution should be taken while devaluing a country’s currency. Though the demand for exported goods increases when a currency is devalued, increased demand may lead to rising prices thereby normalizing the currency devaluation effect. Further other countries may notice the devaluation effects and decreasing demand for their products, they may also be tempted to devalue the currency. Thus, it may lead to currency wars among countries.
- Though currency devaluation helps reduce the trade deficit, there is a potential downside to it. Most of the developing countries have foreign currency loans. Thus, currency devaluation may lead to an increase in debt burden when the loans are priced in the home currency. Non-service of such debts may cast a negative image of the country among investors.
Important Points to Note
- Currency devaluation is a deliberate or forced downward movement of the value of a currency vis-a-vis other currency (of any other country) or currency standard. Currency devaluation is generally referred to as deliberate devaluation tactics. Such tactics are referred to as monetary policy and are used by the countries that have a fixed exchange or semi-fixed exchange rate.
- Currency devaluation sets a new exchange rate for a currency. The exchange rate is usually stabilized by a central bank that is responsible to buy or sell currency to maintain its exchange rate vis-à-vis other currency.
- The majority of times currency devaluation is used as a monetary policy tool to boost a country’s trade. However, there are multiple limitations to these policies and a country should take a proper analyzed decision if they decide to roll out such policy.
- Further, devaluations may be forced on a country when it is not able to defend its exchange rat any longer. For currency devaluation example, Russia was earlier trying to maintain the exchange rate of Ruble in comparison to Dollar and in the quest for the same was buying rubles and selling the dollar. However, the market noticed the same and started selling rubles, thus posing a threat to the government on losing out on their Dollar reserves. Thus the government was left with no choice but to let the ruble selling continue and to sit and watch the exchange rate of Ruble against dollar fall.
This has been a guide to Currency Devaluation and its definition. Here we discuss the top 3 causes of currency devaluation along with examples, limitations, and downsides. You can learn more about financing from the following articles –