Devaluating a currency is when a currency loses its value relatively with other currencies in the foreign exchange market. It is an intentional action by the central bank wherein they declare the local currency cheaper in reference to a foreign currency. The action is a result of the monetary policy and since it’s a deliberately done, it is different from depreciation. It is a tool amongst many that the central banks use in order to boost the exports and in turn improving the trade balance which runs in deficit.
Why devalue a currency?
Economies which follow a fixed exchange rate usually tend to devalue their currency as its better controlled and not determined by the market forces. The foreign exchange market determines the prevailing exchange rate by letting the demand and supply depending on the sentiments of the traders. The fundamental and technical factors drive the forex rates. But when the currency rate is managed or controlled like in a fixed exchange rate, the government or the central bank give a reference rate for every day.
Apart from boosting exports, devaluation improves country’s trade balance and helps build forex reserves. As the central government tries to devalue the currency by purchasing the foreign currency and supplying the domestic currency, which increases the foreign exchange reserves which the country holds. In order to stimulate the exports, the domestic output is encouraged thereby improving employment. Import substitution takes priority and thus increasing the gross domestic product (GDP) of the economy. Upon devaluing the currency, the country’s products and services have higher chances of being sold at lower prices in the international markets giving them a competitive edge over other economies whose currency has appreciated.
With uncertainties due to the prevailing US China trade war, the Chinese central bank – People’s Bank of China devalued its currency for the first time in over a decade to level peg the reference rate below $7 in Aug 2019. If the aim of devaluing is to meet a target of particular exchange rate, then it sometimes is inappropriate for the economy.
US President, Donald Trump already targeting higher tariffs on more goods and service imports labeled China as a ‘currency manipulator’. This started a possible currency war, which the global equity markets didn’t take quite well and fell across the boundaries. Now with a signing of the phase 1 deal between the US and China on Jan 15, US promptly removed the manipulator tag in an attempt to re-build the bridge.
Does it mean devaluation has no demerits?
Well devaluing a currency can give a thrust to the exports and reduce the trade deficit but for any economy which has higher imports, the consequences can be on the negative too. Higher imports will may lead to more domestic demand and thus increase in employment and production in turn, but the competitiveness is lost making the companies less efficient. Inflation can be higher as imports are costlier than before. With a demand led inflation pull and exports being cheaper, the domestic manufacturers may keep higher cost of products and services to sell higher in local markets.
The Indian central bank, Reserve Bank of India (RBI) has a difficult task of regulating the Indian currency. Being a heavy oil importing country, any drop in Rupee got the importers lobby raising their concern when the currency went towards 74 to the dollar. Similarly exporters make noise when sudden appreciation is seen in the currency. Here the central bank is intervening in the currency markets through the public sector banks and it is assumed the deals are on behalf of the RBI. But to opening declare that the central bank is willing to buy or sell currency in order to maintain the exchange rate labels it as devaluation.
When a government finds a regular outflow of capital from its country or when the total value of imports is significantly higher than the total value of exports (trade deficit), devaluation of the currency may take place.
So does it really help the economy?
Devaluation is a short term booster of exports and growth, but the organic economic growth would happen with increase in productivity and long term capacity growth instead of an artificial domestic demand boost. The higher frequency of devaluation of currency makes the foreign investor jittery and may not encourage long term investors to stay invested in such economies thereby damaging the long term economic growth. The spiral of inflation, devaluation and inflation negatively continues making it difficult to escape the situation. The entities which tend to lose when currency devaluation happens are importers of oil, raw material used for manufacturing exports, tourist industry, travelling abroad for work or leisure or studies.
Having understood both the merits and demerits of devaluing a currency, the economies which are less dependent on imports may choose to keep a devalued currency whereas others may prefer the market forces to play the game instead.
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