Does Currency Devaluation Help The Economy?

Does Currency Devaluation Help The Economy?

27 Jan 2020 02:13 PM
 

The impact of the value of domestic home currency is quite prominent on the foreign exchange rates and ultimately international trade. Whether it is for retail forex transactions that are of a smaller scale like college fees of international universities, foreign travel needs, etc. or currency transactions for export/import of goods or services that are of larger magnitude, the jolt can be felt in every aspect associated with dealings in foreign currency. What impact does a deliberate decrease in a country currency’s value bring to a nation?

The deliberate downward adjustment of a country's currency value relative to another currency or group of currencies due to governmental activities is known as currency devaluation. There might be numerous reasons why a country might devaluate its currency, including combating trade imbalances by shrinking the trade deficit. It can also serve as a monetary tool to control money supply and demand. The impact of currency devaluation is not just observed on international trade but also by domestic residents who find foreign travel and imports more expensive. Irrespective of the advantages that it might bring in terms of boosted exports for a country, the negative implications it brings out by creating uncertainty and tension within global markets and competing countries cannot be unnoticed.

Example of currency devaluation

A better understanding of a devaluating currency's impact can be established through certain examples. One instance that is widely considered as a beneficial devaluation is that of the British Pound in 1992. Widely known as Black Wednesday, Pound lost significant value on 15-16 September 1992. As per the Exchange Rate Mechanism (ERM) set up by the European Union, member countries (including Britain) had to keep their currency within a prescribed range. Due to a prolonged economic recession, British Pound was regularly depreciating and was reaching the lower limit of the prescribed exchange rate range. In an attempt to keep the pound from declining further and retain it in the ERM (European Exchange Rate Mechanism), interest rates were increased from an already high 10% to 12% to entice traders to buy Pound. Market traders and dealers continued selling the Pound and the UK Government was forced to withdraw the Pound from the ERM. In some ways, Black Wednesday led to economic recovery and kept the UK out of the Eurozone. 

It is not necessary that currency devaluation will bring the intended benefits to a country. The Brazilian economy is one such example as steep currency devaluation has not been able to offset the problems like augmenting corruption scandals, plunging crude oil and commodity prices from the time Brazilian Real has witnessed a dip since 2011 resulting in sluggish growth. 

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 USDCNY reference rate below $7 in Aug 2019. US President, Donald Trump already targeting higher tariffs on more Chinese goods and service imports labelled China as a 'currency manipulator'. This started a possible currency war, which the global equity markets did not 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, the US promptly removed the manipulator tag to rebuild the bridge.

Why countries devalue their currency?

It might appear confusing to some to ascertain the relevance of currency devaluation to help a country's economy. Contrary to popular beliefs and unknown to many, a stronger currency does not always reflect the best interests of a country. However, a weaker currency, on the other hand, can facilitate a nation's export to become more competitive in global markets while making imports more expensive. The resultant hight export volume is able to boost economic growth wherein the heightened import prices also corroborate the cause by making consumers prefer cheaper local alternatives rather than costly imported goods. Faster GDP growth and higher employment are enabled with improvement in terms of trade (ratio between a country's export and import prices) that generally translates into a lower current account deficit. 

However, a country must evaluate the negative impact a currency devaluation can bring as it may reduce the overseas purchasing power of a nation's citizens, and lower productivity caused by the enhanced expensiveness of the imports of capital equipment and machinery. 

Following are the top three reasons for a country's government to pursue currency devaluation:

  1. Boosting exports - In the global market, countries are competing with each other, wherein exports are encouraged, and imports are discouraged. A less valuable currency can make exports relatively cheaper for purchase in foreign markets. For example, for carmakers in America competing with carmakers in Europe and Japan, the decrease in the value of the euro against the dollar can make the car prices sold by the European manufacturers in America to be less expensive. The matter of caution at hand for countries to consider is that while the demand for the country's exported goods increases worldwide, a normalizing effect would soon come into the picture with the increased prices. It might also create an incentive for other countries to tread on the same path, eventually leading to currency wars and unchecked inflation.
  2. Shrinking the trade deficits - Shrinking of trade deficits is witnessed when the exports become more competitive while the imports become expensive as it enables an improved balance of trade (Exports minus Imports). Devaluating home currency can help correct the balance of payments and reduce trade deficits that are unsustainable in the long run leading to crippling debt. However, currency devaluation can also lead to increased challenge regarding servicing of foreign currency debts, especially for developing countries like India due to the increased debt burden of foreign-currency-denominated loans when priced in home currency.
  3. Reducing debt burdens - If the debt payments are fixed, a government might be incentivized to pursue a currency devaluation policy to make payments less expensive over time in the case of sovereign debt. As most countries over the globe have some form of foreign currency debt, this tactic might also lead to a currency war. Also, if a country holds a large number of foreign bonds, currency devaluation might not result in favourable results but might make the interest payments more expensive.

Disadvantages of currency devaluation

  1. Currency devaluation can cause inflation due to imports becoming expensive. It can create the looming concern of lowered productivity with exporters relying on devaluation to improve competitiveness than finding any incentives in cutting costs. 
  2. It can lead to a reduction in real wages, and the overseas purchasing power of domestic citizens, such as international travel which can become more expensive. 
  3. International investors might not find it in their favour as the real value of their holding is being reduced. Also, there might be a steep increase in debt repayments for consumers who have debts in foreign currencies. One example of a case in point being Hungary, wherein devaluation made it very expensive for many to pay off their Euro-denominated mortgages.

Devaluation is a short term booster of exports and growth, but the organic economic growth would happen with an increase in productivity and long term capacity growth instead of an artificial domestic demand boost. The higher frequency of devaluation of the currency makes the foreign investors jittery. It may not encourage long term investors to stay invested in such economies, thereby damaging long term economic growth. The spiral of currency devaluation and imported inflation makes it challenging to maintain domestic prices. The entities which tend to lose when currency devaluation happens are importers of oil, raw material used for manufacturing exports, the tourist industry, travelling abroad for work or leisure or studies.

The impact of the changes in the home currency value and foreign exchange rates is very prominent to the export and import industry. Since India is a heavy oil-importing country, any decrease in the rupee value has the importers clamouring for relief and raising their concerns. The same is the case with the exporters when currency appreciation happens. The overall profitability of a firm can be drastically affected by currency value movements. Myforexeye is India’s first full-service forex company providing solutions to individuals, organisations and traders to make their forex convenient and cost-efficient. Our services like transaction process outsourcing (TPO) enable our clients to access favourable forex rates through our negotiations with their banks. Besides TPO, we also offer import and export finance services like buyer’s credit and supplier’s credit wherein our clients are able to avail the best quotes available in the market. We also empower our clients with forex risk management, live forex updates, high-quality research, custom alerts, and many more so that they can enjoy a process that is hassle-free and is working towards extending them enhanced savings from their forex transactions

Conclusion

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