Currency Devaluation

Currency devaluation is deliberately practiced to adjust the established exchange rates by the government. It is mostly performed in the cases of fixed currencies, and such a mechanism is used by economies with a semi-fixed exchange rate or fixed exchange rate and must not be confused with depreciation.

It helps boost exports by making goods more competitive globally, reducing the trade deficit and debt burden. However, the currency reduces in value. The country’s monetary authority officially makes this adjustment, and it is different from currency depreciation. Thus it is a method to revive and boost the economy.

• Currency devaluation in developing countries  are deliberately practiced to adjust the established government’s exchange rates.
• It is mainly performed in the cases of fixed currencies. Such a mechanism is used by economies with a semi-fixed or fixed exchange rate and must not be confused with depreciation.
• The top 3 causes/reasons for currency devaluation are boosting exports and encouraging imports, narrowing the trade deficit, and reducing the sovereign debt burden.
• Primarily, currency devaluation is used as a monetary policy tool to boost trade. However, these policies have multiple limitations, and a government should make a properly analyzed decision if they decide to roll out such a policy.

• Currency devaluation is a deliberate or forced downward movement of the value of a currency vis-a-vis another currency (of any other country) or currency standard. Currency devaluation is generally referred to as deliberate devaluation tactics. Such tactics are called monetary policy and are used by countries with 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 responsible for buying or selling currency to maintain its exchange rate vis-à-vis other currencies.
• Most of the time, currency devaluation is used as a monetary policy tool to boost trade. However, there are multiple limitations to these policies, and a government should take a properly analyzed decision if they decide to roll out such a policy.
• Further, devaluations may be forced on a country when it can no longer defend its exchange rate. For the currency devaluation example, earlier, Russia tried to maintain the rubble's exchange rate compared to the dollar. The quest for the same was buying rubles and selling the dollar. However, the market noticed and started selling rubles, thus threatening the government to lose out on its dollar reserves. So, the government was left with no choice but to let the ruble selling continue and witness the ruble's exchange rate against the dollar's fall.

#1 - To Boost Exports and Discourage Imports

The trade war is a common happening in the world market nowadays. Every country wants its products to be in demand and traded across nations in the world market. A currency devaluation causes the products of an economy to become more competitive in the foreign market. 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 collapse, making imports for America from Europe cheaper. On the contrary, if a currency gains in value, it makes the export more costly, thus negatively affecting the demand for the goods. In other words, as an impact of currency devaluation,  The exports become more lucrative and it discorages imports.

#2 - To Narrow Down the Trade Deficit

The trade deficit is the difference between exports and imports of the company.

Trade Deficit = Imports – Exports

A negative trade deficit may negatively impact the country's economy and lead to massive debt levels, thereby crippling the economy. Thus, currency devaluation can help boost exports by making exports cheaper and reducing imports by making them more costly for the country's residents. Therefore, can achieve a balance of trade by currency devaluation.

#3 - Reduce Sovereign Debt Burden

If a country has issued multiple sovereign bonds to raise money, it 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 the US Government issued sovereign debt, the majority was purchased by European investors. Suppose the US government pays $500 per month to these investors every month, and the interest charges are fixed at $500 per month.

Thus, say Dollar is devalued in comparison to Euro, the monthly service burden will reduce as mentioned below:

The various effects of currency devaluation is as follows:

1. There are many downsides to currency devaluation, like rising inflation, and more costly foreign debt servicing.
2.  It further reduces the confidence of foreign investors in the country’s currency as well.
3. Though a global currency devaluation helps boost exports, caution should be taken while devaluing a country’s currency. Though the demand for exported goods increases when a coin is devalued, increased demand may lead to rising prices, normalizing the devaluation effect. Different 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.
4. Though currency devaluation helps reduce the trade deficit, it has a potential downside. Most developing countries have foreign currency loans. Thus, currency devaluation may increase the debt burden when the loans are priced in the home currency. Non-service of such debts may cast a country's negative image among investors.

Let us look at some examples to understand the concept. 

Example #1

Say a European car on April 20, 2018, was sold at 12,000 Euro in America. As of April 20, 2018, the exchange rate for Euro to Dollar was:

1 Euro = 1.2 US Dollar

On April 25, 2018, Euro devalued compared to the Dollar as a part of monetary policy. Thus, the effect of devaluation on European cars would be:

Thus, the European car in America will become cheaper by $1,800, making it more lucrative to buyers, increasing demand, thus driving the exports for the European country.

Thus, the European car in America will become cheaper by $1,800, making it more lucrative to buyers, increasing demand, thus driving the exports for the European country.

Example #2

The currency of Egypt has weakened to a great extent due to devaluation, which is about 2.3% against US dollar. According to the bankers of the country, that currency traded very less after its third devaluation in one year.  

Let us look at some the advantages and disadvantages of devaluation.

Advantages

1. It helps in increasing exports by making themcheaper in global market.
2. It helps in maintaining competitiveness.
3. Due to fall in imports, the trade deficits comes under control.
4. It reduces the debt burden of a country. Since domestic currency is weak, payment is far less enpensive.

Disadvantages

1. International investors will slowly lose faith in that currency.
2. Since currency value falls, foreign travel and buying foreign goods become expensive.
3. It results in demand-pull inflation, where the prices in the domestic economy rises due to rise in demand, because imports getting expensive.
4. If individuals and companies have foreign debt, they lose money.

Currency devaluation is the monetary authority’s effort to reduce the currency’s value, whereas currency depreciation occurs due to market forces of demand and supply. However, the basic differences between them are as follows:

This article has been a Guide to Currency Devaluation definition. Here, we discuss the top 3 causes, currency devaluation example, limitations, and downsides. You can learn more about financing from the following articles: -

• Deficit vs Debt
• What is the Currency Market?
• Functional Currency
• Invest in Currency