Currency Devaluation Definition Top 3 Causes Limitations

Currency Devaluation Definition

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.

Key Takeaways

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 Explained

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 Monetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more 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.

Reasons of Currency Devaluation

#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 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 deficitTrade DeficitWhen the total sum of goods or services that a country imports from other countries is higher than the total sum of goods or services that a country exports to other countries, this is referred to as a trade deficit, which is the opposite of the balance of trade theory.read more is the difference between exports and imports of the company.

Trade Deficit = Imports – Exports

A negative trade deficit may negatively impact the country’s economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more 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 tradeBalance Of TradeThe balance of trade (BOT) is the country’s exports minus its imports. BOT is one of the significant components for any current economic asset as it measures a country’s net income earned on global investments.read more by currency devaluation.

#3 – Reduce Sovereign Debt Burden

If a country has issued multiple sovereign bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more 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 DebtSovereign DebtSovereign debt is the money borrowed by a country’s central government, primarily achieved by selling government bonds and securities. Treasury notes, bonds, and bills are some examples of sovereign debt issued by the United States.read more 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:

Effects of Currency Devaluation

The various effects of currency devaluation is as follows:

There are many downsides to currency devaluation, like rising inflation, and more costly foreign debt servicing. It further reduces the confidence of foreign investors in the country’s currency as well.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.Though currency devaluation helps reduce the trade deficit, it has a potential downside. Most developing countries have foreign currency loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more. 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.

Examples

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.

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.

Advantages And Disadvantages

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

Advantages:

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

Disadvantages:

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

Currency Devaluation Vs Currency Depriciation

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: