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Devaluation

What Is Devaluation?

Devaluation is the deliberate downward adjustment of a country's official currency value relative to another currency or a standard, typically implemented by a government or central bank operating under a Fixed exchange rate system. This action falls under the broader category of monetary policy within international finance. Unlike market-driven fluctuations, devaluation is a conscious decision by authorities to alter the official exchange rates. The primary goal of devaluation is often to make a nation's exports cheaper and more competitive in global markets, while simultaneously making imports more expensive for domestic consumers.7

History and Origin

The practice of currency devaluation has a long history, often employed by nations to recover from economic crises or to stimulate economic growth. Before the widespread adoption of floating exchange rate systems among major industrialized countries in 1973, fixed exchange rates were common, making official devaluation a frequent tool for economic adjustment. The establishment of the International Monetary Fund (IMF) was partly influenced by concerns over countries using devaluation to gain unfair competitive advantages.6

A notable recent example occurred in August 2015, when the People's Bank of China (PBOC) initiated a series of devaluations of the Chinese yuan. On August 11, 2015, the yuan's daily midpoint trading price was lowered by 1.9% against the U.S. dollar, followed by another 1.62% the next day.5 This move, the most significant single drop in 20 years, was widely interpreted as an attempt to boost China's exports amid slowing economic growth, although the PBOC stated it was part of reforms toward a more market-oriented economy.

Key Takeaways

  • Devaluation is a deliberate government or central bank action to lower a currency's official value in a fixed exchange rate regime.
  • Its main objectives include boosting exports, reducing a trade deficit, and making debt payments cheaper.
  • Devaluation makes a country's exports more competitive and imports more expensive.
  • Potential negative consequences include domestic inflation and reduced purchasing power for citizens.
  • It differs fundamentally from depreciation, which is a market-driven decrease in currency value.

Interpreting Devaluation

When a country devalues its currency, it effectively signals a strategic shift in its economic policy, primarily aimed at altering its international trade position. For instance, if a country devalues its currency by 10%, it means that it now takes 10% more units of its domestic currency to buy one unit of a foreign currency, assuming the foreign currency's value remains constant. This makes domestic goods cheaper for foreign buyers, potentially increasing exports and improving the balance of payments. Conversely, imported goods become more expensive for domestic consumers, discouraging imports and encouraging the consumption of domestically produced alternatives. The impact of devaluation is typically measured by its effect on a country's trade balance and its overall economic performance.

Hypothetical Example

Consider the fictional country of "Agraria," which pegs its currency, the "Agra," to the U.S. dollar at a fixed rate of 10 Agras to $1. Agraria's government observes a persistent trade deficit and decides to devalue the Agra to make its agricultural exports more competitive.

They announce a new official exchange rate of 15 Agras to $1.

  • Before devaluation: An Agrarian farmer sells wheat for 100 Agras. A U.S. buyer pays $10 (100 Agras / 10 Agras per dollar).
  • After devaluation: The same Agrarian wheat still sells for 100 Agras domestically. However, the U.S. buyer now only pays approximately $6.67 (100 Agras / 15 Agras per dollar).

This makes Agraria's wheat cheaper for American consumers, potentially increasing demand. Simultaneously, an imported item costing $10 in the U.S. would now cost 150 Agras (10 dollars * 15 Agras per dollar) for an Agrarian consumer, up from 100 Agras, making imports less attractive.

Practical Applications

Devaluation is a powerful monetary policy tool primarily used by countries with fixed or semi-fixed exchange rate regimes. Its practical applications are centered on influencing a nation's economic relationships with the rest of the world. Governments may use devaluation to:

  • Boost Export Competitiveness: By making domestic goods cheaper for foreign buyers, devaluation can stimulate exports and provide a competitive edge in international markets. This was a key motivation behind China's yuan devaluation in 2015.4
  • Reduce Trade Deficits: A significant reason for devaluation is to correct a large and persistent trade deficit. As exports rise and imports fall, the imbalance between a country's foreign currency inflows and outflows can shrink.
  • Lower Real Debt Burden: For governments with substantial sovereign debt denominated in their domestic currency, devaluation can effectively reduce the real cost of servicing these debts over time, making payments cheaper in real terms.
  • Manage Foreign exchange reserves: In times of dwindling foreign currency reserves or speculative attacks on the currency, devaluation can be used to stem capital outflows and preserve reserves by making domestic assets less attractive to sell off and foreign assets more expensive to acquire.

Limitations and Criticisms

While devaluation can offer short-term economic benefits, it also carries significant limitations and criticisms. A major concern is the potential for increased domestic inflation. As imports become more expensive, the cost of imported raw materials and finished goods rises, which can pass through to consumer prices. This rise in prices can erode the purchasing power of citizens and reduce their standard of living.

Furthermore, devaluation can be perceived as a sign of economic weakness, potentially dampening investor confidence and hurting a country's ability to attract foreign investment. There is also the risk of triggering "beggar-thy-neighbor" policies or currency wars, where other countries retaliate with their own devaluations to maintain competitiveness, leading to a race to the bottom that benefits no one.3 Some economists also argue that while devaluation can bring about a depreciation fairly quickly, its intended effects on the trade balance may be transitory and come at the cost of rekindling inflation.2

Devaluation vs. Depreciation

The terms "devaluation" and "depreciation" both refer to a decrease in a currency's value, but they fundamentally differ in their cause and context.

  • Devaluation is a deliberate policy action taken by a government or central bank in a fixed exchange rate system. It is an official announcement to change the fixed parity of the currency against another currency or a basket of currencies.
  • Depreciation, conversely, is a market-driven phenomenon that occurs in a floating exchange rate system. It reflects a decrease in a currency's value due to the forces of supply and demand in the foreign exchange market, without direct government intervention to alter the official rate. For example, if demand for a country's currency falls relative to another, its value will depreciate.1

The key distinction lies in the intentionality and the underlying exchange rate regime. Devaluation is a political and economic decision, whereas depreciation is a consequence of market dynamics.

FAQs

Why do countries devalue their currency?

Countries typically devalue their currency to make their exports cheaper and more competitive globally, thereby boosting trade. They may also do so to reduce a trade deficit or to alleviate the burden of government debt denominated in the local currency.

What are the risks of devaluation?

The primary risks of devaluation include domestic inflation, as imported goods become more expensive. It can also reduce the purchasing power of citizens and may be perceived negatively by international investors, potentially leading to reduced foreign investment.

How does devaluation affect imports and exports?

Devaluation makes a country's exports cheaper for foreign buyers, which tends to increase their volume. Conversely, it makes imports more expensive for domestic consumers, typically leading to a decrease in imported goods. This shift aims to improve the trade balance.