Currency Devaluation

Introduction

Currency devaluation is the active decision of a government to reduce the value of its own currency with reference to other currencies. Devaluation occurs exclusively in fixed currencies, when the currency in question is pegged to another currency. Governments devalue their own currencies to make their exports less expensive in foreign markets. If a company exports its products for the same price in the local (devalued) currency, it is cheaper for consumers to buy those products in their own currency.

Devaluation is most often used in situations where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metal might abruptly lower the weight or purity of the coins without announcing this, or else decree that the new coins had equal value to the old, thus devaluing the currency.

Later, paper currencies were issued, and governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by abruptly decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.

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Currency devaluation takes place when one country's currency is reduced in value in comparison to other currencies. After currency devaluation, more of the devalued currency is required in order to purchase the same amount of other currencies. A fictional example: If last year, one U.S. dollar purchased 10 Mexican pesos, then this year, one U.S. dollar can only purchase five Mexican pesos, the U.S. dollar has undergone a currency devaluation.

Currency devaluation can take two forms. It can either be the natural result of market forces, or it can be the result of government intervention. In the first scenario, the global market changes its opinion about the stability, value or future of a currency and decides that it is willing to pay less. In the second scenario, a nation's government fixes the relative price of their currency below its present level and prohibits currency exchange at any other rate.

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Why Do Governments Devalue Their Currency Rates? (The process)

The value of a currency is determined relative to the value of the other currencies i.e. how much of the other currency can be bought by one unit of your home currency. In general, this is the exchange rate of this currency pair and it fluctuates over time with currencies gaining or losing value against each other. When a currency reduces its value against other currencies, this process is called devaluation.

Devaluation is a natural process in the history of financial markets. All currencies witness their currency rates falling and rising and if 10 British pounds were able to buy, say, 20 U.S. dollars a year ago, today the pound could be devalued and its purchasing power would only be enough to buy only 15 dollars. In contrast to market devaluation, governments around the world sometimes resort to devaluation as a tool to protect their trade balances. Thus, the local currency is forcedly devalued and its currency rates against other major currencies are reduced while restrictions are often imposed preventing the home currency from being exchanged at higher rates.

These types of government intervention in the foreign exchange market are a perfect example of official devaluation while the natural market devaluation is often referred to as depreciation, a process when the currency rates fluctuate downwards. In both cases, the country whose currency is devaluated could benefit from the lower cost of its export of goods, which now are cheaper to buy by customers in countries whose currencies are stronger. The history of trade recalls many

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examples of intentional devaluation with the purpose of conquering new markets through the lower currency rates of the devalued currency. One of the biggest devaluation waves in history was in the 1930s when at least nine of the leading world economies devalued their national currencies, including Australia, France, Italy, Japan and the United States. During the Great Depression, all these nations decided to abandon the gold standard and to devalue their currencies by up to 40%, which helped revive their economies and stabilized currency rates.

Meanwhile, Germany, which lost the Great War a decade earlier, was burdened to pay strenuous war reparations and intentionally provoked a process of hyperinflation in the country. Thus, the Germans witnessed the biggest ever devaluation of their national currency and the currency rates hit rock bottom. At that time, the currency rate of the German mark to the U.S. dollar stood at several million or billion marks per dollar. On the other hand, this devaluation helped the German government in covering its debts to the war winners although the average Germans paid a disastrous price for this government policy.

The governments around the world are often tempted to lower unnaturally the currency rates in order to benefit from the lower value of the national currency. The lower currency value encourages exports and discourages imports improving the countrys trade deficit and imbalances. However, the average citizen of a country with a recently devalued currency could suffer from higher prices of imported goods and overseas holiday costs.

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Factors Contributing to Devaluation Policies

A currency devaluation usually comes about when some determination is made that the domestic currency is overvalued relative to major world currencies. It may be used as a policy tool to relieve an unfavorable balance of trade or simply to stimulate fledgling export industries. Such policies assume that devaluation will make the country's exports more attractive abroad and imports from other countries less attractive at home, but in reality other factors may diminish these effects, making a planned devaluation a risky undertaking. Even if conditions at home are suitable for the ideal devaluation scenario, one country's devaluation may trigger a cycle of competitive devaluations by other countries and thereby undermine the initial country's strategy.

At the same time, developing countries in particular are periodically faced with a currency crisis in which they may need to consider devaluation. This can occur when chronic trade deficits, government budget deficits, or other internal weaknesses cause slack demand for a nation's currency, as was the case during the Asian financial crisis of the late 1990s. Although a variety of circumstances fomented this crisis, one of the most profound was a sell-off in the FX markets which led to sharp depreciations in several Asian currencies.

Technically, the biggest cause of devaluations is the existence of rate controls and other government exchange rate policies. If these did not exist, there would of course still be currency

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depreciations, but never an organized (even if reluctant) effort to allow a currency's value to fall. However, in the interests of stability, nearly all nations practice some form of rate intervention from time to time, whether by occasional targeted transactions on the open market or by a strict regime of price controls. The currencies most vulnerable to devaluation, hence, are those belonging to nations with uncertain economic prospects and with active rate control/support policies.

Still, the attraction of devaluation as a policy is its ease of implementation, and it can be seen as a panacea for an errant small economy with a trade deficit. In the estimation of some government officials, devaluation is easier for a population to swallow than the harsh structural changes, e.g., voluntary cutbacks in demand for imported goods that are otherwise necessary to ameliorate current account deficits and promote growth of output.

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Competing Views on Devaluation

According to the orthodox theory of international trade found in most textbooks, a planned devaluation is not necessary and is, in fact, disruptive since it interferes with free market forces. In theory, any trade deficit in a relatively open market system will automatically be translated into a decline in the affected country's price levels (via the outflow of money that is assumed to reduce prices and, in turn, depreciate the country's real exchange rate). This, according to the theory, would make that country's goods more competitive, expand its exports, and lead it toward trade balance. A similar process is envisioned for trade surpluses. A controversy arises, however, because it is highly questionable that this process actually plays out in reality. The prolonged study of the effects of devaluation has produced results that are theoretically indeterminate and empirically unconfirmed.

Though its validity is still debated, the theoretical J curve (see Figure 1) supports the argument that a devaluation can indeed have positive effects, albeit not immediately. Indeed, devaluation is expected to worsen the trade balance in the short termpossibly causing a contraction in output and employmentbefore improving the overall balance. One explanation for this phenomenon is that changes in unit demand often move more slowly than price corrections, causing an immediate decrease in export revenues (due to lower prices) without an initial increase in units to offset it. Another hypothesized influence is known as the Marshall-Lerner condition, which states that the sum of price elasticity (the responsiveness of demand to a change in prices) of

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imports and exports must be greater than 1.0 if the depreciation is to induce a shift to greater export revenues, and hence, an improvement in the trade balance. Some empirical evidence supports the J curve and suggests that despite its negative effects in the short run, devaluation can lead to improved trade balances.

Figure 1 J Curve: Theoretical Shift in Balance of Trade Following Devaluation Some have argued that devaluation policies can lead to other more subtle repercussions in the international trading system. Other factors being equal, an improvement in country's trade balance means a decrease in the trade balance somewhere else in the world, since the sum of all world trade balances must equal zero. By logic of this argument, an improvement in one country's trade balance must be gained at the expense of its trading partners' trade balances. This is why devaluation is often referred to as a "beggar-thy-neighbor" policy.

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Devaluation in modern economies

Present day currencies are usually fiat currencies with insignificant inherent value. When the U.S. dollar was fully disassociated from the gold standard in 1971, the value of any fiat currency became solely determined by the willingness of its issuing State to accept it as payment for taxes. Some countries hold floating exchange rates while others maintain fixed exchange rate policies against the United States dollar or other major currencies. These fixed rates are usually maintained by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply. Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in devaluation (as persistent surpluses and capital inflows may lead them towards revaluation).

In an open market, the perception that devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate). In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low
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on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the 1994 economic crisis in Mexico.

Generally, a steady process of inflation is not considered devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies. Especially where a country deliberately prints money (a usual cause of hyperinflation) to cover a persistent budget deficit without borrowing, this may be considered a devaluation.

In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners. This would imply that existing currency increased in value, as opposed to the case with denomination where a country issues a new currency to replace an old currency that had declined excessively in value (such as Turkey and Romania in 2005, Argentina in 2002, Russia in 1998, or Germany in 1923).

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Effects of Devaluation

A significant danger is that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government may have to raise interest rates to control inflation, but at the cost of slower economic growth. Another risk of devaluation is psychological. To the extent that devaluation is viewed as a sign of economic weakness, the creditworthiness of the nation may be jeopardized. Thus, devaluation may dampen investor confidence in the country's economy and hurt the country's ability to secure foreign investment. Another possible consequence is a round of successive devaluations. For instance, trading partners may become concerned that devaluation might negatively affect their own export industries. Neighboring countries might devalue their own currencies to offset the effects of their trading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economic difficulties by creating instability in broader financial markets.

Since the 1930s, various international organizations such as the International Monetary Fund (IMF) have been established to help nations coordinate their trade and foreign exchange policies and thereby avoid successive rounds of devaluation and retaliation. The 1976 revision of Article IV of the IMF charter encourages policymakers to avoid "manipulating exchange rates...to gain an unfair competitive advantage over other members." With this revision, the IMF also set forth each member nation's right to freely choose an exchange rate system.

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Drawbacks

Currency devaluation also has negative consequences. Individuals holding a recently devalued currency have lost international buying power. Their ability to purchase goods or services from other countries has diminished. Additionally, if a government artificially devalues its currency, it may be forced to purchase its own currency with foreign reserves, depleting its own assets and ability to pay public debt. This occurred in Russia after its 1998 currency crisis. Example: Argentina In 2001, the Argentine peso was pegged to the U.S. dollar. One peso was equal to one dollar. However, the government grew increasingly unable to pay its public debt and in the beginning of 2002, the government devalued the peso. While the initial effects were chaotic, leading to rampant unemployment and poverty, they have improved. Unemployment and poverty have diminished, and exports as a percentage of gross domestic products have skyrocketed. United States Between 2002 and 2009, the U.S. dollar has been devalued, although the change has taken place more slowly than in Argentina, and from market forces rather than government edict. In 2002, one euro cost about $0.86. In August 2009, the price reached $1.41. This resulted in a decrease in Americans traveling in Europe and buying European products and an increase in Europeans traveling to the U.S. and buying U.S. products. The same effects on the U.S. dollar took.

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Conclusions

The effects of devaluation can be complex and far-reaching. In theory, a weaker currency means that exports from the affected country will be cheaper relative to prices in other countries, and that imports will be more costly. These conditions may provide a boost to an economy that has undergone devaluation, but typically there are negative consequences as well, both internally and externally. And depending on the nature of a country's trading structure, the benefits may never materialize at all.

For large international corporations, devaluations often translate into lost revenue and decreased profitability in the affected country (assuming the company isn't based there), as companies usually can't raise their prices enough in competitive markets to make up for the losses stemming from the lower exchange rate. Moreover, since devaluations frequently coincide with broader economic turmoil such as inflation, instability in the financial markets, and recession, spending is likely to be tight in countries whose currencies have been devalued, further eroding sales. On the other hand, for companies with substantial export-oriented operations in countries whose currencies have been devalued, the business may be able to enjoy some cost advantages in its labor and materials, enhancing its competitive position abroad.

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Reference

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Wikipedia, the free encyclopedia. Devaluation. Retrieved 1st May 2011 from http://en.wikipedia.org/wiki/Devaluation

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Joshua Curtiss, eHow Contributor. What is currency devaluation? Retrieved 1st May 2011 from http://www.ehow.com/about_5295910_currency-devaluation.html

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Why Do Government Devalue Their Currency Rates? Retrieved 2nd May 2011 from http://www.currencysolutions.co.uk/currency/why-do-governments-devalue-theircurrency-rates

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