What is devaluation?

Devaluation is the deliberate downward adjustment in the value of a country’s currency against another currency, group of currencies, or a monetary standard. Countries that have a fixed or semi-fixed exchange rate use this monetary policy tool. It is often confused with depreciation and is opposed to revaluation, which refers to the readjustment of the exchange rate of a currency.

Key points to remember

  • Devaluation is the deliberate downward adjustment in the value of a country’s currency.
  • The government that issues the currency decides to devalue a currency.
  • Devaluation of a currency lowers the cost of a country’s exports and can help reduce trade deficits.

Understanding devaluation

The government of a country can decide to devalue its currency. Unlike depreciation, it is not the result of non-governmental activities.

One of the reasons a country can devalue its currency is to fight against a trade imbalance. Devaluation lowers the cost of a country’s exports, making them more competitive in the world market, which in turn increases the cost of imports. If imports are more expensive, domestic consumers are less likely to purchase them, which further strengthens domestic firms. As exports increase and imports decrease, the balance of payments is generally better as the trade deficit decreases. In short, a country that devalues ​​its currency can reduce its deficit because there is greater demand for cheaper exports.

Devaluation and currency wars

In 2010, Guido Mantega, Brazil’s finance minister, alerted the world to the potential for currency wars.He used the term to describe the ongoing conflict between countries like China and the United States over the valuation of the yuan.

Although some countries do not force their currencies to devalue, their monetary and fiscal policies have the same effect and they remain competitive in the global trade market. Monetary and fiscal policies that have a currency devaluation effect also encourage investment, attracting foreign investors to (cheaper) assets like the stock market.

On August 5, 2019, the People’s Bank of China set the daily benchmark rate for the yuan below 7 per dollar for the first time in more than a decade. This, in response to new tariffs of 10% on $ 300 billion in Chinese imports imposed by the Trump administration, was due to go into effect on September 1, 2019. Global markets have soared, including in the United States. , where the Dow Jones Industrial Average (DJIA) lost 2.9% on its worst day of 2019 so far.

The Trump administration responded by calling China a currency manipulator. It was just the latest salute in the US-China trade war, but certainly not the first time China has devalued its currency.

The disadvantages of devaluation

While devaluing a currency can be an attractive option, it can have negative consequences. The increase in the price of imports protects domestic industries, but they can become less efficient without competitive pressure.

Higher exports relative to imports can also increase aggregate demand, which can lead to increased gross domestic product (GDP) and inflation. Inflation can occur because imports become more expensive. Aggregate demand causes demand-driven inflation, and manufacturers may have less incentive to cut costs because exports are cheaper, which increases the cost of products and services over time.

Real world examples

China has been accused of practicing quiet currency devaluation and attempting to become a more dominant force in the trade market. Some have accused China of secretly devaluing its currency so that it can revalue the currency after the 2016 presidential election and appear to be cooperating with the United States. However, after taking office, US President Donald Trump threatened to impose tariffs on cheaper Chinese goods in part in response to the country’s stance on its currency. Some feared this could lead to a trade war, putting China in a position to consider more aggressive alternatives if the United States followed through.

President Trump has imposed restrictions on Chinese products, including tariffs on more than $ 360 billion of its imports. However, according to The New York Times, the COVID-19 pandemic that hit hard in 2020 has thwarted the strategy. Global supply chains did not return to the United States, and China’s strong manufacturing position strengthened as consumers around the world were stranded, stayed at home, and resorted to purchasing products made in China. China through online e-commerce sites.

Egypt has faced constant pressure from trading the US dollar on the black market, which began as a result of a foreign exchange shortage that hurt domestic businesses and discouraged investment in the economy. The central bank devalued the Egyptian pound in March 2016 by 14% against the US dollar to dampen black market activity.

According to a Brookings article, the International Monetary Fund demanded the devaluation of the pound before allowing Egypt to receive a $ 12 billion loan over three years. The Egyptian stock market responded favorably to the devaluation. However, the black market responded by depreciating the exchange rate of the US dollar against the Egyptian pound, forcing the central bank to take further action.

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