Devaluation

The downward adjustment to a country’s value of money relative to a foreign currency or standard

What is Devaluation?

Devaluation is a downward adjustment to a country’s value of money relative to a foreign currency or standard. Many countries that operate using a fixed exchange rate tend to use devaluation as a monetary policy tool to control supply and demand.

 

Devaluation

 

Summary

  • Currency devaluation refers to the downward adjustment to a country’s value of money relative to a foreign currency or standard.
  • Countries use devaluation to boost exports due to the lowered value in currency perceived by countries that import the goods, reduce trade deficits, and lower the cost of interest payments on government debt.
  • The negative implications of devaluation include fostering uncertainty within the global markets and creating tension between other competing countries.

 

Why Devaluation Happens (Pros)

Devaluation happens due to the following:

  1. To boost exports
  2. To shrink trade deficits
  3. To reduce the country’s debt

 

The reason why devaluation occurs is due to trade imbalances. Using devaluation, it can reduce the cost of a country’s exports, which ultimately makes them more competitive on a global scale. However, imports would then increase in cost, causing domestic consumers to be less willing to purchase higher-priced goods from foreign businesses and instead purchase goods domestically at a lower price.

The increase in domestic spending would then stimulate money circulation within one’s own economy. As exports begin to increase due to cheaper prices and imports decrease due to perceived higher prices from domestic consumers, it ultimately decreases trade deficits. Meaning, the devaluation of domestic currency can reduce deficits through strong demand for less costly exports and more costly imports.

Also, the government may encourage devaluation if a large sum of government-issued sovereign debt exists. By reducing the value of the currency, it generally makes debt payments cheaper over time.

For example, if the government needs to pay $2 million every month in interest on its current debt, if it devalues its currency, the interest payments lower, which will help with covering the interest. Particularly, if the government must pay $2 million to pay per month, and the currency is devalued by half, their debt may then only be worth $1 million.

Such a tactic would not work with bonds issued from a different country, as a devaluation on domestic currency would ultimately increase the cost of paying off foreign debt.

 

Cons of Devaluation

Devaluation can result in an increase in the prices of products and services over time. The increase in the price of imports causes consumers to purchase their goods from domestic industries. The amount of the price increases, however, is dependent on the competition of supply and aggregate demand.

Higher exports due to the devaluation in the currency will increase aggregate demand, which raises the gross domestic product (GDP) and inflation. Inflation is factored in because suppliers are faced with higher import prices, which causes manufacturers to increase cost price and, respectively, market price as well.

Furthermore, devaluation can also increase uncertainty within the market. The market uncertainty can negatively affect supply and demand due to a lack of consumer confidence, causing potential recession over time. Moreover, devaluation may also spark trade wars.

 

Examples of Devaluation

In the past, China’s been cited for practicing devaluation to increase its GDP and become a dominating force within the global trading scene. In 2016, they were said to be devaluing their currency to revalue it after the 2016 U.S. presidential election. However, President Donald Trump imposed tariffs on Chinese goods in response to their plan to increase the value of their currency relative to the value of U.S. currency.

The Brazilian real was steeply devalued in the past, plunging in value since 2011. As a result, it encountered many other problems, such as declining crude oil and commodity prices, as well as corruption.

Another example would be in March 2016, when Egypt’s central bank reduced the Egyptian pound’s value by 14% relative to the U.S. dollar to decrease any sort of potential black-market activity. However, the black market in Egypt responded by depreciating the exchange rate conversion between the U.S. dollar and the Egyptian pound.

 

More Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, the additional resources below will be very helpful:

  • Dollarization
  • Fixed vs. Pegged Exchange Rates
  • Purchasing Power Parity
  • Trade-Weighted Exchange Rate

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!