While currency devaluation is a well-known monetary policy instrument, not everyone is aware of its most apparent effects. Discover the main reasons why a country or currency area might resort to devaluation, and what can be the major consequences of such an instrument.
Devaluation is described as a deliberate reduction in the value of one currency relative to others. It is a tool used by the monetary authority or central bank of a particular country or currency area.
While the devaluation of a currency offers certain advantages for the country involved, such as more price-competitive exports, it is not without risk.
But what are the main risks involved? And what is the difference between currency devaluation and currency depreciation?
Contrary to currency devaluation, depreciation is not intentional. Rather, depreciation refers to a decline in a currency’s value due to adverse economic developments, which can usually be observed by tracking economic indicators. It results from phenomena that are quite simply beyond the control of the State or monetary authority concerned.
On the other hand, devaluation is a monetary policy tool deliberately used in fixed or semi-fixed exchange rate systems. Under such regimes, the exchange rate is pegged to a reference or pivot of some kind, usually made up of a currency, a basket of currencies or a commodity, such as gold for example.
In floating (or flexible) exchange rate regimes, the value of a currency fluctuates freely in accordance with supply and demand on the foreign exchange market, and intervention is limited.
There are many reasons for currency devaluation. As an instrument, its main objective is to reduce a trade deficit through the promotion of exports. Another direct effect of currency devaluation is that it sometimes leads to higher wages.
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Did you know? In 1967, the British government decided to devalue the pound sterling, then pegged to the US dollar, in accordance with the prevailing fixed exchange rate regime of the era. The cabinet of Harold Wilson, initially reluctant to take such action, ultimately gave in to pressures caused by a burgeoning trade deficit and the United Kingdom’s poor economic performance. As a result, between 1966 and 1968, the UK’s year-on-year GDP growth went from 1.6% to 5.4% and inflation reached 4.65%. |
Currency devaluation can present significant drawbacks, ranging from more expensive imports to higher inflation, as well as a decline in local consumer purchasing power. It can also result in less efficient and less competitive domestic industries in the medium term.
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Did you know? In 1998, Russia’s rising interest rates and increased capital outflow stoked fears of a devaluation of the rouble and a default on the country’s debt. In August of the same year, Russia’s stock, bond and currency markets collapsed. To limit the damage, the government undertook a series of measures, including the devaluation of the rouble. As a result, the inflation rate reached 27.6% in 1998, before rising to 85.7% in 1999. |
Devaluation, unlike depreciation, is a voluntary decrease in the value of one currency relative to others. It is a well-known monetary policy tool, but the extent of its advantages and disadvantages is sometimes glossed over.
The main advantage of devaluation is to make the exports of a country or currency area more competitive, as they become cheaper to purchase as a result. This can increase external demand and reduce the trade deficit. China, for example, is a clear adept of currency devaluation for this reason. Conversely, devaluation makes imported products more expensive and stimulates inflation. Purchasing power and domestic consumption may suffer.
It is important to note that devaluation is a technique adopted by central banks or monetary authorities in fixed or semi-fixed exchange rate regimes. In floating (or flexible) exchange rate regimes, these institutions tend to limit their interventions since the value of their currencies fluctuates on the foreign exchange market in accordance with supply and demand.