What Is Devaluation?
Devaluation is the deliberate downward adjustment of the value of a country’s money relative to another currency, group of currencies, or currency standard. This monetary policy tool is often used by countries having fixed or semi-fixed exchange rates. Please don’t confuse devaluation with depreciation which is a reduction in the value of an asset over time, due in particular to wear and tear. It’s actually the opposite of revaluation which is the adjustment of the value of a currency in relation to other currencies’ exchange rates.
Why a country devalue its currency?
One of the reasons a country devalues its currency is to reduce the trade deficit as devaluation decreases the cost of a country’s exports, making its exports more competitive in the global market because of the strong demand for cheaper products. Secondly, it will also increase the cost of imports, domestic customers will not buy imported goods, further strengthening the domestic market. Increasing exports while decreasing imports will have a better effect on the balance of payments by shrinking trade deficits.
Drawback of Devaluation
Increasing the price of imports protects domestic industries, but they may become less efficient without the pressure of competition. Higher exports relative to imports can also increase aggregate demand, which can lead to higher gross domestic product and inflation. Inflation can occur because imports are more expensive than they were. Aggregate demand causes demand-pull inflation, and manufacturers may have less incentive to cut costs because exports are cheaper, increasing the cost of products and services over time.
Currency devaluations can be used by countries to achieve economic policy. Having a weaker currency relative to the rest of the world can help boost exports, shrink trade deficits and reduce the cost of interest payments on its outstanding government debts. There are, however, some negative effects of devaluations. They create uncertainty in global markets that can cause asset markets to fall or spur recessions. Countries might be tempted to enter a tit for tat currency war, devaluing their own currency back and forth in a race to the bottom. This can be a very dangerous and vicious cycle leading to much more harm than good.
For example, China has been accused of practicing a quiet currency devaluation, trying to make itself a more dominant force in the trade market. Some accused China of secretly devaluing its currency so it could revalue the currency after the 2016 presidential election and appear to be cooperating with the United States. However, after assuming office, U.S. President Donald Trump threatened to impose tariffs on cheaper Chinese goods partly in response to the country’s position on its currency. Some fear this may lead to a trade war, putting China in a position to consider more aggressive alternatives if the U.S. were to go ahead.