Competitive Devaluation: Meaning, Pros and Cons, Example
Since moving away from the gold standard (in which a printed banknote could be exchanged for a fixed quantity of gold), most currencies are allowed to float on the international exchange. In the end, the effect of devaluation is a shift in international trade, changing the balance of trade in favor of the devaluing country. Altering how much one currency is worth relative to another means the relative cost of goods from each country also shifts. Today, devaluation is more common for emerging economies than for established ones. That’s because an emerging economy can attract more foreign investment and can access a more extensive consumer base by making its products cheaper. Meanwhile, citizens tend to have lower incomes, meaning most imports are already unaffordable and raising prices further has fewer negative consequences.
Many currencies, including the U.S. dollar, used to be backed by gold, but no longer. In other words, exporters become more competitive in a global market. Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map.
- However, if other countries respond with devaluation or trade barriers, it could result in a currency war, damaging trust, reducing trade volumes and negatively impacting all involved parties.
- 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.
- It can impact the economy and society of a nation and its trading partners, depending on multiple factors such as the magnitude, frequency, timing, motivation, coordination and response to the devaluation.
- Therefore, the devaluation of domestic currency can reduce deficits through strong demand for less costly exports and more costly imports.
By reducing the value of the currency, it will make debt payments cheaper over time. The most notable modern example of a country devaluing its currency is China. The most recent instance occurred in 2019, when China allowed the value of the yuan to fall relative to the dollar.
Does Currency Devaluation Help an Economy?
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 metals might decrease the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency. Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by decreeing a reduction in the currency’s redemption value, reducing the value of everyone’s holdings. Such a tactic would not work with bonds issued in a different currency, as a devaluation on domestic currency would ultimately increase the cost of paying off foreign debt. Most countries experience some change in the value of their currency over time.
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Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation. There has been historical conflict between countries such as China and the United States over the valuation of their currencies. A monetary policy that stresses devaluation allows a country to remain competitive in the global trading marketplace. Devaluation also encourages investment, drawing in foreign investors to cheaper assets. 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.
China devaluing the Yuan in 2015, as the world’s largest exporter, had a significant impact on both foreign exchange markets and international equity markets. However, a country should be wary of the negatives of currency devaluation. Currency devaluation may lower productivity, since imports of capital equipment and machinery may become too expensive.
How Does Devaluation Affect International Trade?
If the global economy is in recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation. 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.
The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. 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. Currency devaluations can be used by countries to achieve economic policy.
As a result, it improves a country’s trade balance (exports minus imports). Though economists usually deploy the term in reference to international trade policy that ends up hurting a country’s trade partners, in competitive devaluation the term applies primarily to currencies. Economists trace the origin of such policies to attempts to combat domestic depression and high unemployment rates by increasing the demand for the nation’s exports via trade barriers and competitive devaluation. Currency devaluation impacts imports, exports, inflation rates and international competitiveness. While it can boost exports and attract foreign investment, it can also lead to higher import prices and inflation.
Understanding Competitive Devaluation
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Reasons Why Countries Devalue Their Currency
Currency devaluation is the deliberate reduction of the value of a country’s currency relative to another currency or a basket of currencies. It is different from currency depreciation, which is the natural fluctuation of the forex broker rating exchange rate due to market forces. Currency devaluation is usually a policy decision made by a country’s government or central bank to achieve particular economic objectives.
What Would Happen If the U.S. Devalued the Dollar?
If the devaluation is aiming to meet a certain exchange rate target, it may be inappropriate for the economy. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like India or Argentina, which holds lots of dollar- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency. Countries that use free-floating currency, or a floating exchange rate, cannot devalue their currency. In their case, it only appreciates and depreciates according to market forces.
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