What is Devaluation?

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Definition:

Devaluation occurs when a country intentionally reduces the value of its currency relative to one or more foreign countries.

🤔 Understanding devaluation

Devaluation occurs when a government wishes to increase its balance of trade (exports minus imports) by decreasing the relative value of its currency. The government does this by adjusting the fixed or semi-fixed exchange rate of its currency versus that of another country. By making its own currency cheaper, the country can boost exports. At the same time, foreign products become more expensive, so imports fall. In some instances, a country may take the opposite action by increasing the value of its currency, which is called revaluation. Devaluation is different from depreciation and deflation. Depreciation occurs when a free-floating currency loses value in the international currency market. Deflation occurs when the general price for domestic goods falls.

Example

China manages its currency a little differently than most countries. The People’s Bank of China (PBOC), the nation’s central bank, sets a band of allowable exchange rates each day. On Aug. 5, 2019, PBOC devalued the yuan by allowing its value to go above 7 yuan per US dollar for the first time since 2008. Reducing the value of the yuan meant that it cost fewer US dollars to purchase Chinese goods. Some critics, including President Donald Trump, responded to PBOC’s action by accusing China of currency manipulation. China dismissed accusations that the move was a “competitive devaluation” in response to additional tariffs the US had announced days earlier.

Takeaway

Devaluation is like offering to work for a lower price…

If you had a small cleaning business, you would set a price for your services — somewhere between the lowest you were willing to work for and the highest you thought people would pay. Potential customers compare what you charge against what they are willing to pay to avoid doing the chore themselves. To get more business, you could lower your prices (devalue your currency). In response, more people would likely hire you (import your products) instead of doing the work themselves (manufacturing goods domestically).

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What is devaluation?

Devaluation is when a country’s government intentionally reduces the value of its currency. A nation can only take this action if it pegs its domestic currency to another currency, rather than letting market forces determine its value. For example, Panama pegs its currency (the balboa) to the US dollar. So, if the US dollar changes in value against the euro, the balboa automatically changes by the same amount.

Right now, you can exchange one US dollar for one Panamanian balboa. But Panama could decide to devalue its currency by changing that fixed exchange rate. If the Panamanian government suddenly said that one US dollar was worth two balboa, that would be a 50 percent devaluation.

What is the revaluation of currency?

Revaluation is the opposite of devaluation — It’s when a country with a fixed exchange rate decides to increase the value of its currency. For example, imagine that the Panamanian government was willing and able to change the fixed exchange rate so that it cost two US dollars to get one balboa.

This revaluation would double the value of the balboa. Everything in Panama would become twice as expensive for Americans, and all American products would cost half as much for Panamanians.

What are the reasons for devaluation?

Devaluation doesn’t happen often. When it does, a government typically devalues its currency to increase its gross domestic product (the total value of economic activity within its borders). Devaluation makes domestic products cheaper for foreigners and foreign products more expensive for residents. So the country should see exports rise while imports fall. The end result should theoretically be economic growth through an improved balance of trade (exports minus imports).

In this way, devaluation can be considered a mercantilist policy (one that protects domestic companies from foreign competition). It was a common practice during the Great Depression, which sharply curtailed world trade.

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.

Is currency devaluation good or bad?

Devaluation can benefit domestic companies but might negatively affect a country’s citizens. The opposite is true for foreigners: Devaluation can benefit foreign citizens, but might negatively affect foreign businesses. Consider China devaluing the yuan against the US dollar as an example of who wins and who loses.

Who are the winners?

Chinese companies should see increased demand for any product they ship to the US. That’s because it costs fewer US dollars to buy those products. Consequently, Chinese firms are likely to require more labor, which provides jobs for Chinese workers. Meanwhile, American companies and citizens find themselves on the other side of the devaluation. Anything they were already importing from China gets cheaper, so they have more money to spend on other things.

Who are the losers

Any American company that was sending products to China will see demand for their goods drop after a devaluation. That could result in fewer US jobs. Any Chinese citizens will have to pay more for those imported goods. They’ll have to either reduce other spending to keep buying those products or substitute less desirable ones. In either case, they are worse off.

What are the effects of devaluation?

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.

For example, assume you have 100 US dollars (USD) to spend on clothes. If you go to the local mall, you can buy one pair of pants.

If you decide to purchase it on the internet from a store in Canada, the cost is 140 Canadian Dollars (CAD). At a foreign exchange rate of 1 USD for 1.4 CAD, there would be purchasing power parity (the same amount of money can buy the same items in each country). Imagine Canada devalued its currency by creating a fixed exchange rate of 2 CAD per 1 USD.

At this new exchange rate, you can buy pants that cost 140 CAD with just 70 USD. In other words, the Canadian pants become cheaper. In response, people are more likely to buy those pants from the Canadian store. That means demand at the US store falls, and the Canadian store sees its sales increase.

Overall, devaluation tends to increase demand for exports, economic growth, and inflation in the short term. It can also signal that a country is economically troubled, reducing confidence among investors. Finally, it may set off a “currency war” in which trading partners retaliate by devaluing their own currencies.

What is the difference between devaluation, depreciation, and deflation?

Devaluation happens when a government changes the fixed exchange rate of its currency. It can only occur when a central bank controls the exchange rate. Most currencies traded on foreign exchange markets are not pegged to another currency. Instead, the market determines their value. These are called floating exchange rates. In the case of floating exchange rates, the demand for one type of currency might change relative to another due to various market forces. When a floating currency loses value compared to another currency, that’s called a depreciation (not to be confused with the accounting term). If its value increases, that’s called appreciation.

Another term that relates to the purchasing power of money is called inflation (the general tendency for prices to increase over time). A negative inflation rate is called deflation (the general reduction in prices across all products). Deflation is rare, and generally only occurs during a deep recession (contraction of economic activity). If a recession causes deflation, it is because spending decreases so much that it causes the prices of many goods to fall. While lower prices mean your dollar goes further (you can buy more things with the same amount of money), deflation typically accompanies lower wages and high rates of unemployment.

While devaluation and depreciation both refer to changes in how affordable foreign products are, deflation happens entirely within the country’s own currency. However, a change in a currency’s value domestically is also likely to alter its exchange rate, and vice versa.

For instance, if it costs more dollars to buy a pair of shoes at the Nike Store, it will probably also cost more dollars to buy those same shoes on the internet from a foreign country. So although the terms have different meanings, there is a relationship between inflation and depreciation, or deflation and appreciation.

Which countries have devalued their currencies?

Most countries experience some change in the value of their currency over time. A few nations have even watched their money become worthless on the international exchange during bouts of hyperinflation (extremely high levels of inflation). Examples include Germany after World War I, Bolivia in the 1980s, and Zimbabwe in the 2000s.

Those examples are not technically devaluations, although many people incorrectly use the terms depreciation and devaluation interchangeably. Devaluation is a deliberate reduction in exchange rates by a central bank or government. That process is much less common these days, since the International Monetary Fund (IMF) coordinates currency exchange rate policy.

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. Therefore, the ability to force devaluation is limited.

A few countries still manage their currency within a fixed range relative to the US dollar. Consequently, there are a handful of examples of devaluation occurring in the modern landscape. Often, this occurs because a country’s existing fixed exchange rate can’t be sustained with existing foreign exchange reserves, or to alter the balance of trade.

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. In 2013, the Japanese Yen depreciated significantly against the dollar. Some analysts believed that outcome was an intentional devaluation. In 1994, Mexico devalued the peso against the dollar, attempting to stabilize its currency. However, the policy move failed and the peso was allowed to float.

What are “currency wars”?

A currency war describes a situation in which one country manipulates the value of its currency relative to another in order to alter the dynamics of trade, which could theoretically lead to a retaliatory devaluation of the other country’s currency. In the extreme, these devaluations could go back and forth, escalating the process and damaging both countries’ economies. A full scale currency war has never occurred, although some countries have been accused of competitive devaluation to shift economic activity into their borders and unemployment onto other nations.

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