What is ‘Devaluation’?

 

What is ‘Devaluation’?

Devaluation is a monetary policy tool used by countries to cause a deliberate downward adjustment to the value of a country's currency relative to another currency, group of currencies or standard. Some countries resort to devaluation of their currency for the benefit of the country. For example, this step may be taken for enhancing trade exchanges between this country and other countries since reducing the country’s currency value may result in a significant increase in exports because the currency of this country is less than other currencies in terms of value. Some countries use this technique in an attempt to overcome their economic problems, because it is obvious when the currency’s value is reduced, this leads to increased exports. But not all countries succeed in reaching this end.

While devaluating a currency can seem like an attractive option, it can have negative consequences.

For example, if the country devaluating its currency has the raw materials it needs, then devaluation can be of great benefit for it. On the other hand, if it does not have the required raw materials and imports them, then devaluation shall not have the desired effects, i.e. increasing exports. In addition, in that case, the national products shall have less price leading to higher exports. But higher exports relative to imports can also increase aggregate demand, which can lead to inflation – let alone the fact that this country may be importing the required raw materials for its products. I will leave what may happen in this case to your imagination, dear reader.

If the country devaluating its currency has the total value of its exports equal to, or similar to, the total value of its imports, then the reduction process may be successful with relation to the trade balance. However, the whole process may depend on the size of the exports after the reduction. If the imports are larger than the exports, the reduction equation may be accompanied by a deficit. This is not my personal opinion; let’s take a look at Marshall–Lerner condition. It is a very simple condition concerned with assessing the effect of any changes in the exchange rate on the trade balance of any country. It states that an exchange rate devaluation or depreciation will only cause a balance of trade improvement if the absolute sum of the long-term export and import demand elasticities is greater than unity.

This equation revolves around increasing exports’ revenues and decreasing imports, which helps improving the balance of trade.

To make it even easier for the reader, over the past 20 years, no developing country took the step of currency devaluation managed to improve its balance of payments. Let me explain why it did not improve in all these countries: the process of currency devaluation is closely related to two effects: firstly, the ‘J curve’ effect, which refers to a type of diagram where the curve of a country’s trade balance following a devaluation falls at the outset and eventually rises to a point higher than the starting point, suggesting the letter J. Secondly, the S-curve effect. 

The question is: why the developing countries only witnessed the S-curve effect after devaluation of their currency? The S-curve effect refers to the negative effects of devaluation when production and employment levels would show a rapid, exponential increase and thus raising living standards for a period time, followed by a tapering or leveling off of the trade balance. In this case, the country which devaluated its currency cannot revalue its currency because prices hiked up after devaluation. After this introduction on the devaluation of currency and the accompanying problems which the developing countries may face after devaluation of their currency, such as efflux of capital; it should be noted that such a step should be taken after a thorough analytical study by the country’s economists and not just a mere political decision that may lead the country to destruction and drive it back. Such a decision may have positive effects for a few years right after devaluation, then the negative effects start to surface leading to economic destruction, deficit, … etc.  According to Comparative Economic Systems, if we were manufacturing a product (×) worth (10) dollars, after devaluation, it shall have less value as a result of currency value differences and exchange rate. It may be worth (8) dollars. In that case, this product shall witness an increase in demand for a short period after devaluation.  Therefore, decision makers and economists must know the actual value of product (x) globally before the devaluation of the currency. Because if it was sold internationally for (8) dollars before devaluation, then the devaluation step shall be meaningless. In other words, if the product (x) was sold for (10) dollars before devaluation, then devaluation decision was made with the purpose of increasing trade exchange and the product (x) is sold afterwards for (8) dollars, the common international price. Then, there shall not be any rise in the country’s balance of trade. In fact, in that case, the whole economic situation of the country should be analyzed first.

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Director General of Googan Group