The economy is a difficult system to control. Many different tools are used to control this system. Devaluation is only one of these countless tools. Knowing that devaluation is a tool is an important detail because being a tool means that it is being used by someone. In other words, devaluation is done by a government or a central bank itself.
Devaluation, in its simplest definition, is the devaluation of a country’s currency. Although it may seem like a treacherous plan of foreign powers, this tool is actually implemented by the government. The aim is to reduce imports and increase exports, thereby stimulating local trade. Of course, this has its pros as well as its cons. Let’s take a closer look at questions such as what is devaluation, what happens if there is a devaluation.
Let’s start with a basic definition; What is devaluation?
The instrument used to reduce the value of a country’s currency against assets such as gold, silver or other foreign currencies at a fixed exchange rate, and this situation itself is called devaluation. In countries where a fixed or semi-fixed exchange rate regime is implemented, devaluation is a kind of monetary policy tool.
Why is devaluation applied?
Closing the gaps in the permanent balance of payments is the main purpose of the devaluation practice. As the value of the local currency used in the country decreases, imports decrease because imported goods become more expensive. Thus, the people turn to local goods and at the same time, the export of local goods increases. In this way, the local trade of the country is mobilized and economic revival is provided.
Who implements the devaluation?
The power to implement the devaluation rests with the government of that country or the central bank of that country. In other words, the local currency of that state is devalued by the state itself. In some cases, the IMF and similar international economic institutions advise the country in question to devalue its currency. However, the decision and power to implement the devaluation rests solely with the institutions of that state.
What exactly is a devaluation? Let’s take a look at a few examples, shall we?
We encounter the earliest examples of devaluation in Ancient Greece and Ancient Rome. These civilizations printed more money by reducing the amount of gold and silver in the coins they used, thus lowering the value of their money. In other words, they devalued the value of their own currency against gold and silver.
To give a more modern example, we can look at the devaluation policy of Egypt in 2016. In Egypt, when the US dollar fell on the black market, the government devalued its own currency by 14 percent. Of course, this was an unsuccessful move because the black market movements accelerated while incredible rises occurred in the stock market.
A similar example of devaluation happened to China in 2015. Due to major problems in the country’s credit markets, the Chinese government devalued the local currency. It even managed to influence global markets by repeating it several times. Of course, because this situation affects the world, China has been warned by international financial institutions.
So what happens if there is a devaluation?
- Imports are expensive.
- Exports are cheap.
- The current account deficit decreases.
- Inflation rises.
- Interest rates rise.
- The economy slows down.
- An increase in the budget deficit occurs.
Import is expensive:
When a country’s local currency depreciates, it becomes very expensive for a country to make purchases in different currencies, that is, to import. Imported goods become more expensive in direct proportion to the devaluation. Therefore, the interest in imported goods also decreases.
Exports are cheaper:
When the local currency of a country becomes worthless, the interest in the goods of that country increases because the rate of the goods bought for the same currency increases. This situation increases the competitiveness in foreign markets.
The current account deficit decreases:
The current account deficit does not decrease in every devaluation move. Since the interest in imported goods will decrease with the devaluation, if local production increases and this production becomes sufficient to meet both domestic and foreign demand, then the current account deficit begins to decrease.
Inflation rises:
The rise in inflation is also dependent on other economic policies. Inflation also increases in parallel with the devaluation, depending on the ratio of basic consumption items in imported goods, the total of intermediate goods and similar items.
Interest rates rise:
If the country’s inflation started to rise with the devaluation, the country’s financial institutions may raise interest rates in order to balance this inflation. Because, to control inflation, interest rates need to be increased.
The economy slows down:
Devaluation alone will not slow down the economy, but investments will decrease as credit costs will rise after moves such as interest rate hikes. On the other hand, since imported goods are expensive, if domestic production does not meet these needs, consumers will not make new purchases or new investments.
An increase in the budget deficit occurs:
An increase in the budget deficit is most common when there is a devaluation because an increase in the exchange rate increases the cost of imported goods. If there is foreign debt in foreign currency, an increase in the budget deficit is inevitable.
The devaluation effect can be described by the J curve:
Devaluation is not always a fast-acting monetary policy. Therefore, experts explain this effect through a model called the J curve. As the markets adapt to the devaluation, the export deficit will decrease. Foreign demand for exported goods will gradually increase and a new trade balance will be created. This situation is called the J curve because it resembles the letter J in the table.
Is devaluation really a necessary move?
Frankly, it is not possible to say unequivocally that devaluation is good or bad. The main purpose of devaluation is to increase exports, reduce the foreign trade deficit, reduce the foreign exchange demand in the country and reduce inflation. It’s like playing a three-dimensional chess match, where each move makes an impact on a different area and then requires new moves. Steps should be taken by considering the next ten moves, not the next.
There is also the reverse of devaluation; Revaluation
In the case of revaluation, which you can define as the opposite of devaluation, the country’s local currency gains value against foreign currencies. In case of revaluation, it becomes easier for the country to import and export becomes more difficult.
We answered the curious questions of what is devaluation, which is a financial tool used by a country to devalue its local currency, and what happens if it happens. The effects of the devaluation on the social life of that country is the subject of a different article.
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