Currency Devaluation Explained

by FX EA Review
Currency Devaluation Explained

It’s pretty counterintuitive to imagine a fairly strong currency may not be entirely suitable for a country, isn’t it? 

This is where currency devaluation comes in, a mechanism where a monetary authority (most notably a central bank) strategically makes their country’s currency less valuable in relation to another particular foreign currency.

Ultimately, this radical decision is meant to spur economic growth by boosting exports, shrinking trade deficits, and lowering sovereign debt. Let’s observe how currency devaluation occurs, its causes and benefits, and recent real-world examples of this phenomenon.

What is currency devaluation?

Currency devaluation is the deliberate, official lowering of an exchange rate against another currency by a central monetary authority. It often applies to countries using a fixed-exchange-rate system where the currency in question is intentionally pegged to another currency, most commonly the US dollar.

Importantly, there’s a difference between devaluation and depreciation. Depreciation happens more automatically in a floating-exchange rate system where market forces and supply and demand determine prices. In simpler terms, a currency is said to be depreciated when it loses value naturally because of a severe economic crisis.

Devaluation is deliberately fostered by an authority like a central bank to gain an economic edge in global trade. Like anything, the risks and benefits of this strategy are equal.

Benefits-wise, one of the primary motivations for a currency devaluation is a country’s exports becoming a lot cheaper, improving their balance of trade (exports minus imports). Yet, this, in turn, makes imports more expensive. 

With pricier imports, the domestic market becomes less competitive, people demand higher wages, ‘unchecked’ inflation may occur, etc. Lastly, this depreciation can lead to a ‘currency war,’ where multiple countries intentionally cheapen their currencies as well (effectively a ‘competitive’ devaluation). 

Nonetheless, let’s explore more why a country might participate in currency devaluation.

Reasons why currencies are devalued

Below are two main reasons why a nation’s currency may be intentionally depreciated.

Stimulating exports

The concept of exports is one of the oldest forms of international trade and widespread economic transfer. Exporters understand the significance of their products being in as many markets as possible to increase their bottom line. 

Yet, this, of course, creates high competition. Let’s consider that, for instance, American cell phone makers are competing with the same groups in Canada. If the value of the Canadian dollar (CAD) increased against the US dollar, phones in the US would become more expensive.

Yet, if CAD were less valuable than the greenback, the phones would be cheaper in America and other foreign markets. As expected, there’s a trade-off here where exports are emphasized over imports, which does have negative consequences.

Yet, any prosperous country will generally want more exports than imports. This prevents a trade deficit or trade imbalance, which is positive for the economy overall. When a country exports more than imports, more money comes in than leaves. 

Reducing government debt

Another reason for currency devaluation is where a nation cannot keep up with payments for large government-issued debt denominated in a stronger foreign currency. Devaluating their money makes the credit repayments far cheaper. 

For instance, if a government owed $1 million in monthly interest, they’d essentially need to pay $500 000 instead if their currency was devalued by 50%.

Recent examples of currency devaluation

Let’s observe real-world examples of currency devaluation in action from several countries.

Chinese yuan

One of the most recent demonstrations is between China and the US. The Chinese 

government had maintained a fixed-currency peg to the dollar since 1994. The yuan’s value is also relatively low compared to several other countries. 

It’s one of the reasons making China’s exports more inexpensive than most nations, thereby amplifying the nation’s dominance in recent history. Yet, the Chinese government had felt economic growth was at its slowest for a long time.

In August 2015, the PBOC (People’s Bank of China) devalued the yuan several times in succession, effectively lowering it by about 3% in value against other countries, most notably the USD.

To this day, America seems incensed with China, resulting in increasing trade tensions between the two over the years.

Venezuelan bolívar

One catastrophic example of a currency devaluation in recent history is of the 

Venezuelan bolívar, which had undergone five currency valuations between 2010 and 2018. These were performed for improving exports in numerous sectors like food, healthcare goods, cars, and electronics. 

Unfortunately, over the years, the devaluation resulted in negative consequences further exacerbated by a drastically reduced minimum wage, heavy money-printing, deficit spending, and a loss of citizen confidence in the currency overall.

In November 2016, the bolívar officially entered into hyperinflation. Most research suggests the inflation had been at over 2 000 000% by 2018, causing a massive socioeconomic and migration crisis that took a few more years to tame.

Iraqi dinar

The latest publicized currency devaluation was of the Iraqi dinar in 2020. Iraq’s 

government devalued the dinar by roughly 20% from ع.د 1190 to ع.د1450 for 1 US dollar.

Experts believe the Iraqi government cheapened the dinar to lower budget deficits, increase reserves, and make their domestic goods more competitive in international markets. Technically, the country is facing an economic crisis triggered by a dip in oil prices, a commodity which they heavily rely on for exports. 

This devaluation is the first since 2003. So, it’ll be interesting to see what the consequences of it will be over time.

Final word

As expected, the effects of a currency devaluation are usually two-fold. While this action makes exports cheaper (one of the main benefits), imports understandably become pricier. 

This wouldn’t provide an incentive to buy imported products. While the result would benefit domestic producers, it’d consequently reduce the actual income and purchasing power of consumers.

It’s worth noting currency devaluations don’t happen frequently. However, as a forex trader, you can still take advantage of any economic crises where a currency may be losing significant value against another for reasons which may not necessarily relate to currency devaluation. 

For instance, the Turkish lira has been growing weaker against the US dollar for more than a decade as it continually hits record lows over time. Ultimately, you should understand the relationships between the strengths of currencies and look for those rare opportunities where notable economic disparities are present.

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