If you’ve been reading or watching the news, you’ve probably heard talk of trade wars. One of the hot topics surrounding the trade wars topic is the concept of currency devaluation. But what is currency devaluation and why do countries want to devalue their own currency?
What is Currency Devaluation?
Currency devaluation occurs when a country devalues its own currency to lower its own purchasing power. Lower purchasing power may be a bad thing, but it can also help to expand exports and keep an economy running.
However, while exports may improve, imports will be more expensive because the currency’s value is lower. Consumers often struggle with higher prices as import prices rise, meaning that their purchasing power is lower following a devaluation.
Companies and manufacturers may have less purchasing power, yet they enjoy higher exports, which improves revenue.
Central banks or a country’s government have the power to declare an exchange rate for their currency, or they can devalue their currency by buying and selling their currency to control the market value.
In the past, many countries had their currency tied to gold, but this has changed to a floating exchange rate. Aside from a floating exchange rate, there is also a “pegged exchange rate.”
Pegged exchange rates mean that Country A has a fixed exchange rate for Country B’s currency.
For example, Saudi Arabia has a 3.75 exchange rate for the Riyal, which is tied to the USD. Countries often tie their pegged rate to a country or currency in which they do the most business or that has stability.
Similarly, Africa’s countries that follow a pegged rate fix it to the euro.
If Saudi Arabia wanted to, they could adjust the exchange rate to 2.75, or any number they see fit, to change their currency’s value.
Whether a country has a floating or pegged exchange rate, devaluation often serves the same purpose.
Why Do Countries Devalue Their Currency?
Devaluing currency is a practice that is filled with advantages and disadvantages. However, central banks or governments often engage in currency devaluation for the following reasons:
- Improve a country’s export competitiveness, allowing them to increase their exports
- Increase economic growth, thanks to the increase in exports
- Improve the number of local goods purchased because consumers will have lower purchasing power, pushing them to purchase local goods rather than imports
- Employment rises with currency devaluation because exports rise, leading to stronger economic growth
- GDP growth soars with a devalued currency
- Sovereign debt falls if debt payments remain fixed
- Trade deficits may shrink as exports increase
Housing and capital markets improve when a currency devaluation occurs. The upsides are met with the risk of entering into a currency war with other countries.
A primary risk of currency devaluation would be that imports become increasingly more expensive for local manufacturers and consumers.
In this case, if importing equipment is not viable and there are no other alternatives, it can lead to lost employment and business.
Currency devaluation can be a strategy to improve GDP, employment and local sales, but it can also have dire consequences.