Why and is it a viable policy?
Countries over the years have adopted as a policy the deliberate downward adjustment of the value of their money relative to another currency, group of currencies, or currency standard. Countries that have a fixed exchange rate or semi-fixed exchange rate use this monetary policy tool. It could be confused with depreciation (the result of nongovernmental activities) or revaluation, (which refers to the readjustment of a currency’s exchange rate).
Reasons Why Countries Devalue
1. To Boost Exports
2. To Shrink Trade Deficits
3. To Reduce Sovereign Debt Burdens
The three top reasons why a country would pursue a policy of devaluation:
1. Expand Exports
A country may devalue its currency is to combat a trade imbalance. Devaluation reduces the cost of a country’s exports, rendering them more competitive in the global market, which, in turn, increases the cost of imports. If imports are more expensive, domestic consumers are less likely to purchase them, further strengthening domestic businesses. Because exports increase and imports decrease, there is typically a better balance of payments because the trade deficit shrinks. In short, a country that devalues its currency can reduce its deficit because there is greater demand for
In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged. There should be some caution, however, for two reasons. First, as the demand for a country’s exported goods increases worldwide, the price will begin to rise, normalizing the initial effect of the devaluation. The second is that as other countries see this effect at work, they will be incentivized to devalue their own currencies which can lead to tit for tat currency wars and lead to unchecked inflation.
2. Reduce Trade Deficits
Exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favors an improved balance of payments as exports increase and imports decrease, shrinking trade deficits. Unfortunately however, continuous deficits are unsustainable in the long run and can lead to dangerous levels of debt which can cripple an economy. Devaluing the home currency can help correct balance of payments and reduce these deficits. There is a potential downside to this rationale, however. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like Nigeria which hold lots foreign-denominated debt. These foreign debts become more difficult to service, reducing citizens confidence in their domestic currency.
3. Reduce Debt Burdens
A government with a lot of sovereign debt may be incentivized to encourage a weak currency policy. If debt payments are fixed, a weaker currency makes these payments effectively less expensive over time. Again, this tactic should be used with caution. As most countries around the globe have some debt outstanding in one form or another, this tactic will fail if the country in question holds a large number of foreign bonds since it will make those interest payments relatively more costly.
The Flip side to Devaluation
It is worth noting that a strategic currency devaluation does not always work, and moreover may lead to a ‘currency war’ between nations. This occurs more frequently when both currencies have managed exchange-rate regimes rather than market- determined floating exchange rates. Even if a currency war does not break out, a country should be wary about the negatives of currency devaluation. Currency devaluation may lower productivity, since imports of capital equipment and machinery may become too expensive. Devaluation also significantly reduces the overseas purchasing power of a nations citizens.
Inflation can occur because imports become more expensive. Aggregate demand causes demand-pull inflation, and manufacturers may have less incentive to cut costs because exports are cheaper, increasing the cost of products and services over time. A country like Nigeria as we are experiencing increasing high cost of goods, because we are import dependent .
Currency devaluations can be used by countries to achieve economic policy. Having a weaker currency relative to the rest of the world can help boost exports, shrink trade deficits and reduce the cost of interest payments on its outstanding government debts. There are, however, some negative effects of devaluations. They create uncertainty in global markets that can cause asset markets to fall or spur recessions. Countries might be tempted to enter a tit for tat currency war, devaluing their own currency back and forth in a race to the bottom. This can be a very dangerous and vicious cycle leading to much more harm than good.