The decision to lower the value of a currency at a fixed exchange rate is known as devaluation. If the value of the currency decreases, there is currency depreciation. Imports and international trips will be more expensive for locals. On the other hand, domestic exporters will benefit from the lower cost of their exports.

Intro

In anticipation of a possible trade war between China and the United States, there has been speculation that the Chinese are employing currency depreciation as a strategy. However, given China's recent efforts to stabilize and globalize the Yuan, the volatility and dangers involved may not be worth it this time.

The Chinese have previously denied it, but Donald Trump has accused the world's second-largest economy of weakening its currency to benefit its economy. The irony is that the US administration urged China to devalue the Yuan for years, claiming that it offered them an unfair competitive edge in international commerce and kept their capital and labor prices artificially low.

There have been numerous currency devaluations since world currencies abandoned the gold standard and allowed their exchange rates to fluctuate freely against each other. These events have harmed the citizens of the countries concerned and have also had a global impact. A country's currency may be devalued for a variety of reasons. The main goal is to keep the trade balance cost low.

When export costs are lower than import expenses, a country does well, and currency value plays a big part. A currency devaluation is an economic term that describes when a country decides to lower the value of its currency. It is done to assist a country in overcoming financial difficulties.

Devaluation, in the end, allows a government to spend less while bringing in more until the economic tides turn in its favor.

What Does Devaluation Mean?

Devaluation is the intentional reduction in the value of a country's currency compared to another currency, group of currencies, or currency standard. Countries with a regular or semi-fixed exchange rate use this monetary policy instrument. It is commonly confused with depreciation and is the polar opposite of revaluation, which refers to a currency's readjusted exchange rate. 

It may seem counterintuitive, but a strong currency is not always in the best interests of a country. A weak native currency makes a country's exports more competitive in global markets while also raising the cost of imports. Higher export volumes stimulate economic growth, whereas expensive imports have a comparable effect since customers choose to buy local items over imported ones. This increase in trade terms usually correlates to a smaller current account deficit (or an enormous current account surplus), more jobs, and quicker GDP growth. The wealth effect stimulates domestic consumption by stimulating monetary policies that normally result in a weak currency.

It's worth emphasizing that strategic currency depreciation doesn't always work, and it can even lead to a global currency war. Competitive devaluation is a scenario in which one country responds to a sudden national currency devaluation by devaluing its currency. In other words, a currency devaluation in one country is matched by a currency devaluation in another. When both currencies have regulated exchange-rate regimes rather than market-determined floating exchange rates, this happens more frequently. Regardless of whether a currency war breaks out, a country should remain cautious of the negative consequences of currency depreciation. 

Currency depreciation may reduce productivity by making capital equipment and machinery imports prohibitively expensive. Devaluation also decreases a country's inhabitants' purchasing power in other countries.

Top 10 Reasons Why Countries Choose to Devalue Their Currency

1. To boost exports

Each country's goods must compete with those of other nations on the global market. US automobile manufacturers compete with their European and Japanese counterparts. If the euro depreciates versus the US dollar, the price of automobiles sold by European manufacturers in the United States in dollars will be effectively lower than before. In contrast, a more valuable currency makes exports more expensive to buy in overseas markets.

In other words, exporters improve their worldwide competitiveness. Imports are discouraged, but exports are encouraged. Hence, two considerations should be taken into account. A country's export commodities will rise in price when global demand increases, the price will begin to rise, normalizing the devaluation's initial effect. The second is that when other countries observe this impact in action, they will be enticed to deflate their currencies in a "race to the bottom." It might result in tit for tat currency wars and rampant inflation.

2. To shrink trade deficits

Imports will fall as exports become cheaper and exports become more expensive. The balance of payments improves as exports rise and imports decline, resulting in reduced trade imbalances.Year-after-year deficits aren't uncommon these days. with the United States and many other countries experiencing chronic imbalances. On the other hand, continuing deficits are unsustainable in the long run, according to economic theory, and can lead to hazardous levels of debt that can collapse an economy. Depreciation of the national currency can aid in the correction of the balance of payments and the reduction of these deficits.

This logic, however, could have a disadvantage. When foreign-denominated loans are priced in the native currency, depreciation raises the debt burden. It is a significant problem for poorer countries like India and Argentina, which have significant debt in dollars and euros. These international debts become more difficult to service, causing people to lose faith in their home currency.

India's trade deficit rose by 87.5% to a record ₹192 billion in 2021-22 from ₹102 billion in the previous financial year, and government data showed on Monday. The increase was primarily on account of the sharp increase in petroleum imports due to the surge in global crude oil prices.

India's trade deficit has widened to an all-time high of about $23 billion in November amid higher imports. A rebound in oil prices drives this growing trade deficit.

3. To reduce sovereign debt burdens

If a government has a lot of government-issued sovereign debt to serve on a regular basis, it may be enticed to favor a weak currency policy. The cost of debt payments is reduced over time by a weaker currency when debt payments are fixed.

Consider a government that must pay $1 million in interest payments each month on its outstanding obligations. However, it will be easier to pay interest if the same $1 million in fictitious costs loses value. A $1 million debt payment valued at $500k will now be worth only $5000 if the domestic currency is devalued to half its original value.

This strategy should be utilized with prudence once more. If almost every country on earth owes money in one form or another, a currency race to the bottom could ensue. If the country in question has a high number of foreign bonds, this strategy will fail since it will make interest payments more expensive.

4. Exports cheaper

Exports will be more competitive and appear cheaper to foreigners if devalue the currency rate. It will raise export demand. Furthermore, following a devaluation, UK assets become more appealing; for example, a depreciation in the Pound might make UK property appear cheaper to foreigners.

Every country wishes to increase its exports in order to raise money. Every nation competes with each other for supply and demand and the costs of goods, as in any free market. Yes, a country may discount its currency to generate more cash from exports.

It might be everything from gasoline to automobiles to paper materials. In the United States, the top three manufacturers (Ford, Chrysler, and GM) are constantly battling with Japanese and European suppliers for the pricing of their goods (i.e., Hyundai, Toyota).

Imports are sometimes less priced in America, which is a social and economic point of conflict for consumers.

On the other hand, if a more economical automobile allows Americans to eat more, they will buy it. To counteract these economic trickle effects, a country will concentrate its efforts on exports and devaluation. To some, emphasizing exports over imports is more patriotic, but it is simply good business to others.

5. Imports are more expensive 

An increasing trade deficit and rising imports can have a negative impact on a country's exchange rate. A weaker domestic currency encourages exports while raising the cost of imports; on the other hand, a robust domestic currency discourages exports while lowering the cost of imports.

Imports such as gasoline, food, and raw materials will become more expensive due to the depreciation. Import demand will be reduced as a result. It may also persuade British tourists to visit the UK rather than the United States, which suddenly appears to be more expensive. As a result, if consumers spend more money on imports, domestic demand will fall. As a result, AD growth and inflation are both reduced.

6. Increased aggregate demand (AD) 

A depreciation could boost economic growth. Because (X-M) is a component of AD, stronger exports and lower imports should boost AD (assuming demand is relatively elastic). Higher AD is expected to lead to higher real GDP and inflation under normal conditions.

Following a devaluation, inflation is likely to develop because: 

• Imports are more expensive, generating cost-push inflation; 

• AD is increasing, causing demand-pull inflation.

• As exports grow more affordable, firms may be less motivated to lower costs and improve efficiency. Hence due to this, costs may rise over time.

7. Current account balance has improved

We should see more robust exports and fewer imports as exports get more competitive and imports become more expensive, reducing the current account deficit. The UK had a near-record current account deficit in 2016, necessitating a devaluation to lower the extent of the deficit.

Policy divergence Between RBI and Federal Reserve: 

• The dollar has strengthened in response to more robust US economic growth forecasts and low-interest rates from the Federal Reserve (the US central bank).

• The Reserve Bank of India is purchasing dollars regularly to increase its reserves and prepare for any potential turbulence.

8. Wages 

The Pound's depreciation makes the UK less appealing to international workers. Migrant workers from Eastern Europe, for example, may prefer to work in Germany rather than the UK if the value of the Pound falls. More than 30% of workers in the UK food production business are EU citizens. To maintain foreign workers, UK businesses may have to raise wages. Similarly, getting a job in the US becomes more appealing for British workers because a dollar wage will go further. (FT – Migrants are becoming increasingly selective about employment in the UK)

Every citizen in the world is affected by money daily, and a devalued currency will impact how comfortable a citizen's life is. The impact can be seen at the pump, in the bank, on their mortgages, and even on their jobs.

A depreciated currency inhibits a country's economic progress, while higher import costs damage the average citizen.

A depreciated currency also impacts a country's social and psychological effects. Consumers are affected every day by these effects.

For example, the expense of a tank of gas may devastate a family's entire month.

Furthermore, when a country devalues its currency, whether intentionally or due to economic factors, its credibility suffers, and trading partners become wary.

The International Monetary Fund seeks to help countries avoid repeated devaluation and revaluation, ensuring that all countries have a level playing field in trade and currency problems.

 9. Falling real wages 

Devaluation can produce a drop in actual earnings during sluggish wage growth. Depreciation creates inflation, but real wages will fall if inflation outpaces wage gains.

The outflow of Capital and Exchange Rates 

The transfer of assets out of a country is known as capital outflow. Capital outflow is frowned upon since it is frequently the result of political or economic unrest. When international and local investors sell their holdings in a country because of perceived economic weakness and the conviction that better opportunities exist elsewhere, this is known as asset flight.

Individuals selling currency to foreign countries boosts a country's currency supply. China, for example, sells Yuan to buy dollars. The value of the Yuan declines. As a result of the increased supply, cutting the cost of exports and boosting the cost of imports.The Yuan's subsequent devaluation causes inflation because demand for exports increases while imports decrease.

$550 billion in Chinese assets departed the nation in the second half of 2015, searching for higher returns. While government authorities had anticipated minor capital outflows, the massive volume of capital flight sparked concerns in China and worldwide. A closer look at the $550 billion in asset sales in 2015 revealed that over half of it was used to pay down debt and finance acquisitions of foreign competitors. As a result, the fears were unwarranted, primarily in this case.

The benchmark S&P BSE Sensex Index has fallen by nearly 10% from its all-time high reached in October 2021 because of a flight of foreign capital from stocks.

10. National debts

The United States' national debt level is a measure of how much the government owes its creditors. The national debt continues to climb because the government usually always spends more than it receives in taxes and other revenue.

The majority of the national debt is issued in the form of Treasuries, or government bonds. Some fear that high amounts of government debt will have an influence on economic stability, with implications for currency strength in trade, economic growth, and unemployment.

Others argue that the national debt is manageable and that citizens need not be concerned.Yes, national debt loads will have a considerable impact on currency depreciation. Devalued currency might make debt payments easier for a government with foreign debt.

When a country's currency devalues, it becomes more difficult to repay a million dollars in monthly interest on national debts.

After the devaluation, the payment becomes less valuable, but the country making the payment is unaffected. Still, a country that devalues only for this purpose would be closely scrutinized by the rest of the world.

Every country has a debt burden, which must be managed in a way that has the least amount of negative impact on its population.

The Bottom Line

Countries can utilize currency devaluations to implement economic policies. A weaker currency concerning the rest of the world can assist promote exports, reducing trade deficits, and reduce interest expenses on the country's outstanding government debts.However, devaluations have some detrimental consequences. They induce global market uncertainty, which can lead to asset market declines or recessions. Countries may be tempted to compete for the cheapest currency, depreciating their currencies back and forth. This hazardous and vicious loop can cause far more harm than benefit.

However, devaluing a currency does not always result in the desired benefits. Brazil is a good example. The Brazilian real has plummeted since 2011, However, the steep depreciation has not been enough to compensate for other difficulties like dropping crude oil prices and commodity prices and an expanding corruption scandal. As a result, the Brazilian economy has grown at a slow pace.