The Economic Effects Of Devaluation Of The Currency Exchange Rate

The Economic Effects Of Devaluation Of The Currency Exchange Rate

Articles    Dr. Muhannad Talib Al-Hamdi *

An exchange rate devaluation is an intentional devaluation of the official exchange rate of a country's currency and the setting of a new rate in relation to a foreign currency reference such as the US dollar. The devaluation of the currency exchange rate is made by the monetary authority of the country (the central bank) and this is often done in cases of fixed exchange rate currencies.

The devaluation of the currency should not be confused with the natural devaluation of the currency in the market compared to other major currency standards resulting from the interaction of supply and demand forces. The process of reducing the exchange rate of the foreign currency makes the foreign currency more expensive compared to the local currency.

Reasons for devaluing the currency :

Countries often use devaluation to achieve some economic policy goals. Lowering the price of a country's currency compared to foreign currencies could improve exports, reduce the trade deficit, and reduce the country's debt burden. When the local currency is cheaper than the foreign currency, exports will be encouraged and imports discouraged. Because foreign countries will find commodity prices cheaper in the country whose currency is lowered.

However, countries are cautious to avoid a significant increase in exports, as this may cause a disturbance in the forces of domestic supply and demand, which may lead to upward pressure on prices and cause inflation, thus robbing the currency exchange rate devaluation of its expected effect . The devaluation of the exchange rate also helps reduce the impact of the trade deficit because it will improve the balance of payments because the value of exports will be higher than the value of imports.

Reasons for reducing the currency exchange rate.

To increase exports and discourage imports: A trade war is a common occurrence in the global market nowadays. In the global market, every country wants its products to be in demand and to be traded across countries. Every country wants its products to be competitive with those of other countries.

For example, mobile phone makers in South Korea may compete with cell phone makers in the United States. If the Korean won depreciates against the dollar, then the Samsung US phone that was previously available at a certain price is now cheaper in dollars, making US imports from South Korea cheaper. And vice versa as well. In other words, a depreciation of the currency exchange rate makes exports more profitable and discourages imports .

The lowering of the exchange rate makes exports more competitive and appears cheaper to foreign buyers, and this increases demand for exports. Also, after the devaluation of the dinar exchange rate, Iraqi assets could become more attractive. For example, real estate in Iraq may seem cheaper for those who live outside the country and thus increase their demand for it.

The lowering of the exchange rate also means that imports such as cars, food and raw materials will become more expensive. This will reduce the demand for imports, and may also encourage Iraqi tourists to spend their vacations inside Iraq, instead of traveling to other countries that now seem more expensive.

To narrow the trade deficit: The trade deficit is the difference between the value of a country's exports and the value of its imports. The trade deficit is linked to the country's net exports.

Net exports = value of exports - value of imports.

There is a trade deficit if the value of exports is less than the value of imports. The trade deficit could have negative effects on the country's economy and could lead to huge debt levels, which would cripple the economy. This was a matter of grave concern to the Iraqi government.

Thus, depressing the exchange rate can help boost exports by making exports cheaper and reducing imports by making them more expensive for the country's population. Thus a balance of trade (equaling the value of exports and imports) or a trade surplus (the value of exports is greater than the value of imports) can be achieved by reducing the exchange rate of the currency .

With increasing competitiveness of exports and increasing the cost of imports, the economy should witness higher exports and lower imports, thus reducing the trade balance deficit. Since 2010, the Iraqi trade deficit has recorded record numbers compared to the gross domestic product, so the devaluation of the dinar may be considered necessary to reduce the size of the deficit.

3 - Reducing the burden of sovereign debt: If a country issues several sovereign bonds to raise money, the state may have an incentive to reduce the currency exchange rate. In other words, a devaluated currency helps reduce the systematic service burden of the sovereign debt (i.e. interest paid on debt) issued by a country if investments are high by foreign investors and the interest to be paid is fixed.

For example, if the government of Iraq issued sovereign debt, most of it was purchased by American investors. Let us assume that the government of Iraq must pay 500 million Iraqi dinars per month to these investors and that interest charges are fixed at this amount. If the exchange rate of the dinar were reduced from 1,200 dinars to 1,450 dinars per dollar, the monthly service burden would drop from 416.66 thousand dollars to 344.83 thousand dollars.

Increasing aggregate demand: A depreciation of the currency exchange rate can lead to higher economic growth. Part of aggregate demand is the difference between the value of exports and imports. Therefore, increasing exports and decreasing imports (assuming that demand is relatively elastic) increases the overall demand for domestic goods and commodities. Under normal circumstances, a rise in aggregate demand is likely to cause real GDP and inflation to rise as well.

Inflation is likely to occur after devaluation for the following reasons. Imports become more expensive, which creates inflation driven by increased import costs. The rise in aggregate demand raises the level of inflation driven by the increase in demand. And with the lower cost of exports, local manufacturers may have less incentive to cut costs and increase efficiency.

Therefore, production costs can increase over time. In the short term, a devaluation of the currency exchange rate leads to inflation, higher growth and increased demand for the country's exports. Exports become cheaper for foreign customers and imports are more expensive.

Wages: Lowering the exchange rate of the dinar makes Iraq less attractive to foreign workers. For example, with the lowering of the dinar exchange rate, migrant workers from Asia may prefer to work in Kuwait or the United Arab Emirates rather than in Iraq.

In the service sector, for example, many workers are of Asian nationalities, and their Iraqi employers may have to raise their wages to keep them. Likewise, getting a job outside Iraq becomes more attractive to Iraqi workers because the wage they will receive in foreign currencies will earn them more Iraqi dinars than it serves their purposes (or their families) inside Iraq.

Decline in real wages: In a period of stagnant nominal wage growth, a depreciation of the currency exchange rate can lower real wages, that is, how much goods and commodities wages buy. And because the devaluation causes inflation, real wages only decrease if the rate of inflation is higher than the increases in nominal wages.

The impact of a devaluation depends on a combination of factors, including :

Elasticity of demand for exports and imports: If the demand for goods and commodities is inelastic in relation to prices, then the fall in the price of exports will only lead to a slight rise in the quantity of goods and commodities exported.

Therefore, the value of exports may actually decrease. The improvement of the trade balance depends on the state of elasticity of demand for exports and imports. If the difference in the value of exports and imports is positive, then lowering the exchange rate will improve the trade balance.

The devaluation of the currency exchange rate may take some time to affect the local economy. In the short run, demand may be inelastic, but over time the demand may become more price elastic and have a greater impact.

The state of the global economy: If the global economy is in a recession, as it is now due to the Corona pandemic, then devaluing the exchange rate may not be sufficient to boost export demand. If global economic growth became robust after a vaccine becomes available, there will be an even greater increase in demand. In a boom, however, a devaluation is likely to exacerbate inflation.

Inflation: The effect of inflation depends on factors such as :

The economy's surplus production capacity. For example, in a recession, a devaluation is unlikely to cause inflation because there is an excess of output above demand.

Whether or not importing companies pass the increased import costs on the consumers. Importing companies may reduce their profit margins, at least in the short term in the hope that they will develop their operations in the future by not losing market share.

Import prices are not the only determinant of inflation. There may be other factors affecting inflation such as increased wages, or a decrease in domestic productivity, among others.

The reason behind reducing the currency exchange rate. If it is due to loss of competitiveness, a depreciation of the currency exchange rate can help restore competitiveness and economic growth. But if the exchange rate devaluation aims to achieve a certain currency rate, then it may be inappropriate for the economy if it is not compatible with structural changes to the economy. .

The winners and losers from the devaluation of the currency:

Winners: exporters, the domestic tourism industry, and those working in export industries. Economic growth may increase, and the trade deficit should improve.

The Losers: Consumers who buy imported goods, residents who want to travel abroad, companies that import foreign raw materials for production, people with fixed incomes who will suffer from inflation, foreign exporters and the foreign tourism industry.

The effects of devaluing the currency exchange rate

An increase in foreign demand for exported domestic goods can create inflation. When this happens, the government can raise domestic interest rates but that will slow the growth of the country's economy.

The devaluation of the currency exchange rate can also cause psychological damage to foreign investors because it may cause investors to view the weaker currency as an indicator of the country's economic weakness and thus make them afraid to invest and get their money out of the country quickly.

Another effect of devaluation is that it may lead to fears by neighboring countries, which leads them to reduce the exchange rate of their currencies also in a "race to the bottom" and thus cause financial instability in neighboring markets, or what is called currency war.

Although the devaluation of the currency exchange rate might help reduce the trade deficit, there is a potential downside to it. Most developing countries have foreign currency loans. Thus, a devaluation of the currency exchange rate may increase the debt burden when loans are priced in local currency.

Failure to service such debts may project a negative image of the country among foreign investors. The devaluation of the currency exchange rate is most often used as a monetary policy tool to boost a country's trade. However, there are multiple limitations to these policies.

Moreover, a country may have to make devaluations in the currency exchange rate when it is not able to maintain the official exchange rate. For example, the case of Russia after the collapse of the Soviet Union. In the early days after Russia emerged as a separate country, the Russian Bank tried to maintain the ruble exchange rate compared to the dollar. During that time there were large operations of buying the ruble and selling the dollar.

The markets noticed this and currency traders realized that it was not sustainable, and therefore the ruble was sold, which posed a threat to the central bank regarding the possibility of losing reserves of the dollar. Consequently, the Central Bank of Russia had no choice but to let the ruble sale continue and watch its exchange rate drop against the dollar .

Why is the reduction important?

The most important benefit of lowering the exchange rate of the local currency, whether deliberately or as a result of the market climate, is to reduce the price of the country's GDP. This has the potential to benefit the economy by helping to increase the volume of exports. Conversely, import volumes are shrinking as the prices of foreign goods and services rise dramatically .

* Professor of Economics and Political Science, Kansas State University, USA.

Number of observations 131 Date of addendum 01/17/2021  https://economy-news.net/content.php?id=23664