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Devaluation

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For other uses, seeDevaluation (disambiguation).
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Inmacroeconomicsand modernmonetary policy,adevaluationis an official lowering of the value of a country'scurrencywithin afixed exchange-rate system,in which amonetary authorityformally sets a lowerexchange rateof the national currency in relation to a foreign reference currency orcurrency basket.The opposite of devaluation, a change in the exchange rate making the domestic currency more expensive, is called arevaluation.A monetary authority (e.g., acentral bank) maintains a fixed value of its currency by being ready to buy or sell foreign currency with the domestic currency at a stated rate; a devaluation is an indication that the monetary authority will buy and sell foreign currency at a lower rate.

However, under afloating exchange ratesystem (in which exchange rates are determined bymarket forcesacting on theforeign exchange market,and not by government or central bank policy actions), a decrease in a currency's value relative to other major currency benchmarks is instead calleddepreciation;likewise, an increase in the currency's value is calledappreciation.

Related but distinct concepts includeinflation,which is a market-determined decline in the value of the currency in terms ofgoods and services(related to itspurchasing power). Altering the face value of a currency without reducing its exchange rate is aredenomination,not a devaluation or revaluation.

Historical usage

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Devaluation is most often used in a situation where a currency has a defined value relative to the baseline. Historically, early currencies were typicallycoins,struck from gold or silver by an issuing authority, which certified theweightand purity of the precious metal. A government in need of money and short on precious metals might decrease the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency. Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (agold standard). Again, a government short on gold or silver might devalue by decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.

Causes

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Fixed exchange rates are usually maintained by a combination of legally enforcedcapital controlsand thecentral bankstanding ready to purchase or sell domestic currency in exchange for foreign currency.[citation needed]Under fixed exchange rates, persistent capital outflows ortrade deficitswill involve the central bank using its foreign exchange reserves to buy domestic currency, to prop up demand for the domestic currency and thus to prop up its value. However, this activity is limited by the amount of foreign currency reserves the central bank owns; the prospect of running out of these reserves and having to abandon this process may lead a central bank to devalue its currency in order to stop the foreign currency outflows.

In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country'sforeign reserves,increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, abalance of payments crisisoccurs. EconomistsPaul KrugmanandMaurice Obstfeldpresent a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate).[1]In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the1994 economic crisis in Mexico.

Economic implications

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There are significant economic consequences for the country that devalues its currency to address its economic problems. A devaluation in the exchange rate lowers the value of the domestic currency in relation to all other countries, most significantly with its major trading partners. It can assist the domestic economy by makingexportsless expensive, enablingexportersto more easily compete in the foreign markets. It also makesimportsmore expensive, providing a disincentive for domestic consumers to purchase imported goods, leading to lower levels of imports (which can benefit domestic producers),[2]but which reduces the real income of consumers.[3]Devaluation tends to improve a country'sbalance of trade(exports minus imports) by improving the competitiveness of domestic goods in foreign markets while making foreign goods less competitive in the domestic market by becoming more expensive. The combined effect will be to reduce or eliminate the previous net outflow of foreign currency reserves from the central bank, so if the devaluation has been to a great enough extent the new exchange rate will be maintainable without foreign currency reserves being depleted any further. However, the devaluation increases the prices of imported goods in the domestic economy, thereby fuelinginflation.[2]This, in turn, increases the costs in the domestic economy, including demands for wage increases, all of which eventually flow into exported goods. These dilute the initial economic boost from the devaluation itself. Also, to combat inflation, the central bank would increase interest rates, hitting economic growth.[2]A devaluation could also result in anoutflow of capitaland economic instability.[2]In addition, a domestic devaluation merely shifts the economic problem to the country's major trading partners, which may take counter-measures to offset the impact on their economy arising out of a loss of trade income arising from the initial devaluation.

Devaluations in modern economies

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UK economy

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1949 devaluation

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At the outbreak ofWorld War II,in order to stabilise sterling, thepound sterlingwas pegged to theUnited States dollarat the rate of $4.03 with exchange controls restrictingconvertibilityvolumes. This rate was confirmed by theBretton Woods agreementsof 1944.[4]

After the war, USLend-Leasefunding, which had helped finance the UK's high level of wartime expenditure, abruptly ended and theAnglo-American loanwas conditional upon progress towards sterling becoming fully convertible into US dollars, thereby aiding US trade.[5]In July 1947, sterling became convertible but the resultant drain on the UK'sforeign exchange reservesof US dollars was such that 7 weeks later, convertibility was suspended,rationingtightened andexpenditure cutsmade.[6]The exchange rate reverted to its pre-convertibility level, a devaluation being avoided by the new Chancellor of the Exchequer,Stafford Cripps,choking off consumption by increasingtaxesin 1947.

By 1949, in part due to a dock strike, the pressure on UK reserves supporting thefixed exchange ratemounted again at a time when Cripps was seriously ill and recuperating in Switzerland.[7][8]Prime MinisterClement Attleedelegated a decision on how to respond to three young ministers whose jobs included economic portfolios, namelyHugh Gaitskell,Harold WilsonandDouglas Jay,who collectively recommended devaluation.[9]Wilson was despatched with a letter from Attlee to tell Cripps of their decision, expecting that the Chancellor would object, which he did not.[10]On 18 September 1949, the exchange rate was reduced from $4.03 to $2.80 and a series of supporting public expenditure cuts imposed soon afterwards.[4][8]

1967 devaluation

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When the Labour Government of Prime MinisterHarold Wilsoncame to power in 1964, the new administration inherited an economy in a more precarious state than expected with the estimated balance of payments deficit for the year amounting to £800 million, twice as high as Wilson had predicted during the election campaign.[11]Wilson was opposed to devaluation, in part due to the bad memories of the 1949 devaluation and its negative impact on theAttleegovernment, but also due to the fact that he had repeatedly asserted that Labour was not the party of devaluation.[12]Devaluation was avoided by a combination of tariffs and raising $3bn from foreign central banks.[13]

By 1966, pressure on sterling was intensifying, due in part to theseamen's strike,and the case for devaluation being articulated in the higher echelons of government, not least by the deputy prime ministerGeorge Brown.[14]Wilson resisted and eventually pushed through a series of deflationary measures in lieu of devaluation including a 6 month wage freeze.[15][16]

After a brief period in which the deflationary measures relieved sterling, pressure mounted again in 1967 as a consequence of theSix-Day War,the Arab oil embargo and a dock strike.[17]After failing to secure a bail-out from the Americans or the French, a devaluation from US$2.80 to US$2.40 took effect on 18 November 1967.[18][16]In a broadcast to the nation the following day, Wilson said, "Devaluation does not mean that the value of the pound in the pocket in the hands of the… British housewife… is cut correspondingly. It does not mean that the pound in the pocket is worth 14% less to us now than it was." This wording is often misquoted as "the pound in your pocket has not been devalued."[19][20]Nevertheless the devaluation forcedJames Callaghanto resign asChancellor of the Exchequer,making way forRoy Jenkins.[21]

Other economies

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ThePeople's Bank of Chinadevalued therenminbitwice within two days by 1.9% and 1% in July 2015 in response to slowing economic growth, leading to the2015–2016 Chinese stock market turbulence.Although the devaluation was welcomed by theInternational Monetary Fund,it led theUnited States Department of the Treasuryto label China as acurrency manipulatorin 2019.[22][23][24]On 5 August 2019, China devalued its currency in response to theimposition of trade tariffs by the United States against China.[2]

India devalued theIndian rupeeby 35% in 1966.[25]

Mexico devalued theMexican pesoagainst theUnited States dollarin 1994 in preparation for theNorth American Free Trade Agreement,leading to theMexican peso crisis.

On January 11, 1994, France decided to devaluate the CFA Franc in 14 African countries in Central Africa and West Africa.[26]

See also

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References

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  1. ^Krugman, Paul;Obstfeld, Maurice(1999). "17 [Appendix II]".International Economics(5th ed.).Longman.ISBN978-0-321-07727-1.
  2. ^abcdeThe United States and China may be headed for a currency war
  3. ^Frieden, Jeffry A.; Stein, Ernesto; Bank, Inter-American Development (2001).The Currency Game: Exchange Rate Politics in Latin America.IDB. p. 4.ISBN978-1-886938-87-8.
  4. ^ab"Dollar Exchange Rate from 1940".miketodd.net.Retrieved14 October2018.
  5. ^Jenkins, Roy (1998).The Chancellors.London: Macmillan. p. 448.ISBN0333730577.
  6. ^Beckett, Francis(1997).Clem Attlee.London: Richard Cohen Books. p. 235.ISBN1860661017.
  7. ^Pimlott pp134-6
  8. ^abBeckett p278
  9. ^Pimlott pp136-7
  10. ^Pimlott pp138-9
  11. ^Pimlott, Ben (1992).Harold Wilson.London: Harper Collins. p. 350.ISBN0002151898.
  12. ^Campbell, John (2014).Roy Jenkins - A Well-rounded Life.London: Jonathan Cape. pp. 280–1.ISBN9780224087506.
  13. ^Pimlott pp352-4
  14. ^Pimlott p414
  15. ^Campbell p281
  16. ^abHealey, Denis (1989).The Time of my Life(Penguin paperback 1990 ed.). London: Michael Joseph. p. 333.ISBN0140153942.
  17. ^Campbell p303
  18. ^Pimlott pp477-82
  19. ^Pimlott pp483-4
  20. ^"BBC ON THIS DAY - 19 - 1967: Wilson defends 'pound in your pocket'".news.bbc.co.uk.19 November 1967.
  21. ^Thorpe, Andrew (1997).A History of the British Labour Party.London: Macmillan Education UK. p. 159.doi:10.1007/978-1-349-25305-0.ISBN978-0-333-56081-5.
  22. ^"China's Sudden Currency Plunge Raises Risk of a 2015-Style Panic".Bloomberg.2022-04-28.Retrieved2022-06-28.
  23. ^"The Impact of China Devaluing the Yuan in 2015".Investopedia.Retrieved2022-06-28.
  24. ^"China stuns financial markets by devaluing yuan for second day running".the Guardian.2015-08-12.Retrieved2022-06-28.
  25. ^Doerer, Kristen (Aug 17, 2015)."Your guide to China's devaluation of its currency".PBS NewsHour.
  26. ^"Les 30 ans de la dévaluation du Franc CFA dans 14 pays francophones".Radio France Internationale.Jan 11, 2024.
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