One of the most exciting events that can happen during currency trading is currency devaluation, especially when it is a surprised one. Currency devaluation not only has a profound effect on your profit and loss but also has a big impact on the lives of the citizens. So what is it, and what is the reason for it? Why did a U.S. Federal Reserve official describe currency devaluation as “peeing in bed”?
What is currency devaluation?
Strictly speaking, currency devaluation only happens in a fixed exchange rate system where a home country’s currency is pegged to another currency. When the government officially reduces the value of its currency relative to other currencies, it has engineered a devaluation. Currency depreciation, which goes in the same direction as currency devaluation, technically only happens in a floating rate system and is caused by changes in the demand and supply factors.
For example, a country’s currency was set at 10 units to one U.S. dollar, or one unit of home currency was equal to 10 U.S. cents. To devalue, the government may announce that the currency will now officially be set at 15 units to one dollar. In other words, the dollar has appreciated 50 percent against the domestic currency. On the flip side, the home currency has depreciated 33 percent against the dollar. To purchase the same foreign good as before, the home country citizen has to pay a lot more. Devaluation often raises the price levels in the domestic country and lowers citizens’ standard of living. This is because devaluation leads to more money printing and a higher inflation. Remember the hyperinflation after the WWI in the Weimar Republic (Germany) due to excessive money printing and devaluation? High inflation will eventually lead to a higher interest rate and a slower growth. Recently, when Venezuela changed its official rate from 4.3 to 6.3 to the U.S. dollar, the Venezuelans queued up in long lines to purchase TVs and air tickets before the price increase.
Why do governments implement it?
In a fixed rate system, the country needs to have sufficient dollar reserves to sustain the fixed exchange rate. When a government engages in macroeconomic policies that encourage over-consumption of goods and services or raise inflation rapidly, a country’s exchange rate will become uncompetitive and untenable, leading to a downward pressure on the country’s foreign exchange reserves used to pay imports and to service external debt. In the recent global financial crisis, countries have engaged in currency wars or competitive devaluation in order to give a boost to their economies. This means that a country deliberately lowers the value of their currencies against another in order to boost exports and stimulate the domestic economy. Ultimately, global trade will be disrupted.
How is competitiveness restored?
When a government devalues its currency, the country’s exports will become cheaper and more competitive. The country will earn more foreign exchange reserves while the citizens will have to pay more for imported goods. Devaluation should help to reduce the country’s current account deficit and to prevent a further drain on the foreign exchange reserves. Notice that immediately after the devaluation, the imports and exports volume may not change, resulting in a bigger deficit or a smaller surplus in the current account – the “J-curve” effect of a currency devaluation.
Central banks’ attitudes towards devaluation
Given a central bank’s primary objective is to control inflation or to maintain price stability as well as full employment, a central bank’s attitude towards devaluation depends on the country’s political orientation and how the government wants the competitiveness to be restored. Traditionally, the central banks prefer to guard the level of the currency so that inflation does not rise rapidly. Therefore, the central bank may prefer lowering the nominal wage level rather than devaluing the currency to restore competitiveness. Nowadays, the central banks prefer not to target the exchange rates and achieve their domestic objectives by using domestic means.
In summary, effective currency devaluation is easier said than done. A U.S. Fed official remarked that a currency devaluation may feel good at first but can become a real mess. Devaluation can prompt more devaluation from trade partners. For forex traders, the ability to understand a country’s exchange rate system, the economic policy environment, the country’s political orientation, the central bank’s attitude towards devaluation as well as other countries’ responses can mean a world of difference to your bottom line.
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