Devaluation of a currency is a deliberate lowering of an official exchange rate of a country and setting a new fixed rate with respect to a reference of foreign currency such as the USD. It should not be confused with depreciation which is the decrease in the currency value as compared to other major currency benchmarks due to market forces. The process of devaluation tends to render the foreign currency more expensive than the local currency.
For instance, a country whose 10 units of its currency is equivalent to one dollar may decide to devalue its currency by fixing 20 units to be equal to one dollar. By doing so, the home country would be half as expensive as the dollar.
Reasons for Devaluation
Countries often use currency devaluation for economic policies. Lowering of the home currencies as compared to foreign currencies will:
- Improve exports. When the local currency is cheaper than the foreign currency, exports will be encouraged and imports discouraged. This is because foreign countries will find the prices of goods cheaper in the devaluing country. Caution should be however exercised to avoid the extensive exports that causes the effects of demand and supply that increases the prices of goods that could normalize the devaluation effect. Again other countries might find the trick and hence themselves also devalue their currency in the “race to bottom” that can, as a result, lead to inflation.
- Shrink trade deficits. Devaluation helps solve the effects of trade deficit since it will cause a balance of payments since the exports will be higher than the imports.
- Reduce a county’s debt burdens. If a government has sovereign debts to pay on a regular basis, and the payment of this debt is fixed, maintaining a weaker currency makes the debt less expensive over time. The same should also be done with caution as countries might resort to a race to bottom war nullifying the effect of devaluing.
Effects of Devaluation
An increase in demand for exported goods can lead to inflation. When this happens, the government can raise interest rates but a cost since it will slow the county’s economy.
Devaluation can also cause psychological damage to the foreign investors. This is because a weaker currency may be viewed as an indication of economic weakness hence scaring away foreign investors.
Another effect of devaluation is that it may lead to concerns by neighboring countries to devalue their currencies too in the race to the bottom hence causing financial instability in the bordering markets.
Revaluation is a significant rise in a county’s official exchange rates in relation to a foreign currency. The process of revaluation can only be done by the central bank of the revaluing country.
For instance, if a countries currency trades at 10 units to 1 US dollar, to revalue it, the said country can change to using 5 units of its currency to be equivalent to 1 dollar in order to make it twice expensive compared to the dollar.
Causes of Currency Revaluation
Changes in interest rates of various countries could cause a country to resort to currency revaluation so as to maintain its profitability and economic competitiveness.
Countries can also revalue their currency for speculative purposes. For instance, prior to the 2016 Brexit by Britain, a lot of other countries’ currencies fluctuated because of speculative reasons and need to remain profitable despite any outcome of the vote.
The issue of currency revaluation and devaluation lead to the establishment of the International Monetary Fund (IMF), a body that regulates the frequent devaluation and revaluation that are used by different countries to unfairly gain a competitive advantage over others. The IMF has also given each member a right to choose an exchange rate to use. These policies have helped the ill-advised motives of devaluation and revaluation.