Devaluation of Currency| Reasons, Effects, Example and Critical Evaluation

Sometimes there arise some situations when the value of the domestic currency tends to increase drastically and faces monetary barriers. The government and the central bank intervene with some effective monetary policies for the correction of exchange rates, trade deficits, etc. One of these practices is the Devaluation of Currency. Devaluation of Currency is a monetary policy tool practised by the government of a country in order to adjust the prevailing exchange rate.

What is Devaluation of Currency?

Devaluation of Currency is a monetary policy tool practised by the government of a country in order to adjust the prevailing exchange rate. Currency devaluation is mostly practised in cases of fixed or semi-fixed currencies, in developing countries. Reduction of trade deficit and/or debts, encouraging exports, and discouraging imports are the essence of currency devaluation. The government of the country deliberately reduces the value of its currency in order to adjust the non-desirable exchange rate. Devaluation of Currency is also known as Forced Downward of Currency and Deliberate Devaluation Tactic. Currency Devaluation sets a new and revised exchange rate for currency. Usually, the Central Bank of the country performs this practice because Central Bank is responsible for buying and selling of foreign exchange.

Key takeaways from the Devaluation of Currency:

• It is a deliberate practice performed by the government of a country in order to adjust the prevailing foreign exchange rate and boost the economy. However, it does not remain deliberate when the country is unable to handle the situation, in that case, this practice gets imposed on the country.
• It is a practice of forced downward of the value of the currency to make the exchange rate favourable for the domestic economy.

Note: Currency depreciation and currency devaluation are two different concepts. Currency Devaluation is a deliberate practice to stabilize and achieve a favourable exchange rate; whereas, Currency Depreciation is driven by market forces of demand and supply, and thus is not controlled by the government or Central Bank.

Reasons for Devaluation of Currency

1. Exports Encouragement: Every country wants its product to be more competitive in the international market and devaluation of currency helps them do so. In case, the currency gains value, exports will be costly, creating a negative impact on demand and not be so much of a help to the home country.

2. Reduction of Debt Burden: Currency Devaluation makes the repayment of debts easy. As the currency becomes weak, it makes the payment of instalments less expensive.

3. Narrowing the Trade Deficit: A negative trade balance can affect the country’s economy adversely and can lead to borrowing. Thus, currency devaluation can encourage exports which will help the trade balance to reduce, and/or cut down its deficit balance.

Trade Balance = Exports – Imports

Example of Currency Devaluation

Assume an American car on August 16, 2023, was sold at USD 12,000 in India. As of August 16, 2023, the exchange rate for USD to INR was: 1 USD = INR 83.234. On August 17, 2023, USD was devalued as compared to the INR as a part of monetary policy, and on the date, it was 1 USD = INR 83.101. Thus, the American car in India will become cheaper by INR 1,596, as shown below:

Effects of Currency Devaluation

Currency Devaluation has many impacts on the economy of the country on a micro as well as macro level. Some of the effects of currency devaluation are as follows:

1. There as many negative impacts of currency devaluation like inflation, rise in general prices, loss of foreign investment, etc. Currency Devaluation can crush the confidence of the investors and they will be forced to withdraw their money.

2. Currency Devaluation can cause currency wars among countries. As the country devaluates itself, exports will rise, and as a result, demand will increase. When the other companies will notice such positive impacts of currency devaluation, they will also be tempted to devalue their currency, leading to a currency war.

3. When loans are priced in the home currency, and the host currency devaluates its value, it will lead to a loan burden on the shoulders of the host country. Such a situation may form a negative image of the country.

Critical Evaluation of Devaluation of Currency

Advantages of Currency Devaluation:

• Currency Devaluation encourages exports and can further help the company acquire a significant market share in the foreign market. A healthy export level leads to the inflow of foreign exchange in the domestic country.
• Currency Devaluation makes the country more competitive in the foreign market.
• Currency Devaluation makes the repayment of debts cheaper. As the value of domestic currency becomes weak, it makes the payment less expensive.
• Currency Devaluation helps the country in maintaining a healthy balance of trade and overcome the trade deficit, if any.

Disadvantages of Currency Devaluation:

• Currency Devaluation creates a negative image of the country’s economy in the mind of foreign investors. It can adversely affect Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
• Foreign tourism can also get affected as the currency devaluates. Foreign travel and buying activity in the foreign country will be costly.
• When loans are priced in the home currency, and the host currency devaluates its value, it will lead to a loan burden on the shoulders of the host country. Such a situation may form a negative image of the country.