We explain what devaluation is, what its causes are and the consequences it presents, as well as its characteristics and examples.
What is Devaluation?
It is called devaluation the decrease in the nominal value of a country’s currency or currencywith respect to other foreign currencies, considered stronger and used as a reference value. It is also known as depreciation since the currency becomes cheaper on the international market.
Devaluation is usually feared and It is considered a bad indicator in economic mattersas it reflects the loss of economic power of a nation compared to the rest of its international competitors.
However, devaluation is a financial procedure like any otherwith causes and consequences and often part of an economic strategy, since no one is going to depreciate their currency unnecessarily. Devaluations are made official by the central banks of each country.
See also: Open economy.
Origin of the term Devaluation
To devalue is a word formed by Latin words: the prefix “de-” (originally des-which implies opposite meaning, as in fromcompose) and derivations of the noun “value” (such as valer, Evaluación), so it literally means “to lose value”, that is, to become cheaper.
Value of coins
The currencies of the countries In foreign trade they lack their own value: Its value is purely relative and represents the confidence that exists in the productive and commercial capabilities of the country that issues it.
The US dollar, for example, is one of the most widely used currencies for the exchange of goods in the entire world, so its demand is very high and its price stable.
Causes of devaluation
A devaluation may be motivated by one or more of the following conditions:
- International currency valuation. Due to the laws of supply and demand, the most popular currency becomes more expensive, and the currency that no one wants becomes cheaper. If a currency is in high demand (for example, for saving, or for international business) it will become more expensive compared to the others, while currencies that no one wants to have will become less expensive.
- Foreign exchange flight. This occurs when sums of wealth from one country are massively transferred to another, because their holders distrust the direction of the local economy. This also occurs when a massive default on payments is suspected, which generates a bank run or flight of wealth from one currency to another, devaluing the first.
- Monetary issuance. According to some theories commonly called monetarist, the issuance of unbacked banknotes by a country’s central bank to finance public spending leads to artificial liquidity that generates inflation (price increases) and the collapse of its real purchasing power, which in international terms eventually leads to a devaluation.
Consequences of devaluation
A currency devaluation usually has adverse effects on the economy and on the holders of the devalued currency, which may include:
- Inflation and tariff increases. It is a consequence of the decrease in the purchasing power of the currency, since prices and rates lag behind the real value of transactions.
- Erosion of savings and wages. What before the devaluation represented a net international value (measurable in foreign currencies) will have been significantly reduced after the devaluation, so those who use the devalued currency become a little poorer.
- Debt liquefaction. Debts denominated in the devalued currency also lose value, transferring wealth from creditors to debtors, unless there are indexation clauses in the debt contract.
On the other hand, a timely devaluation can have positive effects on an economy in crisis, such as:
- More competitive exports. The sale of local products becomes more profitable, as the local currency (in which production processes are paid) is worth less compared to international markets (since the product is sold in foreign currency).
- Increase in tourism. If it is a tourist country, devaluation lowers the costs of the average tourist and makes their visit more attractive since their savings in foreign currency can be exchanged for more local currency.
- It makes imported products more expensive. The currency is worth less against the international currency, importing becomes more expensive and this can fuel domestic consumption of national products, provided there is a rise in wages.
Types of devaluation
There are the following forms of monetary devaluation:
- Competitive devaluation. Two countries competing (currency war) to position their currency above the other’s, favoring the balance of trade exchange in their country.
- Internal devaluation. In pursuit of increased competitiveness, an internal devaluation is based on a strategy of adjusting incomes and wages and reducing the deficit.
- Fiscal devaluation. This is the name given to the reduction of fiscal rates (taxes) by a State that seeks to promote exports and reduce local production costs.
Tequila Effect
It was called by this name Mexico’s economic crisis in 1994which had worldwide repercussions. It is also known in Mexico as “The December Error” and occurred during the presidency of Ernesto Zedillo.
It started with the lack of international reserves of this country, which drastically devalued the peso against the US dollar, leading to a wave of mass layoffs in Mexican companies that held debt in dollars and a massive flight of investors from the local market that quickly spread throughout the Latin American continent, as many investors feared that it was a block collapse of Latin America.
Vodka effect
The Russian financial crisis It was known by this name and took place in 1998, when the ruble (the local currency) was devalued as a result of the Asian financial crisis of the previous year and the fall in the price of raw materials (natural gas, oil, metals and wood) on which the Russian economy depended.
This crisis ended that same year but marked the beginning of the slowdown of the world economy.
Fixed exchange rate
When you talk about a fixed exchange raterefers to an exchange rate regime in which the value of a currency is adjusted according to that of another foreign currency that serves as a reference.
This stabilizes the value of the local currencyfacilitates trade and investments between the country whose currency serves as reference and the one that applies the exchange rate regime, but prevents the latter from using monetary policies to achieve macroeconomic stability.
Revaluation
Contrary to devaluation, revaluation implies the increase in the price of the local currency compared to the international marketunder a fixed exchange rate. Under a floating rate regime, the term is preferred appreciation.
In general It is given deliberatelyas an adjustment from a reference frame that can be a foreign currency or the basket of currencies of the entire world.
If the nominal value of the currency is altered without changing its exchange rate, this will be a monetary reconversion (equivalent to reinventing the currency) and not a revaluation.
Examples of devaluation
A very clear example of devaluation is The Venezuelan currency in the last decadewhen its reference value against the dollar fell dramatically despite the exchange control system implemented for almost twenty years in the Caribbean country.
So, The bolivar went from a (black) rate of 70 Bs. per dollar in 2014at 1,000 Bs. per dollar in 2016 and around 16,000 Bs. per dollar in 2017.