Currency Devaluation
When you ask a layperson if it’s in a country’s interest to reduce the value of their own currency, more often than not we would hear a resounding no. It’s obvious, isn’t it? The more your currency is worth as compared to those of other countries, the wealthier your country is. This raises the question: why do countries with larger economies like China and Japan have currencies that aren’t as valuable as, for example, the British Pound? Moreover, why was it that China intentionally devalued theirs multiple times?
Trade Surplus and Deficit
A country usually wants to export everything under the sun while importing the bare minimum to have what’s called the trade surplus. Meaning they would like to encourage their citizens to consume products from the domestic market while also selling their products to citizens of other nations. To tip the scales in favour of the domestic market, a government usually employs tariffs so that imported goods are costlier compared to domestically manufactured goods. But levying a tariff costs political capital. There is the threat of retaliatory tariffs, worsened relations, and the lot. Moreover, the pressure from the WTO can discourage them from doing so as well. So a country can find underhanded ways to give a boost to the local economy. One such method is currency devaluation.
How Does It Help?
By devaluing its currency, a government will effectively make its population poorer to the rest of the world. The money they have buys fewer products from other countries, all other things being equal. On the other hand, exports from the country are cheaper. The same amount of foreign currency can buy more goods and services. Their internal economy is not directly affected, though, since everyone is impoverished to the same extent.
The Catch
A nation can devalue its currency only if it is pegged to other currencies. For example, the Chinese Yuan is pegged to the US Dollar. Here, the Chinese government declares that one US Dollar would get them a certain amount of Chinese Yuan. This is unlike free-floating currencies like the Indian Rupee, for instance, where the RBI does not set the value of the Rupee. Market forces determine its worth. The issue with having a currency pegged to another is that the government has to maintain cash reserves for all the other currencies. The Chinese government has to be able to provide the cash if someone wishes to convert the Yuan to US Dollars. And this can get expensive. There is some relief in that other people can trade amongst themselves based on the rate set by the government. But there is still a deadweight loss from not allowing the free market to operate at its efficient best via exerting such control.
The decision to devalue their currency, therefore, rests on whether a government deems the short term boost to the domestic market worth the cost borne due to the deadweight loss. All in all, the effect of currency devaluation is not too different from levying blanket tariffs on all imports into a country.
– Shreekara Guruprasad
