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It refers to decline in value of a currency with respect to other currencies, which is most of the times brought by central bank. It should not be confused with term depreciation of currency which is a decline in currency value due to market forces without interference of government. When does this happen and how? This happens mostly in developing countries which don’t allow currency prices to be determined by market forces. What happens is that they want to avoid financial crisis, for which they adopt policies to maintain a stable exchange rate to minimize exchange rate risk and save their gold (foreign currency) reserves.
Restrictions placed are either trade barriers or financial. Financial restrictions are on flow of assets or money across border which is associated with policy of fixed exchange rate or managed exchange rate. The nation will be forced to devalue its currency if its market is too weak to justify the exchange rate. Example a country has depleted foreign reserves and is not credit worthy to borrow from IMF then it has to pay for its imports by devaluation. When currency is overvalued or a country wants to reduce trade deficit then devaluation is used as a policy tool.
Advantages of Devaluation One of the major advantages of devaluation is increased exports and reduced imports which in turn result in economic growth of the country. Let me explain now how this happens. As central bank announces loosening of monetary policy, participants in foreign exchange market start selling domestic currency leading to depreciation. As a result producers who want to export their products start producing more and start approaching commercial banks which due to loosening of monetary policy are happy to extend credit at lower interest rate. The fall in exchange rate leads to increased competitiveness at international level.
Due to fall in value of currency imports become expensive and thus are reduced while exports are increased because products are sold at cheaper rate. This increases the inflow of foreign currency and reduced trade deficit. The benefits from devaluation of currency are: * Exports become more competitive, since better quality is available at a cheaper rate leading to increased demand for exports. * Increased exports help in economic growth through employment, inflow of foreign currency * Increased demand of domestic goods and services because of reduced imports which become expensive due to devaluation. As more exports are sold, and if demand of exports is elastic then it leads to improvement in current account and reduced trade deficit.
Devaluation of Rupee in 1966 and 1991 India devalued its currency in 1966 and in 1991. 1966 devaluation was result of major financial crises faced by Indian government. By that time inflation had caused Indian prices to become much higher than world prices. Trade deficits increased in magnitude till 1966 since 1950s and due to budget deficit problem India could not borrow money from abroad or from market.
Then govt. ad to issue bonds to RBI which increased money supply. Policies of export subsidization and import tariffs helped in increasing exports and reducing imports during that time. In 1990 Govt. of India found itself in serious economic trouble, it was close to default and it foreign reserves had dried up to the extent that it could barely finance three week’s imports. Large budget deficit, poor balance of payments, fixed exchange rate policy led to the trouble. Even though exports of the country grew in 1980s but imports and interest payments grew faster resulting in consistent current account deficit.
Due to pressure of deficits and increasing inflation India had to devalue its currency in 1991. Although this policy of devaluation certainly has some benefits but they are received after a certain period. This has been supported by J-curve theory an explanation of change in a country’s trade balance in response to a sudden substantial devaluation of currency. We know that current account CA= EX- IM i. e. exports minus imports of the country and obviously with depreciation if exports increase and imports decrease CA should rise but in real world this does not happen exactly as stated.
In many instances depreciation in currency tend to cause a temporary increase in deficit rather than decrease which is explained by the J curve theory. we can see from the graph that when exchange rate falls instead of increasing CA decreases till t2 from t1 and then starts rising . After t2 CA balance reverses direction and starts rising forming a J curve. This period from t1 to t2 is around one to two years. This is because most of the trade take place in the form of contracts which are set in advance and have fixed local prices and quantities.
Due to fixed contract terms, all importers are not able to hedge their trade through forward contracts. Fall in exchange rate results in immediate rise in value of imports but since quantity don’t change immediately CA balance falls initially in time period between t1 and t2. As the contracts are renegotiated traders adjust quantities demanded and ultimately demand of imports fall. Similarly when export contracts are renegotiated, exports appear cheaper and their demand rises. Change in quantities causes rise of CA balance.