Currency Devaluation and its Likely Economic Effects – 101

4 February 2016


What is a currency devaluation?

The first thing to recognise is that a devaluation of a currency relative to other currencies only happens in a system where a fixed floating rate or a centrally managed floating rate exists. In the Republic of Trinidad and Tobago, we are essentially referring to a managed floating rate (this is often referred to in economic parlance as a “dirty-float”.

A devaluation – or for that matter a revaluation- amounts to an official change in the value of a country’s currency relative to all other international currencies under either a fixed or managed exchange rate system. This can be compared to a pure and automatic floating rate system where changes in the currency rate through either appreciation or depreciation occur automatically as a consequence of the interaction of the supply and demand for that currency.

Why do countries devalue their currencies?

When a central government takes a decision to devalue its currency under a fixed or managed float, it is often because economic events have made the current exchange rate effectively “indefensible”.

To understand this, one needs to understand that a fixed or managed float has to be defended.

In order to sustain a particular exchange rate, a country must have at its disposal a sufficient level of foreign exchange reserves (in the case of Trinidad and Tobago this means a sufficient supply of United States Dollars as this is by far Trinidad and Tobago’s largest trading partner) and the willingness to use them if necessary to purchase all offers of its currency at the established or managed rate of exchange.

In the event that a country is either unwilling (a recent example would be China) or unable (Venezuela) to maintain the current exchange rate, then a decision has to be taken to devalue its currency to a level that it is able (through the existence of enough foreign reserves) and willing to support.

The economic effects and implications of devaluation

There are a number of potential consequences arising from the devaluation of a currency:

  1. Devaluation potentially makes a country’s exports relatively less expensive for foreign consumers because the foreign consumer has to exchange less of his own currency to pay for the imported goods.
  2. Devaluation will potentially make foreign products imported into the domestic market more expensive for domestic consumers. In other words, imported goods appear less attractive to consumers when compared to domestically produced articles of a similar nature.
  3. Devaluation can cause higher economic growth in the domestic economy as consumers switch away from expensive imports towards comparatively cheaper domestically produced substitutes.
  4. Devaluation can result in inflation because imports become more expensive and if the importers of those products pass on the increased costs to consumers then “cost-push” inflation results. In addition, the increased demand for locally produced goods can increase the price of those goods in the event that supply does not rise to match the increased domestic demand. This is referred to as “demand-pull” inflation.

 

'The dollar fell against all major currencies this morning, and then, while getting up, bumped its head, REALLY HARD, on some sort of coffee table. I'm afraid that's all we have right now. Stay tuned for further updates.'

‘The dollar fell against all major currencies this morning, and then, while getting up, bumped its head, REALLY HARD, on some sort of coffee table. I’m afraid that’s all we have right now. Stay tuned for further updates.’

 

How effective are devaluations in practice?

The economic effectiveness of a devaluation as a tool to manage a domestic economy depends upon a number of factors.

  • The elasticity of demand for the country’s exports: Elasticity of demand is a measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. Elasticity of demand is calculated by dividing the % change in quantity demanded by the % change in price.

If a small change in price is accompanied by a large change in quantity demanded, the product is said to be elastic (demand is highly responsive to price changes). Conversely, a product is inelastic if a large change in price is accompanied by a small amount of change in the quantity demanded.

160204 Image 2

Applying this concept to the question of exports, if the demand for a country’s exports is inelastic then a fall in the price of the exports will lead a comparatively smaller rise in the quantity demanded. In this situation, the value of the exports may actually.

  • The elasticity of demand for the country’s imports: Again if demand for a country’s imports is price inelastic an increase in price may have little effect on the quantity demanded, and as a consequence, a devaluation in this situation would have little or no beneficial effect on the country’s balance of payments.

  • The state of the global economy: If taken as a whole the global economy is in a state of recession, then a devaluation is likely to have little effect on boosting export demand. However, if the global economy is not in recession the likely impact on export demand is, all things being equal, likely to be positive. The boost in demand can – if production levels are not increased – lead to inflation

  • The impact on inflation: The effect of a devaluation on inflation depends on a number of factors. In respect of domestically produced products, if there is spare capacity in the economy, then a devaluation is unlikely to cause inflation and should if demand for exports and domestic production in general is stimulated, increase the level of domestic trading activity.

In respect of imports into the country, inflation is likely to increase if the importers of those products choose to pass the increased import costs onto the end consumer. This is often referred to in economic parlance as “imported inflation”.

Depending on the economic situation we can conclude that there is a significant risk that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation in the right circumstances. If this happens in practice, the government may have to raise interest rates to “dampen-down” that inflation. This in turns can act as a break on economic growth as the cost of borrowing funds for new economic enterprises increases.

  • The psychological factors: Often devaluation is seen as a sign of economic weakness, and as a result can have an impact on the credit rating of the country. Effectively, devaluation can dampen potential investors confidence in a country’s economy and impact its ability to secure future foreign investment.

In the second part of this series we look at the history of the exchange rate in Trinidad and Tobago. The series concludes with the third part which addresses whether devaluation of the Trinidad and Tobago dollar against other major trading currencies is inevitable and address the consequences of such a devaluation.

160204 Image 3

Closing thoughts – its nearly time to chill out and play mas

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you!

Also please do not hesitate to take a look here at the indicative prices  as of today, February 4th, 2016.

Comments are closed.