Currency devaluation: Reasons and effects
The massive devaluation of the Naira by the CBN has left Nigerians scratching their heads and each others head. As they ponder the fate of the Naira, and why so many on fixed income see a rapid erosion of their purchasing power, the Council now feels compelled to provide elucidation. While this effort may not provide any relief of collective anxiety, it should provide a sense of direction.
At the Bretton Woods Conference in July 1944, international leaders sought to insure a stable post-war international economic environment by creating a fixed exchange rate system. The United States played a leading role in the new arrangement, with the value of other currencies fixed in relation to the dollar and the value of the dollar fixed in terms of gold—$35 an ounce. Following the Bretton Woods agreement, the United States authorities took actions to hold down the growth of foreign central bank dollar reserves to reduce the pressure for conversion of official dollar holdings into gold.
During the mid- to late-1960s, the United States experienced a period of rising inflation. Because currencies could not fluctuate to reflect the shift in relative macroeconomic conditions between the United States and other nations, the system of fixed exchange rates came under pressure.
In 1973, the United States officially ended its adherence to the gold standard. Many other industrialized nations also switched from a system of fixed exchange rates to a system of floating rates. Since 1973, exchange rates for most industrialized countries have floated, or fluctuated, according to the supply of and demand for different currencies in international markets. An increase in the value of a currency is known as appreciation, and a decrease as depreciation. Some countries and some groups of countries, however, continue to use fixed exchange rates to help to achieve economic goals, such as price stability.
Under a fixed exchange rate system, only a decision by a country’s government or monetary authority can alter the official value of the currency. Governments do, occasionally, take such measures, often in response to unusual market pressures. Devaluation, the deliberate downward adjustment in the official exchange rate, reduces the currency’s value; in contrast, a revaluation is an upward change in the currency’s value.
For example, suppose a government has set 10 units of its currency equal to one dollar. To devalue, it might announce that from now on 20 of its currency units will be equal to one dollar. This would make its currency half as expensive to Americans, and the U.S. dollar twice as expensive in the devaluing country. To revalue, the government might change the rate from 10 units to one dollar to five units to one dollar; this would make the currency twice as expensive to Americans, and the dollar half as costly at home.
Under What Circumstances Might a Country Devalue? When a government devalues its currency, it is often because the interaction of market forces and policy decisions has made the currency’s fixed exchange rate untenable. In order to sustain a fixed exchange rate, a country must have sufficient foreign exchange reserves, often dollars, and be willing to spend them, to purchase all offers of its currency at the established exchange rate. When a country is unable or unwilling to do so, then it must devalue its currency to a level that it is able and willing to support with its foreign exchange reserves.
A key effect of devaluation is that it makes the domestic currency cheaper relative to other currencies. There are two implications of a devaluation. First, devaluation makes the country’s exports relatively less expensive for foreigners. Second, the devaluation makes foreign products relatively more expensive for domestic consumers, thus discouraging imports. This may help to increase the country’s exports and decrease imports, and may therefore help to reduce the current account deficit.
There are other policy issues that might lead a country to change its fixed exchange rate. For example, rather than implementing unpopular fiscal spending policies, a government might try to use devaluation to boost aggregate demand in the economy in an effort to fight unemployment. Revaluation, which makes a currency more expensive, might be undertaken in an effort to reduce a current account surplus, where exports exceed imports, or to attempt to contain inflationary pressures.
Effects of Devaluation
A significant danger is that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government may have to raise interest rates to control inflation, but at the cost of slower economic growth.
Another risk of devaluation is psychological. To the extent that devaluation is viewed as a sign of economic weakness, the creditworthiness of the nation may be jeopardized. Thus, devaluation may dampen investor confidence in the country’s economy and hurt the country’s ability to secure foreign investment.
Another possible consequence is a round of successive devaluations. For instance, trading partners may become concerned that a devaluation might negatively affect their own export industries. Neighboring countries might devalue their own currencies to offset the effects of their trading partner’s devaluation. Such “beggar thy neighbor” policies tend to exacerbate economic difficulties by creating instability in broader financial markets.
Since the 1930s, various international organizations such as the International Monetary Fund (IMF) have been established to help nations coordinate their trade and foreign exchange policies and thereby avoid successive rounds of devaluation and retaliation. The 1976 revision of Article IV of the IMF charter encourages policymakers to avoid “manipulating exchange rates…to gain an unfair competitive advantage over other members.” With this revision, the IMF also set forth each member nation’s right to freely choose an exchange rate system.
Under a fixed exchange rate system, devaluation and revaluation are official changes in the value of a country’s currency relative to other currencies. Under a floating exchange rate system, market forces generate changes in the value of the currency, known as currency depreciation or appreciation.
In a fixed exchange rate system, both devaluation and revaluation can be conducted by policymakers, usually motivated by market pressures.