Currency Devaluation: The Pros and Cons (2024)

Much has been said and debated over the recent decision by the government of PNG to introduce a currency devaluation intervention to its current floating exchange rate.

In this short write-up, I will explain in layman's terms what is currency devaluation, its relation to currency floatation and its positive and negative impact on the economy.

Devaluation of currency refers specifically to a deliberate and official downward adjustment in the value of a country's currency in relation to other currencies. In a devaluation, the government or the central bank takes a proactive decision to lower the exchange rate of the domestic currency. The primary aim of devaluation is to make the country's exports more competitive and increase their attractiveness in foreign markets. By reducing the value of the domestic currency, it takes fewer units of the local currency to buy a unit of a foreign currency, effectively lowering the price of domestic goods and services in foreign markets.

There are several reasons why governments resort to currency devaluation and these include:

1. Boost export competitiveness and increase export revenues.

2. Correct trade imbalances and improve the trade balance.

3. Stimulate economic growth and competitiveness in specific sectors.

The key difference between floating currency and devaluation is in how the exchange rate is determined. In a floating exchange rate regime, the exchange rate is determined by market forces without direct intervention from the central bank. On the other hand, devaluation is a deliberate action taken by the government or the central bank to adjust the exchange rate downward to achieve specific economic objectives, typically aimed at improving export competitiveness and addressing trade imbalances.

It's worth noting that a country with a floating exchange rate regime can still experience fluctuations in its currency's value due to market forces, without any deliberate devaluation action taken by the authorities. In contrast, a fixed exchange rate regime involves a government or central bank actively pegging the currency to a specific value, and devaluation would represent a change in that fixed value, as opposed to a market-driven fluctuation.

Pros of Currency Devaluation

Currency devaluation, when implemented strategically and in the right economic context, can offer certain advantages for a government and its economy. Here are some of the potential benefits:

1. Export Competitiveness: One of the primary objectives of currency devaluation is to boost a country's export competitiveness. A weaker domestic currency makes the country's goods and services cheaper in foreign markets when priced in foreign currencies. This can lead to increased demand for exports, which, in turn, can stimulate economic growth and create jobs in export-oriented industries.
2. Trade Balance Improvement: By increasing the competitiveness of exports and making imports relatively more expensive, devaluation can help improve the trade balance. A positive trade balance (where exports exceed imports) can contribute to economic stability and reduce reliance on foreign borrowing.
3. Domestic Industries Support: Devaluation can provide protection and support to domestic industries that compete with foreign imports. Cheaper domestic products can become more attractive to consumers, leading to increased demand for locally produced goods.
4. Tourism Boost: A weaker currency can make a country a more affordable destination for international tourists. This can lead to an increase in tourist arrivals, benefiting the hospitality and tourism sectors and generating foreign exchange earnings.
5. Debt Repayment Advantage: Countries with foreign-denominated debt may find it advantageous to devalue their currency. As the domestic currency weakens, it becomes cheaper for the government to repay foreign debt in terms of the local currency.
6. FDI Attraction: A devalued currency can make foreign direct investment (FDI) opportunities more attractive to foreign investors. Foreign companies may find it more cost-effective to invest in and set up operations in a country with a lower-valued currency.
7. Incentive for Domestic Production: Devaluation can incentivize domestic production and reduce reliance on imports. This can lead to the development of domestic industries and improve the country's self-sufficiency in certain sectors.
8. Inflationary Control: Devaluation can help reduce imported inflation, as it makes imported goods relatively more expensive. This can be beneficial in controlling overall inflation in the economy.
9. Balance Sheet Improvement: For exporters who generate revenue in foreign currencies, devaluation can lead to an improvement in their balance sheets when their foreign earnings are converted back into the local currency.

It is important to note that the advantages of currency devaluation are not universal and can vary depending on the economic circ*mstances and the overall policy framework of the country. Additionally, currency devaluation should be accompanied by appropriate policy measures to ensure long-term economic sustainability and prevent negative consequences, such as inflationary pressures and loss of investor confidence.

Cons of Currency Devaluation

While currency devaluation can have some potential benefits, it also comes with several disadvantages and challenges for a government and its economy. Here are some of the main disadvantages:

1. Imported Inflation: Devaluation leads to an increase in the cost of imports since it takes more units of the local currency to buy foreign currencies. This imported inflation can result in higher prices for imported goods, leading to a rise in the overall price level in the economy.
2. Reduced Purchasing Power: As the value of the domestic currency decreases, the purchasing power of consumers diminishes. This can lead to a decline in real wages and a decrease in the standard of living for citizens, particularly for those relying on fixed incomes.
3. High Cost of Imported Goods: As devaluation increases the cost of imports, it can create challenges for businesses that rely on imported raw materials and intermediate goods. Higher costs may lead to reduced profitability or higher prices for domestically produced goods.
4. Debt Burden: If a country has significant foreign-denominated debt, devaluation can increase the cost of servicing that debt. It effectively raises the repayment burden in terms of the domestic currency, potentially straining the government's finances.
5. Investor Uncertainty: Currency devaluation can create uncertainty for investors and foreign businesses operating in the country. Concerns about currency volatility may lead to reduced foreign investment, as investors may be wary of potential losses due to exchange rate fluctuations.
6. Capital Flight: A sudden or sharp devaluation can trigger capital flight, where investors and individuals move their assets out of the country in anticipation of further depreciation. This can destabilize the economy and create liquidity challenges.
7. Impact on Foreign Debt: If a country has foreign-denominated debt, devaluation can increase the effective value of that debt, making it more expensive to service.
8. Trade Retaliation: Devaluation can lead to accusations of currency manipulation by other trading partners, potentially resulting in trade disputes or retaliatory actions.
9. Loss of Confidence: A significant and abrupt devaluation can erode investor and consumer confidence in the country's economic stability and governance.
10. Inflationary Expectations: Devaluation can create expectations of further depreciation or inflation, which may lead to wage demands and price increases, exacerbating inflationary pressures.
11. Inequality: Devaluation can disproportionately affect vulnerable populations, particularly those who rely heavily on imported goods or foreign remittances.

It's important to note that the impact of currency devaluation varies depending on the overall economic conditions, government policies, and the country's trade and financial dynamics. While devaluation may provide short-term benefits, it is not a sustainable solution for addressing underlying structural issues in the economy. Governments need to carefully consider the potential disadvantages and implement comprehensive economic reforms to foster long-term economic stability and growth.

Such monetary policy interventions by the government and the central banks usually derive from a 'Conditionality Agreement' between an international financier and a national government in PNG's case the International Monetary Fund (IMF).