If you have ever traveled abroad, you know that exchange rates can fluctuate. When it comes time to convert currencies, you may receive more or less than the amount you expected or planned for. Sometimes, this discrepancy is a result of a currency devaluation. Understanding devaluation and how it can affect you are not only important for tourists traveling overseas; investors whose securities have exposure to more than one currency need to understand devaluation, too. Here are the basics of what you need to know. Consider working with a financial advisor to make sure your portfolio is as protected as possible from devaluation.
What is Devaluation?
Devaluation is an intentional change to the value of the currency in a country. The country’s government or central bank makes this adjustment according to or based on the value of other currencies in the world. The monetary authority of a nation with a fixed or semi-fixed exchange rate may use this tool to change the balance of trade with another country for various reasons, such as increasing exports or decreasing imports.
Countries that use free-floating currency, or a floating exchange rate, cannot devalue their currency. In their case, it only appreciates and depreciates according to market forces. Some of the countries with this exchange rate policy include the U.S. and Japan.
Keep in mind: While they sound similar, devaluation and depreciation are different. Devaluation is purposeful, whereas depreciation is not. In the latter’s case, trends and forces within the market forcefully lower the currency’s value.
Say Country A and Country B trade together. Country B’s currency trades at a fixed exchange rate of 10 units to 1 of Country A’s currency. If Country B wants to devalue its currency, it may take the ratio of 10:1 and make it 20:1. So, 20 units in Country B will equal 1 unit in Country A. That makes it more expensive for residents of Country B to import items from Country A, thus tending to limit such imports. On the other hand, it also tends to make exports from Country B less expensive, thus tending to boost such exports.
Consider China. Its central bank, the People’s Bank of China (PBOC), sets daily exchange rates for its currency, the yuan. In 2019, the PBOC devalued the yuan, making its exchange rate 7 yuan to 1 U.S. dollar. In effect, it cost less money for those using U.S. dollars to purchase Chinese exports. However, moves like this may not always be well received by the international community. The U.S. leveled criticism at China, calling its actions currency manipulation.
How Devaluation Affects the Economy
When a currency has a higher value compared to others on the foreign exchange market, it is considered strong. A strong currency sounds better on the surface; it makes traveling abroad and imports cheaper. But that status also comes with downsides. Namely, it makes exports more expensive, which can reduce those exports. Devaluation, on the other hand, leads to a weaker currency, one that is relatively lower in value. This allows the country to export more easily because its goods are less expensive on the international market and may boost the domestic economy. But it also tends to make it more expensive for residents to travel outside their country.
Since the country focuses on selling more goods than they are bringing in (or make it harder to buy imports), devaluation tends to support higher employment and generates GDP growth. There is also a possible impact on the country’s domestic markets, like housing, which results in greater domestic consumption.
Advantages to Devaluation
By now you may be able to see why devaluation of a currency may help a nation. Countries devalue their currency to improve trade imbalances, which can better their economy. That is because one of the key effects of devaluation is increased attraction to a country’s exports.
Since the currency decreased in value, it can compete more competitively in global markets. This may spur higher volumes of exporting, which help promote economic growth. Although this also increases the costs of imports, it can encourage residents to purchase locally.
Additionally, the cheaper currency makes it easier for investors. A currency with a lower value appeals to foreign traders because it makes the stock market less expensive.
Disadvantages to Devaluation
While devaluation can help in some respects, it may have consequences in the long run. The practice could lead to inflation. Since a country essentially raises the value of a trading partner’s currency in the process of devaluation, it makes imports more expensive. So, prices will rise on items brought in from other countries. A government may have to raise interest rates to combat the inflation.
On a more global scale, it is also possible for a “currency war” to break out. This typically occurs between fixed or managed exchange rate countries. In this scenario, a country sees a trading partner lower its currency value. The first country then believes that will hurt its own export industries, so it devalues its own currency to offset the other’s. That sets off a domino effect between multiple nations. Countries follow this pattern to gain a competitive edge, possibly ending in tension or a trade war.
Many countries rely on devaluation as a strategic tool. By lowering their currency’s value, they may boost their exports, which helps domestic industries and employment. However, devaluation has its disadvantages, both globally and domestically. Internal interest rates may rise to combat inflation, and trading partners could be drawn into a downward spiral of currency devaluations so as not to lose a competitive advantage.
Tips for Investors
- Consider working with a financial advisor as you evaluate possible impacts on your investments from currency devaluation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s advisor matching tool can connect you with professionals in your area in just minutes. If you’re ready, get started now.
- Inflation can cause securities to depreciate. Use a free inflation calculator to gauge the buying power of the dollar over time.
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