Advantages and Disadvantages of Devaluation - 3 Case Studies

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Wednesday, May 25, 2016  9.35AM / Tejvan Pettinger

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate. A devaluation means that the value of the currency falls. Domestic residents will find imports and foreign travel more expensive. However domestic exports will benefit from their exports becoming cheaper.

 

Advantages of devaluation

1.       Exports become cheaper and more competitive to foreign buyers. Therefore, this provides a boost for domestic demand and could lead to job creation in the export sector.

2.      Higher level of exports should lead to an improvement in the current account deficit. This is important if the country has a large current account deficit due to a lack of competitiveness.

3.      Higher exports and aggregate demand (AD) can lead to higher rates of economic growth.

 

Disadvantages of devaluation

1. Is likely to cause inflation because:

  • Imports more expensive (any imported good or raw material will increase in price)
  • AD increases causing demand pull inflation.
  • Firms / exporters have less incentive to cut costs because they can rely on the devaluation to improve competitiveness. The concern is in the long-term devaluation may lead to lower productivity because of the decline in incentives.

2. Reduces the purchasing power of citizens abroad. e.g. more expensive to go on holiday abroad.

3. A large and rapid devaluation may scare off international investors. It makes investors less willing to hold government debt because it is effectively reducing the value of their holdings.

4. If consumers have debts, e.g. mortgages in foreign currency – after a devaluation they will see a sharp rise in the cost of their debt repayments. This occurred in Hungary when many had taken out a mortgage in foreign currency.

 

The impact of a devaluation depends on many factors:

·         The state of business cycle – In a recession a devaluation can help boost growth without causing inflation. In a boom a devaluation is more likely to cause inflation.

·         Elasticity of demand. A devaluation may take a while to improve current account because demand is inelastic in the short term.

·         If the country has lost competitiveness in a fixed exchange rate, a devaluation could be beneficial in solving that decline in competitiveness.

 

CASE STUDIES

 

1. UK – 20% fall in value of Sterling in 2008/09

 

The pound fell considerably against the Euro.


See: Does a devaluation really help the economy?

 

2. Russian economic crisis – 2014

Fall in value of the Rouble – an example of the impact of the devaluation in the value of the Rouble on the Russian economy.

 

With economic sanctions and a plummeting price of oil, the Russian economy is seeing a real economic crisis. The value of the rouble is falling – causing inflation and a decline in living standards. Government tax revenues are falling as oil tax revenues decline. On top of a falling Rouble, the economy faces recession due to declining export revenues, falling real incomes, a collapse in confidence and higher interest rates.

 

Causes of Russian economic crisis:

Oil dependent economy. The Russian economy has done well in recent years from high oil and gas prices. This has led to strong export revenues and government tax revenues. In 2012, the oil and gas sector accounted for 52% of federal tax funds and 70% of exports But, the near 50% in oil prices have caused the economy to suffer. Unfortunately, the strength of the oil industry has meant alternative manufacturing industries remain undeveloped – and unable to benefit from more competitive export prices. The Russian oil economy is an example of the Dutch disease.

 

Falling oil prices. The oil price has collapsed from $115 a barrel in June 2014 to just above $60 in Dec 2014. Falling oil prices have caused a big fall in export revenue, a fall in real GDP and a fall in government tax revenues.

 

Economic sanctions. Sanctions imposed by the EU and US since the issues around the Ukraine have damaged the ability of some Russian firms to raise finance. On their own, the sanctions are quite limited in effect, but combined with the timing, they are a big blow to confidence in the Russian economy.

 

Recession. Due to the 50% devaluation in the Rouble, the price of imported goods has increased, leading to imported inflation. With inflation running at 9%, consumers are seeing a fall in real wages. Wages, pensions and benefits are not keeping up with rising cost of living. This is causing lower spending. The Central Bank faces a difficult dilemma – because of the recession it needs to cut interest rates, but the falling Rouble has caused it to increase interest rates to 17% – to try and protect the value of the Rouble – but, this will further reduce spending and lower growth. (See: effect of higher interest rates). With the oil and gas sector hit, big firms are likely to lay off workers, due to the fall in demand and revenue. This rise in unemployment will exacerbate the recession. It’s a tough combination of factors, which give the government and Central Bank little room for manoeuvre.


Source: Independent

 

Falling Rouble. Despite high foreign currency reserves, the Rouble has fallen in value, suggesting investors have lost confidence in the Russian Central Bank, the Russian economy and the Rouble. The problem of the falling confidence in the Rouble, is that it is encouraging capital flight

– where Russians seek to protect the value of their wealth  by transferring it into other currencies outside Russia. This is a toxic mix – a self-reinforcing cycle of falling Rouble, causing more people to give up on the Rouble. Usually a fall in the value of a currency could cause a boost to export demand and help economic growth. But, the economy has become reliant on the oil and gas industries and so the manufacturing export industry is quite weak and unable to benefit. 

Is the crisis likely to end?

1.       Russia had a very large $200bn trade surplus for 2014. This surplus is shrinking, but still it is better than the situation might suggest.

2.       The boom years did allow Russia to build up more than $400bn in foreign reserves.

3.       Russian manufacturing has received a boost – both from sanctions hitting import spending, and falling Rouble making exports cheaper. It will take time, but the crisis may help rebalance the Russian economy. It may also help the proceeds of economic growth to be distributed more equally. The gas and oil dependent economy lead to the creation of many billionaires. In 2014, 110 individuals owned 35% of Russian financial wealth. One of the highest levels of wealth inequality in the world.

4.       Do the West really want to see the Russian economy enter free fall? Putin may not be liked, but the uncertainty of any alternative may encourage them to prevent any real crisis which could destabilise the region further.

5.       The fall in the Rouble suggests it is not so much economic fundamentals as the ‘animal spirits’ of investors. If this negative cycle can be broken, the Rouble could stabilise on the economic fundamentals which have some positive benefits.

6.       The oil price has collapsed from $115 to $60, but it remains to be seen whether this is a permanent fall; the history of oil prices suggest it is notoriously volatile.

3. UK Exchange Rate Mechanism Crisis 1992



The exchange rate mechanism was designed as a precursor to joining the Euro. The aim was to keep exchange rates stable; it was hoped this would

·         Keep inflation low

·         Provide stability for exporters encouraging trade

·         Enable countries to make the leap to joining the Euro.


In the late 1980s, the chancellor, Nigel Lawson was keen to join the ERM. But, Mrs Thatcher with her euro-sceptic views wanted to stay out. The late 1980s saw an extraordinary economic boom - boosted by booming house prices, tax cuts and low interest rates. Growth reached record levels of 5-6% a year. Enthusiastic government ministers talked of an economic miracle - hoping Government policies had enabled, at long last, to catch up with other countries like Germany.



However, this miracle was an illusion. High growth was unsustainable and led to inflation.(see: Lawson Boom) With inflation of 10%, Nigel Lawson was able to convince Mrs Thatcher that the UK would benefit from joining the ERM to help reduce inflation.

Therefore, the UK joined in October 1990. at a rate of DM 2.95 to the Pound

However, the problem was that the economic situation was declining quickly. The UK was sliding into recession. High inflation and deteriorating economic activity was making the Pound less attractive. Therefore, the Pound kept falling to its lower limit in the ERM. Therefore, the government was bound to protect this value of the Pound by:

·         Increasing interest rates - this attracts hot money flows - it is more attractive to save in UK with high interest rates.

·         Buying pounds with foreign exchange reserves.


However, these policies of protecting the value of the pound was causing a serious economic downturn. High interest rates particularly hit the housing market. With rising house prices, many had taken out large mortgages to get on the property ladder (sound familiar?) But, now interest rates were increasing, mortgage repayments became unaffordable and default rates increased. Combined with rising unemployment from the recession, the housing market saw a dramatic fall in prices that was to last 4 years.

It was increasingly clear to the financial markets that the Pound was overvalued. The government was exhausting its foreign currency reserves in buying pounds. But, more problematically, the high interest rates was causing a serious recession and misery for homeowners.

Financial speculators like George Soros predicted the Pound was doomed, so they were keen to sell their pounds to the British government.(It is said George Soros made £1 billion out of the UK government)

It became a question of pride for Ministers, with Norman Lamont and John Major pledging to keep the UK in the ERM, seemingly at all costs.




For a long time, the British government fought a losing battle. But, the foreign currency reserves of the British government were no match for the trillions of Pound Sterling traded on the foreign currency and the pound kept sliding. It is estimated that the Treasury used £27billion of foreign currency reserves trying to prop up the Pound. The Treasury estimated the final cost to the taxpayer was estimated at £3.4billion

On one desperate day - Wednesday 16th September, the UK government increased interest rates to 15%. In theory, these high interest rates should attract hot money flows. But, the market saw it for what it was - a measure of desperation. The market knew these were fantasy interest rates which couldn't be maintained, the sell off continued and eventually, the government caved into the inevitable and left the ERM. The Pound fell 15%, interest rates were cut, and the economy was able to recover.

It is a classic example, of failed government policy. If the UK had joined the ERM at a high level at the start of the boom, the anti inflationary impact would have helped moderate the boom, keep inflation low and prevent a painful readjustment. But, they joined at the wrong rate at the wrong time. Trying to keep the Pound artificially high caused a recession, deeper than any of our competitors. The artificially high exchange rate just attracted financial speculators who saw the British government as a source of easy profit.

On leaving the ERM, the UK economy soon recovered, but, it left painful scars and played a key role in keeping the UK out of the Euro. It also shows the mistake of targeting inflation through an intermediary such as the exchange rate. As a consequence of this episode, the government gave the Bank a direct inflation target of 2.5%. They also paved the way to given the Bank independence in 1997. The hope was that an independent bank would avoid the excesses of the Lawson boom and bust of the 1980s.

Unemployment



The rise in unemployment from 1990 to 1993 was partly due to the impact of higher interest rates and attempts to keep the Pound in the ERM. 

Economic growth



Leaving the ERM in September 1982 enabled the government to cut interest rates and the economy to recover.

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