How do Countries Devalue Their Currencies
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Countries devalue their currencies only when they have no other way to
correct past economic mistakes - whether their own or mistakes committed by
The ills of a devaluation are still at least equal to its advantages.
True, it does encourage exports and discourage imports to some extents and
for a limited period of time. As the devaluation is manifested in a higher
inflation, even this temporary relief is eroded. In a previous article in this
paper I described WHY governments resort to such a drastic measure. This article
will deal with HOW they do it.
A government can be forced into a devaluation by an ominous trade deficit.
Thailand, Mexico, the Czech Republic - all devalued strongly, willingly or
unwillingly, after their trade deficits exceeded 8% of the GDP. It can decide to
devalue as part of an economic package of measures which is likely to include a
freeze on wages, on government expenses and on fees charged by the government
for the provision of public services. This, partly, has been the case in
Macedonia. In extreme cases and when the government refuses to respond to market
signals of economic distress - it may be forced into devaluation. International
and local speculators will buy foreign exchange from the government until its
reserves are depleted and it has no money even to import basic staples and other
Thus coerced, the government has no choice but to devalue and buy back dearly
the foreign exchange that it has sold to the speculators cheaply.
In general, there are two known exchange rate systems: the floating and the
In the floating system, the local currency is allowed to fluctuate freely
against other currencies and its exchange rate is determined by market forces
within a loosely regulated foreign exchange domestic (or international) market.
Such currencies need not necessarily be fully convertible but some measure of
free convertibility is a sine qua non.
In the fixed system, the rates are centrally determined (usually by the
Central Bank or by the Currency Board where it supplants this function of the
Central Bank). The rates are determined periodically (normally, daily) and
revolve around a "peg" with very tiny variations.
Life being more complicated than any economic system, there are no "pure
Even in floating rate systems, Central banks intervene to protect their
currencies or to move them to an exchange rate deemed favourable (to the
country's economy) or "fair". The market's invisible hand is often handcuffed by
"We-Know-Better" Central Bankers. This usually leads to disastrous (and
breathtakingly costly) consequences. Suffice it to mention the Pound Sterling
debacle in 1992 and the billion dollars made overnight by the
arbitrageur-speculator Soros - both a direct result of such misguided policy and
Floating rates are considered a protection against deteriorating terms of
If export prices fall or import prices surge - the exchange rate will adjust
itself to reflect the new flows of currencies. The resulting devaluation will
restore the equilibrium.
Floating rates are also good as a protection against "hot" (speculative)
foreign capital looking to make a quick killing and vanish. As they buy the
currency, speculators will have to pay more expensively, due to an upward
adjustment in the exchange rates. Conversely, when they will try to cash their
profits, they will be penalized by a new exchange rate.
So, floating rates are ideal for countries with volatile export prices and
speculative capital flows. This characterizes most of the emerging economies
(also known as the Third World).
It looks surprising that only a very small minority of these states has them
until one recalls their high rates of inflation. Nothing like a fixed rate
(coupled with consistent and prudent economic policies) to quell inflationary
expectations. Pegged rates also help maintain a constant level of foreign
exchange reserves, at least as long as the government does not stray from sound
macro-economic management. It is impossible to over-estimate the importance of
the stability and predictability which are a result of fixed rates: investors,
businessmen and traders can plan ahead, protect themselves by hedging and
concentrate on long term growth.
It is not that a fixed exchange rate is forever. Currencies - in all types of
rate determination systems - move against one another to reflect new economic
realities or expectations regarding such realities. Only the pace of changing
the exchange rates is different.
Countries have invented numerous mechanisms to deal with exchange rates
Many countries (Argentina, Bulgaria) have currency boards. This mechanism
ensures that all the local currency in circulation is covered by foreign
exchange reserves in the coffers of the Central bank. All, government, and
Central Bank alike - cannot print money and must operate within the
Other countries peg their currency to a basket of currencies. The composition
of this basket is supposed to reflect the composition of the country's
international trade. Unfortunately, it rarely does and when it does, it is
rarely updated (as is the case in Israel). Most countries peg their currencies
to arbitrary baskets of currencies in which the dominant currency is a "hard,
reputable" currency such as the US dollar. This is the case with the Thai baht.
In Slovakia the basket is made up of two currencies only (40% dollar and 60%
DEM) and the Slovak crown is free to move 7% up and down, around the basket-peg.
Some countries have a "crawling peg". This is an exchange rate, linked to
other currencies, which is fractionally changed daily. The currency is devalued
at a rate set in advance and made known to the public (transparent). A close
variant is the "crawling band" (used in Israel and in some countries in South
America). The exchange rate is allowed to move within a band, above and below a
central peg which, in itself depreciates daily at a preset rate.
This pre-determined rate reflects a planned real devaluation over and above
the inflation rate.
It denotes the country's intention to encourage its exports without rocking
the whole monetary boat. It also signals to the markets that the government is
bent on taming inflation.
So, there is no agreement among economists. It is clear that fixed rate
systems have cut down inflation almost miraculously. The example of Argentina is
prominent: from 27% a month (1991) to 1% a year (1997)!!!
The problem is that this system creates a growing disparity between the
stable exchange rate - and the level of inflation which goes down slowly. This,
in effect, is the opposite of devaluation - the local currency appreciates,
becomes stronger. Real exchange rates strengthen by 42% (the Czech Republic),
26% (Brazil), even 50% (Israel until lately, despite the fact that the exchange
rate system there is hardly fixed). This has a disastrous effect on the trade
deficit: it balloons and consumes 4-10% of the GDP.
This phenomenon does not happen in non-fixed systems. Especially benign are
the crawling peg and the crawling band systems which keep apace with inflation
and do not let the currency appreciate against the currencies of major trading
partners. Even then, the important question is the composition of the pegging
basket. If the exchange rate is linked to one major currency - the local
currency will appreciate and depreciate together with that major currency. In a
way the inflation of the major currency is thus imported through the foreign
exchange mechanism. This is what happened in Thailand when the dollar got
stronger in the world markets.
In other words, the design of the pegging and exchange rate system is the
In a crawling band system - the wider the band, the less the volatility of
the exchange rate. This European Monetary System (EMS - ERM), known as "The
Snake", had to realign itself a few times during the 1990s and each time the
solution was to widen the bands within which the exchange rates were allowed to
fluctuate. Israel had to do it twice. On June 18th, the band was
doubled and the Shekel can go up and down by 10% in each direction.
But fixed exchange rates offer other problems. The strengthening real
exchange rate attracts foreign capital. This is not the kind of foreign capital
that countries are looking for. It is not Foreign Direct Investment (FDI). It is
speculative, hot money in pursuit of ever higher returns. It aims to benefit
from the stability of the exchange rate - and from the high interest rates paid
on deposits in local currency.
Let us study an example: if a foreign investor were to convert 100,000 DEM to
Israeli Shekels last year and invest them in a liquid deposit with an Israeli
bank - he will have ended up earning an interest rate of 12% annually. The
exchange rate did not change appreciably - so he would have needed the same
amount of Shekels to buy his DEM back. On his Shekel deposit he would have
earned between 12-16%, all net, tax free profit.
No wonder that Israel's foreign exchange reserves doubled themselves in the
preceding 18 months. This phenomenon happened all over the globe, from Mexico to
This kind of foreign capital expands the money supply (it is converted to
local currency) and - when it suddenly evaporates - prices and wages collapse.
Thus it tends to exacerbate the natural inflationary-deflationary cycles in
emerging economies. Measures like control on capital inflows, taxing them are
useless in a global economy with global capital markets.
They also deter foreign investors and distort the allocation of economic
The other option is "sterilization": selling government bonds and thus
absorbing the monetary overflow or maintaining high interest rates to prevent a
capital drain. Both measures have adverse economic effects, tend to corrupt and
destroy the banking and financial infrastructure and are expensive while
bringing only temporary relief.
Where floating rate systems are applied, wages and prices can move freely.
The market mechanisms are trusted to adjust the exchange rates. In fixed rate
systems, taxes move freely. The state, having voluntarily given up one of the
tools used in fine tuning the economy (the exchange rate) - must resort to
fiscal rigor, tightening fiscal policy (=collect more taxes) to absorb liquidity
and rein in demand when foreign capital comes flowing in.
In the absence of fiscal discipline, a fixed exchange rate will explode in
the face of the decision makers either in the form of forced devaluation or in
the form of massive capital outflows.
After all, what is wrong with volatile exchange rates? Why must they be
fixed, save for psychological reasons? The West has never prospered as it does
nowadays, in the era of floating rates. Trade, investment - all the areas of
economic activity which were supposed to be influenced by exchange rate
volatility - are experiencing a continuous big bang. That daily small
fluctuations (even in a devaluation trend) are better than a big one time
devaluation in restoring investor and business confidence is an axiom. That
there is no such thing as a pure floating rate system (Central Banks always
intervene to limit what they regard as excessive fluctuations) - is also agreed
on all economists.
That exchange rate management is no substitute for sound macro-
and micro-economic practices and policies - is the most important lesson. After
all, a currency is the reflection of the country in which it is legal tender. It
stores all the data about that country and their appraisal. A currency is a
unique package of past and future with serious implications on the present.
About the Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and
"After the Rain - How the West Lost the East". He is a columnist in "Central
Europe Review", United Press International (UPI) and ebookweb.org and the editor
of mental health and Central East Europe categories in The Open Directory,
Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor
to the Government of Macedonia.
His web site: http://samvak.tripod.com
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Article Published/Sorted/Amended on Scopulus 2007-11-04 00:08:13 in Economic Articles