Devaluation: What It Is and How It Works

What Is Devaluation?

Devaluation is the deliberate downward adjustment of the value of a country's money relative to another currency or standard. It is a monetary policy tool used by countries with a fixed exchange rate or semi-fixed exchange rate.

Devaluation Strategy

By devaluing its currency, a country makes its money cheaper and boosts exports, rendering them more competitive in the global market. Conversely, foreign products become more expensive, so the demand for imports falls. Governments use devaluation to combat a trade imbalance and have exports exceed imports.

As exports increase and imports decrease, there is typically a better balance of payments as the trade deficit shrinks. A country that devalues its currency can reduce its deficit because of the greater demand for its less expensive exports.

Consequences of Devaluation

While devaluing a currency may be an option, it can have negative consequences.

• Increasing the price of imports protects domestic industries, but they may become less efficient without the pressure of competition.
• Higher exports relative to imports can also increase aggregate demand, leading to inflation.
• Manufacturers may have less incentive to cut costs because exports are cheaper, increasing the cost of products and services over time.
  

Currency Wars

There has been historical conflict between countries such as China and the United States over the valuation of their currencies. A monetary policy that stresses devaluation allows a country to remain competitive in the global trading marketplace. Devaluation also encourages investment, drawing in foreign investors to cheaper assets.

The Omnibus Trade and Competitiveness Act of 1988 requires the U.S. Secretary of the Treasury to analyze the exchange rate policies of other countries and determine if they are manipulating the exchange rate between their currency and the United States dollar. In 2019, Secretary Mnuchin found that China devalued its currency to gain an unfair competitive advantage in international trade.

However, in 2023, following several years of trade woes caused by the COVID-19 pandemic, China’s central bank hopes to keep the Chinese yuan from weakening too quickly against the U.S. dollar as imports are becoming more expensive relative to its exports. The offshore yuan traded around 7.15 per dollar in May 2023, and Chinese exports fell more than expected, reflecting the country’s slow recovery path.

The Bottom Line

Devaluation occurs when a country creates a downward adjustment of its currency value to balance trade. Devaluing a currency reduces the cost of a country's exports and makes imports less attractive. As exports increase and imports decrease, there is typically a better balance of payments as the trade deficit shrinks.