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Science & Technology
- GS 3 || Economy || External Sector || Foreign Trade
Why do you mean by Devaluation?
- Devaluation is the deliberate downward adjustment of the value of a country’s money relative to another currency, group of currencies, or currency standard. Countries that have a fixed exchange rate or semi-fixed exchange rate use this monetary policy tool.
- When the value of the currency falls under the Floating Rate System, it is called depreciation.
- Devaluation means reduction in the external value of the domestic currency while internal value of the domestic currency remains constant. A country goes for devaluation of its currency to correct its adverse Balance of Payment (BOP).
- Exchange rate means the price of a nation’s currency in terms of another currency.The market in which the currencies of various countries are exchanged, traded or converted is called the foreign exchange market.
- Devaluation of a currency is associated with countries having a fixed exchange rate regime. Under the fixed rate regime, the central bank or the government decides the value of the currency with respect to other foreign currencies.
- The central bank or the government purchases or sells its currencies to maintain the exchange rate. When the government or the central bank reduces the value of its currency, then it is known as the devaluation of the currency. Under this, the value of the domestic currency is deliberately reduced in terms of other foreign currencies.
- For example, in 1966 when India was following the fixed exchange rate regime, the Indian Rupee was devalued by 36 %.
History of Devaluation of Indian Rupee
- Devaluation of the Indian Rupee took place 3 times since 1947.
- At the time of independence, one can buy a dollar with one Indian rupee but today one has to spend 75 rupees to buy a dollar.
Why the value of the Indian currency declined against the US dollar?
- There were no external loans on India’s balance sheet at the time of independence. However, after the British left India, the Indian economy became paralyzed due to a lack of capital formation and proper planning.
- A lack of funds in the hands of the government
- Faced with a financial crisis, Prime Minister Nehru adopted the Russian model of five-year plans. From the 1950s to the 1960s, the Indian government borrowed foreign money in the form of loans regularly.
- Wars with China and Pakistan
- The Indian government was facing a budget deficit and was unable to borrow additional funds from outside sources due to a negative savings rate. The 1962 India-China war, the 1965 Indo-Pakistan war, and a massive drought in 1966 all crippled the Indian economy’s production capacity, causing inflation to rise.
- To boost domestic production, the Indian government-required technology. To combat higher inflation and open the Indian economy to foreign trade, the government devalued the rupee’s external value.
- The exchange rate was changed to 1 $- Rs. 7.
- Political Instability and the 1973 Oil Shock
- The 1973 oil shock occurred when the Organization of Arab Petroleum Exporting Countries (OAPEC) decided to reduce crude oil production, which increased the cost of oil imports. As a result, to pay the import bill, India borrowed foreign currency, lowering the value of the Indian currency.
- The assassination of Prime Minister Indira Gandhi also lowered foreigners’ confidence in the Indian economy.
- 1991 Economic crisis
- In 1991, India still had a fixed exchange system, where the rupee was pegged to the value of a basket of currencies of major trading partners.
- India started having a balance of payments problems in 1985, and by the end of 1990, it found itself in serious economic trouble.
- The government was close to default and its foreign exchange reserves had dried up to the point that India could barely finance three weeks’ worth of imports.
- As in 1966, India faced high inflation and large government budget deficits. This led the government to devalue the rupee.
- At the end of 1999, the Indian Rupee was devalued considerably.
Currency depreciation around the world
- The dollar has risen sharply against the majority of the world’s currencies.
- For example, it has risen against both the euro and the pound. Because of their relatively unstable political and economic conditions, developing countries have lost portfolio investment.
- Reducing deficit-Devaluation has historically been used to reduce the balance of payments deficit. The currency was devalued to lower export prices by making them more competitive. In addition, imports into the country became more expensive, and their volume in the economy decreased.
- 1949 devaluation-At the outbreak of World War II, to stabilize sterling, the pound was pegged to the US dollar at the rate of $4.03 with exchange controls restricting convertibility volumes.
- China devalued its currency twice within two days by 1.9% and 1% in July 2015.
- India devalued its currency by 35% in 1966
Main causes for the Decline of world currencies
- Reposition in global capital: Following the announcement of a massive reduction in corporate tax rates and rising interest rates, the U.S. economy has become a more appealing option for global capital investors.
- Investors attracted by higher yields in the United States have been withdrawing capital from India at an increasing rate in recent months.
- Falling of crude prices of oil
- One of the reasons for the rupee’s decline is the rise in international crude oil prices, as importers have had to pay more dollars to fund their purchases.
- India imports roughly 80% of its petroleum requirements. The country has been unable to find sustainable domestic energy sources to reduce its reliance on oil imports. As a result, the rise in the price of oil has traditionally put enormous strain on the current account deficit and the currency, as it is doing now.
Pros of currency devaluation
- To increase exports and increase economic growth
- Devaluation of currency makes export cheaper and import costlier which ultimately improves the Balance of Payment of the domestic country.
- For example, China recently devalued its currency to make its goods more affordable in the international market. This was done to increase its overall exports and make its goods more competitive in the global market. This can also boost the country’s economic growth rate due to higher exports and an increase in aggregate demand and the economy.
- Reducing trade deficits
- A country’s exports become cheaper while imports become more expensive. As a result, exports increase while imports decrease.
- This situation favors a better balance of payments and lowers trade deficits. Countries with persistent trade deficits devalue their currencies to correct their balance of payments and reduce their deficits.
- Currency depreciation, on the other hand, increases the debt burden of foreign-denominated external loans.
- Reducing sovereign debt burden
- Countries may opt for currency depreciation and a weak currency policy. If the debt payments are fixed, currency depreciation weakens the domestic currency, making the payments less expensive over time.
- For example- if a country’s domestic currency is devalued to 80% of its initial value, a $10 million debt payment becomes only $8 million. However, if the country holds a large amount of foreign external loans, this policy will fail because the loans will become relatively more expensive.
- Race to the bottom- Competition among countries
- When one country devalues its currency, other countries are incentivized to devalue their currency to maintain competitiveness and access to the international export market.
- This situation has the potential to spark currency wars, also known as the “race to the bottom.” Unchecked inflation can result from competitive devaluation.