Did you know that countries devalue their currency in order to boost exports, shrink trade deficits, and reduce sovereign debt burdens?

As Nigeria devalues the naira in bid to clear up its messy system of exchange rates and attract investment to its economy, we bring to you the reasons why government of a country devalues their currency and what currency devaluation is all about.

According to an article by Adam Hayes published on Investopedia, currency devaluation is defined as an economic policy by a country's government to weaken the value of its currency. The article also revealed that ever since world currencies abandoned the gold standard and allowed their exchange rates to float freely against each other, there have been many currency devaluation events that have hurt not only the citizens of the country involved but have also rippled across the globe.

Before going further, please note the difference between devaluation, depreciation, and redenomination as explained by Prof. Magaji of the Department of Economics, University of Abuja: DEVALUATION means official lowering of the value of a country’s currency relative to other foreign currencies. Currency DEPRECIATION refers to falling exchange value of a currency for other foreign currencies as a result of the forces of demand and supply which may be temporary. Currency REDENOMINATION on the other hand means changing the currency to a lower digital value due to its outrageous falling exchange rate over time. In effect, it means changing the face value of a highly devalued currency.

Here, we look at the three top reasons why a country would pursue a policy of devaluation despite the fallout:

1. To Boost Exports
On a world market, goods from one country must compete with those from all other countries. Car makers in America must compete with car makers in Europe and Japan. If the value of the euro decreases against the dollar, the price of the cars sold by European manufacturers in America, in dollars, will be effectively less expensive than they were before.

On the other hand, a more valuable currency makes exports relatively more expensive for purchase in foreign markets. In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged. .

There should be some caution, however, for two reasons. First, as the demand for a country's exported goods increases worldwide, the price will begin to rise, normalizing the initial effect of the devaluation. The second is that as other countries see this effect at work, they will be incentivized to devalue their own currencies in kind in a so-called "race to the bottom." This can lead to tit-for-tat currency wars and lead to unchecked inflation.

2. To Shrink Trade Deficits
Exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favors an improved balance of payments as exports increase and imports decrease, shrinking trade deficits. Persistent deficits are not uncommon today, with the United States and many other nations running persistent imbalances year after year.

Economic theory, however, states that ongoing deficits are unsustainable in the long run and can lead to dangerous levels of debt which can cripple an economy. Devaluing the home currency can help correct the balance of payments and reduce these deficits.

There is a potential downside to this rationale, however. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency... These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.

3. To Reduce Sovereign Debt Burdens
A government may be incentivized to encourage a weak currency policy if it has a lot of government-issued sovereign debt to service on a regular basis. If debt payments are fixed, a weaker currency makes these payments effectively less expensive over time.

Take for example a government that has to pay $1 million each month in interest payments on its outstanding debts. But if that same $1 million of notional payments becomes less valuable, it will be easier to cover that interest. In our example, if the domestic currency is devalued to half of its initial value, the $1 million debt payment will only be worth $500,000 now.

Again, this tactic should be used with caution. As most countries around the globe have some debt outstanding in one form or another, a race-to-the-bottom currency war could be initiated. This tactic will also fail if the country in question holds a large number of foreign bonds since it will make those interest payments relatively more costly.

In conclusion, it is worth noting that a strategic currency devaluation does not always work, and moreover may lead to a 'currency war' between nations. Competitive devaluation is a specific scenario in which one nation matches an abrupt national currency devaluation with another currency devaluation. In other words, one nation is matched by a currency devaluation of another. This occurs more frequently when both currencies have managed exchange-rate regimes rather than market-determined floating exchange rates. Even if a currency war does not break out, a country should be wary of the negatives of currency devaluation.

SOURCES: 3 Reasons Why Countries Devalue Their Currency By Adam Hayes — Investopedia  | The Danger in Naira Devaluation by Prof. Magaji of the Department of Economics, University of Abuja as published in The Guardian Nigeria

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