Competitive Devaluation

What Is Competitive Devaluation?

Competitive devaluation is a theoretical scenario in which one nation matches an abrupt devaluation in another country's currency, often in a tit-for-tat manner. In other words, one nation is matched by a currency devaluation of another, which in turn devalues its currency in response. The goal of devaluation in this case is to make a country's exports more attractive on the world market.

This occurs more frequently when both currencies have managed exchange-rate regimes rather than market-determined floating exchange rates.

Understanding Competitive Devaluation

Competitive devaluation is a series of reciprocal currency devaluations between two or more national currencies as a result of these nations making tit-for-tat moves in order to gain an edge in international export markets. Economists view competitive devaluation as harmful to the global economy because it may set off a round of currency wars that could have unforeseen adverse consequences, such as increased protectionism and trade barriers.

At the very least, competitive devaluation can lead to greater currency volatility and higher hedging costs for importers and exporters, which can then impede a higher level of international trade.

Economic Theory

Many economic scholars consider competitive devaluation a “beggar-thy-neighbor” type of economic policy since, in essence, it amounts to a nation attempting to gain an economic advantage without consideration for the ill effects it may have on other countries. Economists use the term “beggar-thy-neighbor” for economic policies enacted by one country in order to address its own economic situation, while it, in turn, makes the economic situation worse for other countries, turning those neighboring countries into “beggars.”

Though economists usually deploy the term in reference to international trade policy that ends up hurting a country's trade partners, in competitive devaluation the term applies primarily to currencies. Economists trace the origin of such policies to attempts to combat domestic depression and high unemployment rates by increasing the demand for the nation’s exports via trade barriers and competitive devaluation. 

Advantages and Disadvantages of Competitive Devaluation

A country may engage in competitive devaluation because the act of strategic currency depreciation will often improve a nation’s export competitiveness. By lowering the cost of goods exported from that nation, the country becomes more appealing to overseas buyers. Because it makes imports more expensive, currency devaluation can positively impact a nation’s trade deficit.

Currency devaluation forces domestic consumers to look for local alternatives to imported products, which then provides a boost to the domestic industry. This combination of export-led growth and increased domestic demand usually contributes to higher employment and faster economic growth.

However, a country should be wary of the negatives of currency devaluation. Currency devaluation may lower productivity, since imports of capital equipment and machinery may become too expensive. Devaluation also significantly reduces the overseas purchasing power of a nation’s citizens.

How Countries Devalue Their Currency

Countries will devalue their currency in a number of ways, mostly controlled by that country's central bank. Since most countries' currencies are free-floating, meaning they aren't pegged to a different currency, there are more complications to devaluing a currency.

Some of the ways a country can devalue its currency are:

• Quantitative easing (QE): Quantitative easing (QE) occurs when a central bank purchases longer-term securities in order to increase the money supply and encourage lending and investment. There are inflationary concerns when engaging QE.
• Lowering interest rates: By lowering its interest rates, a country makes investment in the nation less attractive. The flow of money from the country to other countries with more favorable interest rates will cause the currency of the country that lowered its interest rates to lose some of its value.
• Intervention buying: This occurs when a country purchases assets to support prices. Essentially, this is a country making purchases in assets to lower the value of its currency.
• Controlling capital flows: A central bank can limit the amount of money that is traded from and to the country.
• Diplomacy: This method is mainly about creating the proper rhetoric about the value of a currency and making comments that will drive investor sentiment without needing to change anything in the actual market. Most central banks want to avoid manipulative practices like this, which is why central bank meetings use extremely specific language.

The method a country uses to devalue its currency will depend on its goals and timeline. QE is a more long-term strategy whereas making a few comments on the strength of a currency could have more short-term, easily corrected changes in a currency's valuation.

Real-World Example

There are many examples of past currency wars. Getting off the gold standard in 1971 was an enormous change in currency policy and allowed countries who previously based their currency on a physical commodity to allow it instead to fluctuate against foreign currencies in a dynamic way.

The U.K. dropped the pound against the dollar in 1967 in order to combat high inflation. When this happened, other countries followed their lead. Since they were not the only country to have their currency pegged to the dollar, this became concerning for the U.S. and the U.S. decided that in order to protect their own currency, they needed to reevaluate their relationship with gold.

The U.S. dropping its convertibility into gold shifted the entire financial world into the period we are in now, where currencies are valued against others directly. A currency that is not backed by a physical commodity is known as fiat money.

The Bottom Line

A currency devaluation can be a smart move for countries that want to increase interest in their exports, potentially raise employment, and combat inflation. However, there is always the risk of another country devaluing its currency in response, negating the import/export advantages and driving the original currency down even further.