Devaluation is a downward adjustment to a country’s value of money relative to a foreign currency or standard. Many countries that operate using a fixed exchange rate tend to use devaluation as a monetary policy tool to control supply and demand.
Devaluation occurs when a government wishes to increase its balance of trade (exports minus imports) by decreasing the relative value of its currency. The government does this by adjusting the fixed or semi-fixed exchange rate of its currency versus that of another country. By making its own currency cheaper, the country can boost exports.
At the same time, foreign products become more expensive, so imports fall. In some instances, a country may take the opposite action by increasing the value of its currency, which is called revaluation. Devaluation is different from depreciation and deflation. Depreciation occurs when a free-floating currency loses value in the international currency market. Deflation occurs when the general price for domestic goods falls.
Effects of a devaluation
|Imports more expensive||Exports cheaper|
|Lower Quantity of Imports||Increased Quantity of Exports|
|Current account B of p improves||Inflation higher|
|Aggregate demand (AD) rises||Economic growth improves|
Exports cheaper : A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports. Also, after a devaluation, the assets of Bangladesh become more attractive; for example, a devaluation in the Taka can make the property of Bangladesh appear cheaper to foreigners. Imports more expensive: A devaluation means imports, such as petrol, food and raw materials will become more expensive. An importer has to buy a product from the abroad with the rate higher than the previous rate. This will reduce the demand for imports.
Inflation : Inflation is likely to occur following a devaluation because imports are more expensive and it causes cost push inflation. AD will be increasing and it causes demand pull inflation. With exports becoming cheaper, manufacturers may have less incentive to cut costs and become more efficient. Therefore, costs may increase over time.
Improvement in the current account : With exports more competitive and imports more expensive, we should see higher exports and lower imports, which will reduce the current account deficit. In 2022, Bangladesh’s currentaccount deficit hits an ‘all-time high’ at $14.07 billion, so a devaluation is necessary to reduce the size of the deficit.
Falling real wages : In a period of stagnant wage growth, devaluation can cause a fall in real wages. This is because devaluation causes inflation, but if the inflation rate is higher than wage increases, then real wages will fall.
Evaluation of a devaluation
The effect of a devaluation depends on :
Elasticity of demand for exports and imports : If demand is price inelastic, then a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall. An improvement in the current account on the balance of payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports, the impact of a devaluation may take time to influence the economy. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.
Increased Aggregate demand (AD) : A devaluation could cause higher economic growth. Higher export and lower imports should increase AD (assuming demand is relatively elastic). In normal circumstances, higher AD is likely to cause higher real GDP and inflation.
State of the global economy : If the global economy is in recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation.
It depends on why the currency is being devalued : If it is due to a loss of competitiveness, then a devaluation can help to restore competitiveness and economic growth. If the devaluation is alming to meet a certain exchange rate target, it may be inappropriate for the economy.
Devaluation Effects on the economy
The country, like most other import-dependent nations, is facing difficult choices: immediately devalue the taka at a faster rate or face consequences that nobody could predict as the volatility in the global market is intensifying since the Russia-Ukraine war shows no sign of abating, China is under huge pressure for rising coronavirus cases, and inflationary pressures are deepening globally.
This is the suggestion from a number of economists and senior bankers, as they urge the Bangladesh Bank to immediately depreciate the local currency to a large degree against US dollars. The exchange rate now stands at 92.50 a dollar after the BB devalued the local currency by Tk 0.50 on 13 June 2022. Banks usually sell US dollars to importers, under the arrangement known as BC (bills for collection) selling rate, by adding Tk 0.05 with the interbank exchange rate. But importers now have to pay Tk 94-95 to purchase a dollar from banks. This means that the interbank exchange rate set by the central bank has become inoperative.
The high exchange rate against dollar creates a huge impediment to the importers, as a result the prices of the daily commodities in the local market are getting high gradually. There is a number of consequences for price hike in the local market. Firstly, the consumers who buy imported products have to pay a high price against those imported products. Secondly, the Pirms that buy imported raw materials face the same consequences.
Moreover, those who are on the fixed incomes or wages encounter the effects of devaluation. Finally, the tourist industries working based on the abroad may be hurt by the devaluation of taka. Rising import costs, declining remittances and a large payment to the Asian Clearing Union (ACU) as early as January 2022 triggered the process of short supply of greenbacks and decline in the forex reserve to $14.33 billion on January 5 from $46.39 billion on June 30 last year, which reached a record reserve of $48 billion in August last.
Still the gap between import and export favours widening of the current account deficit. So, this latest forex crunch will put further pressure on the country’s forex reserve. Now the question is, how it will impact the country’s economy and commodity, foods in particular, inflation. Economies the world over suffered on account of the pandemic and the steeply rising prices of fuel oils have triggered a chain reaction of commodity and service inflation, globally.
At home, even utilities are becoming costlier. After gas price hike, electricity is likely to be pricier with a proposal submitted for raising its tariff by 66 per cent. The Bangladesh Energy Regulatory Committee has suggested a. 58 per cent raise for per unit power. At a time when the spectre of hunger looms large over the globe, these developments on the domestic front cannot but make political leaders concerned about its impact on the poorer sections of the population and the overall food security of the country. Although the food minister assures that the country has an adequate stock of paddy and rice, this cannot be taken as a guarantee for food security.
Past experiences in this regard are bitter, indeed. When the official announcement was surplus production of rice, the country all of a sudden came to know that the staple was in short supply. There was desperate search for overseas market from where rice could be imported. At one stage, duty on import by private companies was slashed to just 2.0 per cent from 16 per cent. Adequate stock does not also guarantee access to foods for all people.
Forbidding price levels can leave many people inadequately fed or starved. In the immediate post-pandemic time, out of seven adult Britons, one was forced to curb procurement of necessary foodstuffs; in the aftermath of the Ukraine war, two out of seven are now compelled to adopt the austerity measure. So, the challenges before the government are stiff.
Management of the market and adjustment of taka-dollar exchange rates are the immediate challenge and ensuring a sustainable forex reserve and development is the long-term objective. That the government has decided to go slow on less important development projects is a step in the right direction. But getting the priority right is no mean task, when it comes to preparing for the future.