POLITIQUE DE CHANGE

Theme of Presentation:

 THE CONDITIONS OF A GOOD DEVALUATION

TPE Topics:

 THE FUNCTIONING OF EXCHANGE RATE REGIMES

 THE EFFECTIVENESS OF DEVALUATION

Presented by:

GILLES LIMNYUY YUFENYUY 18E070E

Course instructor:

Dr. MIGNAMISSI Dieudonné

February 03, 2020

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 Table of contents
PART I: THE CONDITIONS OF A GOOD DEVALUATION ............................................................ 3
INTRODUCTION................................................................................................................................... 3
DEVALUATION VERSUS DEPRECIATION .................................................................................... 3
1. REASONS FOR DEVALUATION ............................................................................................... 4
1.1. To Boost the Country’s Export .............................................................................................. 5
1.2. To Reduce Trade Deficits ....................................................................................................... 5
1.3. To Reduce Sovereign Debt Burdens ...................................................................................... 5
2. THE CONDITIONS FOR A SUCCESSFUL CURRENCY DEVALUATION ........................ 5
2.1. A Fairly Elastic Demand for Imports and Exports.............................................................. 5
2.2. International Co-operation .................................................................................................... 6
2.3. Domestic Price Stability.......................................................................................................... 6
2.4. Nature of Imports and Exports.............................................................................................. 7
2.5. Other Policy Measures............................................................................................................ 7
CONCLUSION AND DRAWBACKS OF DEVALUATION ............................................................. 7
PART II: TPE ON CLASS WORK.......................................................................................................... 8
A. THE FUNCTIONING OF EXCHANGE RATE REGIMES ...................................................... 8
Fixed Exchange Rates Regimes ......................................................................................................... 8
Floating Exchange Rates Regimes ..................................................................................................... 8
Managed Exchange Rates Regimes ................................................................................................... 9
International Monetary Systems and Functioning of Exchange Rates Regimes........................... 9
The Evolution of Exchange Rate Strategies.................................................................................... 10
B. EFFECTIVENESS OF DEVALUATION .................................................................................. 11
How Can One Evaluate the Effectiveness of Devaluation? ........................................................... 11
Empirical Findings............................................................................................................................ 13
REFERRENCES ................................................................................................................................... 15

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PART I: THE CONDITIONS OF A GOOD DEVALUATION

INTRODUCTION
The concept of currency devaluation has existed long in the history of International Economics
and Finance and thus has gained place as a constantly discuss issue when it concerns international
trade and exchange rate formulation policies. There is constant debate as to whether devaluation
create contractionary or expansionary effect in the economy and whether the results are felt but in
the short run or in the long run. Our focus here will be to discuss the main conditions that guarantee
that a devaluation yield its objective. We start by throwing light on the concept of devaluation and
depreciation which at times are confused, then we briefly some of the reasons for devaluation, the
conditions as well as the limitation or drawbacks of devaluation.

DEVALUATION VERSUS DEPRECIATION

Devaluation is a deliberate or conscious decision by a government or central bank to lower the
value of its own domestic currency in relation to the foreign currencies. This is a common monetary
policy tool in countries having a Fixed Exchange Rate or Semi-Fixed Exchange Rate Regime. It
consists of adopting measures that will strategically reduce the purchasing power of a country's
own currency in the global market. Devaluation can also be seen as a downward adjustment of a
nation’s official exchange rate in relatively to foreign countries (Krugman & Obstfeld, 1999). The
opposite of devaluation is Revaluation. A country might opt to devalue its currency in order to
correct a trade imbalance. When a country’s currency is devalued it renders the exports of the
country less expensive, making them to be more competitive in the international market. This will
in turn, increase the cost of imports from other countries, making the domestic consumers likely
reduce purchase. Since exports increase and imports reduce, it will favour a better balance of
payments (BOP) by reducing trade deficits. Thus a government can devalue its currency to
decrease its trade deficit since it increases demand for exports which are relatively cheaper.

An example of devaluation is that of the Egyptian pound in March 2016 when faced with persistent
pressure from U.S. dollar black-market trading, that started after a foreign currency shortage that
negatively affected domestic business and discouraged incentives for investments in the country.
The central bank of Egypt devalued their pound by 14% against the U.S. dollar to diminish the

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activities of the black market. Also, in 2016 China devalued the Yuan in order to render its exports
more competitive and gain trade dominance as compared to that of the USA.

Currency depreciation on the other hand refers to the readjustment of a currency's exchange rate.
It can also be seen as a fall in the value of a currency in a Floating Exchange Rate System vis-à-
vis other currencies. Depreciation might occur as a result of factors like economic conditions,
differentials in interest rates, political instability and unrest as well as risk aversion behaviour
among investors. A countries experiencing weak economic conditions like chronic current account
deficits and high inflation rates are generally likely to have a depreciating currency. For example,
when there is too much inflation, it threatens the currency stability and can lead to higher input
costs for export thus making the country’s exports to be less competitive in the international
markets causing a wider trade deficit that can only translate to the depreciation of the currency. If
the depreciation is gradual it can boost or better country’s export competitiveness which thus with
time better her trade deficits. However, large and sudden depreciation of a currency may likely
scare away foreign investors who are afraid of continuous further fall in the value of the currency.
This can therefore cause them to withdrawal of portfolio investments from the country,
accelerating downward pressure on the currency value.

An example of depreciation is the case on the 23 June 2016, where following the U.K vote to leave
the European union (BREXIT) saw an 8% depreciation of the Great British pound (GBP) against
the U.S. dollar (USD). Also after the 2007-2008 subprime financial crisis, the Federal Reserve
adopted a quantitative easing programs to stimulate the economy, this led to the depreciation of
the U.S. dollar. Another more recent example is the over 40% depreciation of the Turkish Lira
over the USD between January and August 2018 following a fear insight amongst investors.

1. REASONS FOR DEVALUATION

Devaluation is not generally a quick tool most governments or central banks will want to resort to.
There exist some key reasons that might make countries adopt this option when other fiscal and
monetary policies have failed to resolve some issues, such as the following:

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 1.1. To Boost the Country’s Export
Most nations opt for devaluation in order to make their exports more competitive in the global
market, while imports from other countries are discouraged. However, there is need for caution
because; firstly, an increase in demand for the nation’s exports in the global market might
eventually cause its price to increase, which will cancel the initial effects of its currency
devaluation. Also, if other countries should also have the same incentive and competitively devalue
their own currencies in a so-called "currency war", this expected outcome will not be attained.

1.2. To Reduce Trade Deficits

Devaluing a countries currency might be to help correct balance of payments deficits as export
goods of the country will be cheaper compared to imports. For instance, three years after the crisis
in the European Monetary System in 1992, Italy, Spain and the United Kingdom significantly
improved their external balances, thanks in particular to the sharp devaluation of their currencies

1.3. To Reduce Sovereign Debt Burdens

One incentive to devalue a currency might be if the government issued sovereign debt to service
on a regular basis are many. Assuming the debt payments are fixed, a devalued currency makes
the repayments less expensive in the due course of time. However, a weaker currency increases
the debt burden of foreign denominated loans when priced in the domestic currency.

2. THE CONDITIONS FOR A SUCCESSFUL CURRENCY DEVALUATION

There are a number of necessary conditions which must be respected or put in place for the success
of any currency devaluation which include;

2.1. A Fairly Elastic Demand for Imports and Exports

If demand for exports and imports is price elastic, then a fall in the price of exports will lead to
only a more than proportionate increase in quantity of exports demanded. Thus a fairly elastic
demand for imports and exports will facilitate the success of devaluation. Thus, a betterment of
the trade balance and in the balance of payments current account depends on the sum of demand
elasticities of exports and imports and the Marshall-Lerner condition, PEDX + PEDM > 1. That is
the sum of elasticities should be greater than unity for devaluation to improve the current account.

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If the sum of elasticities is less than unity, then devaluation will worsen the current account and
terms of trade.

2.2. International Co-operation

For devaluation to be successful, it warrants that the other countries should not react by also
devaluating their currency. When other countries retaliate with a simultaneous devaluation the
purpose of creating a competitive advantage in the global market by trying to render the country’s
export cheaper will not be attained. Therefore, the rest of the world should co-operate with the
country devaluing its currency by not increasing import duties or restrictive trade barriers or by
giving export bounties or by devaluating its currency which thus will cancel the anticipated
benefits of currency devaluation for the country concerned.

2.3. Domestic Price Stability

For devaluation to succeed, it is paramount for the internal purchasing power of a devaluing
country to be maintained or remain unchanged. Thus this requires that as devaluation reduces the
external value of the currency, the internal or domestic value remain unchanged i.e. the cost price
structure of the currency being devalued should not change within that country. We should have
any inflation mounting up. However, the cost-price structure of a nation may be altered and
inflationary pressures may come into play and the devaluation might experience such variations in
the following situations:

i) In the first place, if the domestic output fails to increase and meet up with the quantity of
imported goods reduced, the scarcity of these goods may trigger an increase in their prices
since domestic production is insufficient.
ii) Also, if the demand for exports increase without a corresponding sufficient expansion of
export industries, the supply of such goods in the domestic market is going to reduce making
prices of such goods may rise.
iii) Furthermore, if the country is capital deficient, even with devaluation will still continue to
import necessary capital goods, now at a high cost, and thus the prices of its industrial output
might likely increase (cost push inflation).

Hence, if a tight monetary and fiscal policy is put in place following a devaluation, the inflationary
effect will be minimised.

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 2.4. Nature of Imports and Exports
The nature or structure of a country’s exports and imports will influence the success of devaluation.
If the country’s exports are made of mostly non-traditional products which have a large demand
from other countries, opting for a devaluation will succeed to improve on its trade balance or terms
of trade since demand for its exports will increase globally as the price falls. On the other hand, if
its exports are mostly composed of primary products and its imports are manufactured goods and
industrial raw materials for example, devaluation will worsen the trade balance.

2.5. Other Policy Measures

If devaluation is accompanied with an increase in import duties and quotas, reducing export duties,
liberalization and export promotion programs etc., then devaluation will be more effective and successful.
On the other hand, policy if contrary policy measures are adopted, the desired effects of devaluation will
not be attained.

CONCLUSION AND DRAWBACKS OF DEVALUATION

Before conclude we first highlights some of the limitations or drawbacks of devaluation which
include; Firstly, devaluation may infer acknowledgment economic weakness of an economy.
Secondly, devaluation can also generate inflationary tendencies in the country. Thirdly,
devaluation might inflate the debt servicing burden. Also, devaluation also involves a given time
lag to obtain the desired effects and lastly, the effects of devaluation is general and also drastic.

Conclusively, from the above we can notice that the success of a currency devaluation will depend
on many factors, that a country should examine them carefully before adoption. It thus however
will have some drawbacks or limitation.

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PART II: TPE ON CLASS WORK

A. THE FUNCTIONING OF EXCHANGE RATE REGIMES

An exchange rate regime is the set of rules that determine the intervention of the monetary
authorities in the foreign exchange market, and thus the behaviour of the exchange rate change.
The content of exchange rate policies is conditioned by the nature of the exchange rate regime.
There is a very wide variety of exchange rate regimes of which are distributed traditionally
between two extremes distinguished according to the objectives pursued by the central bank: fixed
exchange rates and flexible exchange rates.

Fixed Exchange Rates Regimes:

Here, the central bank undertakes to maintain the parity of its currency at a fixed level according
to predefined rules. A fixed exchange rate regime implies the definition of a reference parity
between the currency of the country in question and a currency (or a basket of currencies), to which
the bank central bank undertakes to exchange its currency. When the foreign exchange market is
liberalized, compliance with this commitment requires it to intervene in the foreign exchange
market as soon as the exchange rate deviates from the established parity by purchasing the national
currency if the currency tends to depreciate on the foreign exchange market, by selling it in the
contrary case. When the foreign exchange market is controlled, the currency is unconvertible, the
parity is arbitrarily defined and artificially supported.

Floating Exchange Rates Regimes:

Here, the central bank has no exchange rate target, it allows the exchange rate to fluctuate
according to market supply and demand. In a flexible exchange rate regime, on the other hand, no
commitment is made to the exchange rate, which floats freely (Pure float), depending on the supply
and demand of the demand on the foreign exchange market. Monetary policy then regains its
autonomy, but the central bank gives up control of the nominal exchange rate, which is determined
in the foreign exchange market. Floating therefore applies, in principle, to a liberalized foreign
exchange market, even if one can imagine a Dirty floating regime, with exchange controls.

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Managed Exchange Rates Regimes:

Between these two extremes, there are intermediate regimes, which can be distinguished as follows
depending on the fluctuations that the central bank allows around the reference parity, and
depending on how often this parity is realigned. Thus, the currency board, which does not provide
for no realignment, opposes the sliding parity regime, which provides for a realignment schedule.

International Monetary Systems and Functioning of Exchange Rates Regimes:

Historically different international arrangements have generally determined the range of regimes
between the pure floating and absolute fixity. More specifically, the functioning of an exchange
rate regime depends on the nature of the International Monetary System (IMS) in which it operates.
According to Mundell, a monetary system is “an aggregation of diverse entities, united for regular
interactions with some form of control.” Also, the IMS “is concerned with mechanisms governing
interactions between trading countries” (McKinnon, 1993). Thus the IMS operates on the basis of
a set of institutions, rules, and agreements designed to organize monetary operations between
countries. There exist three criteria that help permit the classification of International Monetary
Systems and their associated exchange rate regimes in a clarifying manner:

 The degree of rigour of the exchange rate rule - from pure floating exchange rates to strictly
fixed exchange rates;
 The degree of capital mobility - from zero mobility to perfect capital mobility;
 The degree of sensitivity of monetary policy objectives to external constraints - from
autonomous policies to common policies.

With respect to inflation and growth the work of Gosh et al. (1995), suggest that fixed exchange
rate regimes are associated generally with lesser inflation in the past and lower growth. Although
it is difficult to establish the direction of causality, it is likely that it is the exchange rate regime
that explains the weakness of the exchange rate inflation, and not a less inflationary situation that
causes exchange rate fixity. Further, flexible exchange rate regimes are probably the least well-
functioning characterized with higher inflation, and poor level of growth. The intermediate or
managed regimes like sliding parities, are those that are likely to guarantee the best growth
performance, although, their nature gives room for more inflation. This conclusion falls in line

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with the exchange rate strategies for many countries, especially the developing countries
development since the late 1980s to have been between fix and managed regimes.

In recent times, the advent the liberalization of capital movements and increasing convertibility of
the currencies of developing nations puts these countries at the limits of the Mundell's
Incompatibility Triangle, in an uncomfortable position. This is due to their de facto anchoring
strategy and the increasing mobility of capital which has made the countries of the South to opt
for relatively strict monetary policies in order to avoid inflationary abuses. This imposes relatively
high nominal interest rates which, in the financial crisis like that in Asia helped to fuel the
speculative inflows of volatile capital, and gave way for currency crises. Authors like Eichengreen
(1999), asserts that the malfunctioning of the dollar peg in Asia is leading to advocacy for exchange
rate regimes that are either strictly fixed exchange rate regimes like the exchange rate of the euro
or intermediate exchange rate regimes like the exchange rate of the euro board Argentina Euro
board or flexible exchange rate regimes. However, they also recognize that a quasi-monetary union
is difficult to achieve especially in an emerging country, and that free floating produces a volatility
that can disrupt economic growth.

This problem raises the question of the credibility of economic policies especially exchange rate
policy, and stresses on the vital importance of the choice of an exchange rate regime, and the very
strong constraints that it brings.

The Evolution of Exchange Rate Strategies

It is without doubt that the evolution of exchange rate strategies is obviously going to shape the
IMS in the coming years. Having on one hand, the strategies for effective anchorage or pegging of
the currencies of developing countries on major currencies will still likely continue. While on the
other hand, the euro can establish itself alongside the dollar as an international currency, and thus
become an important reference for foreign exchange strategies (dollarization and euroisation).

It is likely that the move to pegging to major international currencies will continue, undoubtedly
strengthening the regional as well as the international role of the euro. This is what Bénassy-Quéré
and Lahrèche-Révil (1998, 1999) illustrated with respect to the Southern Mediterranean Countries
(SMCs) and Central and Eastern European Countries (CEECs). While the countries close, in
regional terms, to the European Union adopt a reasoning in terms of Optimal currency zones in
order to define the reference currency for their exchange rate policy, they will probably be better

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off using the euro rather than the dollar or yen, because of the importance of their trade links and
proximity with the Union. Also, if one accepts that these countries also aim to stabilize their
external balance, it will reveal that the euro is preferable as a real anchor currency, given that the
euro would in the most cases represent above 70% of the anchor basket. This dual strategy of
probable nominal and real stabilization of the currencies of the CEECs and SMCs on the euro
advocates in principle the adoption of exchange rate regimes with sliding or slippery parity. Given
that most of the Latin American countries and many Asian countries have already chosen to
determine their exchange rate policy in accordance with the dollar, it thus glaring the emergence
of two major regional currency areas for the dollar and the euro.

Conclusively, the bi-polarization of the international monetary system, and the de facto pegging
of an increasing number of currencies to one of the two major monetary anchors, should make
fluctuations between the two major currencies more effective in restoring trade balances between
the two zones (euro and dollar). The greater effectiveness of exchange rate fluctuations between
the euro and the dollar could then limit their magnitude. However, the emergence of large currency
areas will make autonomous strategies increasingly difficult as especially most emerging and
developing countries will try to have an anchorage with one of the major zones.

B. EFFECTIVENESS OF DEVALUATION
In economic theory, a country uses devaluation to restore the balance of its foreign trade. The fall
in the exchange rate leads to a price effect and a volume effect. In the short term, devaluation
worsens the trade deficit. Indeed, the terms of trade deteriorate: the price of imports rises, while
the purchasing power of exports falls. This is the price effect. In the medium term, devaluation
also affects volumes. The rise in the price of imported products leads to a fall in imports while
exports prices fall leading to a larger export.

How Can One Evaluate the Effectiveness of Devaluation?

The effectiveness of devaluation can be judged by whether the devaluation of currency eventually
yields the expected or anticipated outcomes for which it was done or in other words the degree of
success of a devaluation. As earlier mentioned above in the part above, countries will generally
render their currency weaker (through devaluation) like the case with the devaluation of the of the
Franc CFA in 1994 in order to have or restore a competitive edge in the global market and recovery

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of trade balances. The devaluation is primarily intended to stimulate exports and curb imports. As
the Price effect of the devaluation was immediate, the trade balance was expected to deteriorate
initially before recovering as a result of the quantity effect, which generally only becomes apparent
after a certain period of time and whose importance depends, among other things, on the structure
of foreign trade and the scale of the devaluation. Secondly, the reduction of budget deficits through
the increase in the prices expressed of imports and exports, combined with the growth in volume
of export, should make it possible to increase budget revenue, which is largely dependent on the
taxation of foreign trade, and thus contribute to the reduction of public deficits. Thirdly, the return
of confidence, due to the credibility of a more realistic parity, better management of public finances
and a resumption of exports, is expected to foster a sustainable resumption of economic growth.

Having noted that devaluation is aimed, among other objectives, at restoring competitiveness of
an economy. These objectives will only be achieved if the devaluation generates an actual
depreciation of the exchange rate. According to Edwards (1989), the Effectiveness Index of
Devaluation (EID) is the most appropriate indicator to measure the impact of the change in parity
on the real exchange rate. The author defines EID as follows:

𝑅𝐸𝐺𝐾
𝐸𝐼𝐷 =
𝑁𝐸𝐺𝐾

where REGK is the growth rate of the real exchange rate between the pre-devaluation period and
k periods later, and NEGK is the rate of devaluation during the same period. The actual or real
exchange rate used in our calculations is defined as follows:

𝑁𝐸𝐺𝐾 × 𝑃∗
𝑅𝐸𝐺𝐾 =
𝑃

Where P and P* are the domestic and foreign price indices respectively. The evolution of EID over
a period of three years is sufficient to make a statement on the price-competitiveness effect of
devaluation. Indeed, Edwards (1989), in studying 39 cases of devaluation, estimates that if FDI
remains above 30 after three years, then the devaluation will have been a success in terms of
external competitiveness and hence effective.

The devaluation-induced restructuring of relative prices should in principle helping to reduce the
trade deficit by boosting exports and reducing the trade deficit. imports. The two determinants of

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this mechanism for restoring equilibrium are the elasticities of domestic import demand and
foreign demand of export. For example, Marshall's "Critical Elasticity Theorem", formulated by
the and Lerner, states that the change in parity improves the trade balance by local currency only
if the sum of the import demand elasticities and the local currency of export is greater than 1. Most
studies show that export volumes of exports and imports are highly inelastic. Therefore, we cannot
expect an improvement in the trade balance than under the income effect. For instance, three years
after the crisis in the European Monetary System in 1992, Italy, Spain and the United Kingdom
significantly improved their external balances, thanks in particular to the sharp devaluation of their
currencies.

Empirical Findings
Some empirical studies like that of Thanh and Kalirajan (2006), in examining whether could
devaluation be effective in improving the balance of payments (BOP) in Vietnam in 1990; saw
that both the long run and short run results obtained suggest that devaluation can be adopted to
boost exports and to better current account balance and BOP, as well as decrease in the short run
the real exchange rate appreciation.

Handling the concept of devaluation many findings like those of Edwards (1989), Edwards and
Santaella (1992), Kiguel (1994), Morrisson et al. (1993), Guillaumont and Guillaumont (1995), all
view that the effectiveness of devaluations is dependent on a host of factors such as institutional
environment, the exchange rate system, the wage indexation policies as well as the macroeconomic
policies accompanying the devaluation. For instance, Edwards (1989), argue that devaluation can
be very useful tool to restore macroeconomic balances where there is an overvalued real exchange
rate as it lessens the costly and lengthy process of controlling and keeping the domestic inflation
below the global level that will in turn generate a real depreciation. Also, Abbritti and Fahr (2011),
notes that nominal devaluation is more effective in low inflation economies where in domestic
prices and wages adjust relatively slowly, thus making it more likely to influence the real exchange
rate. Contrary to Edwards (1989), Guillaumont and Guillaumont (1995), argue that the
effectiveness of a devaluation is reliant on monetary illusion i.e. on an under-estimation of
inflation. Thus if devaluation were to be a repetitive phenomenon, then the greater the inflation
expectations. If the expectations are closer to real inflation, then the devaluation is likely to be less
effective.

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Furthermore, Stiglitz (2002), highlights the potential role that can be played by exchange and
capital control policies in stabilization of the economy – restriction of mobility of capital will
decrease macroeconomic instability especially for countries facing currency crisis. This is because
as a massive increase in capital inflow increases financial vulnerability through broadening the
current account and fiscal deficits, thus undermining the effectiveness of devaluation (Lartey,
2007; Saborowski, 2009).

More so, socio-political and institutional determinants could also affect the effectiveness of
devaluation. Political stability is very vital for the success of any program for adjustment program
and especially the of a devaluation (Edwards and Santaella, 1992; Morrisson et al., 1993).

Also, Grekou (2015), investigating the effectiveness of devaluation by looked at to what extent a
nominal devaluation led to a real depreciation using a sample of 57 devaluations in 40 less
developed and emergent economies saw that there was potential nonlinear link between the size
of the devaluation and the effectiveness of the nominal adjustment. Hence concluded that
devaluations are likely to operate more efficiently and effective when the magnitude or size of the
nominal adjustment is smaller. This suggest that the effectiveness of nominal devaluations, is
examined by evaluating whether the devaluation is likely to generate a real depreciation i.e. better
the degree of global competitiveness that will in turn lead to a reduction in macroeconomic
imbalances and can further renew economic growth.

Conclusively, we can say that the ability for devaluation to achieve the expected outcome which
is its effectiveness, is highly dependent on a host of conditions and factors as seen above.

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Done by Gilles LIMNYUY YUFENYUY

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