Devaluation is the deliberate downward adjustment of a country’s currency value. The government issuing the currency decides to devalue a currency. Devaluing a currency reduces the cost of a country’s exports and can help shrink trade deficits.
It may seem counter-intuitive, but a strong currency is not necessarily in a nation’s best interests. A weak domestic currency makes a nation’s exports more competitive in global markets, and simultaneously makes imports more expensive. Higher export volumes spur economic growth, while pricey imports also have a similar effect because consumers opt for local alternatives to imported products. This improvement in the terms of trade generally translates into a lower current account deficit (or a greater current account surplus), higher employment, and faster GDP growth. The stimulative monetary policies that usually result in a weak currency also have a positive impact on the nation’s capital and housing markets, which in turn boosts domestic consumption through the wealth effect.
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 about 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.
Below, we look at the three top reasons why a country would pursue a policy of devaluation:
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 make 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 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. This is a big problem for a developing country like Nigeria which hold lots of dollar- and euro-denominated debt. 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 who 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.
The Bottom Line
Currency devaluations can be used by countries to achieve economic policy. Having a weaker currency relative to the rest of the world can help boost exports, shrink trade deficits and reduce the cost of interest payments on its outstanding government debts. There are, however, some negative effects of devaluations. They create uncertainty in global markets that can cause asset markets to fall or spur recessions. Countries might be tempted to enter a tit for tat currency war, devaluing their own currency back and forth in a race to the bottom. This can be a very dangerous and vicious cycle leading to much more harm than good.
Devaluing a currency, however, does not always lead to its intended benefits. Brazil is a case in point. The Brazilian real has plunged substantially since 2011, but the steep currency devaluation has been unable to offset other problems such as plunging crude oil and commodity prices, and a widening corruption scandal. As a result, the Brazilian economy has experienced sluggish growth.
The Journey so far: Nigeria in focus
Concept of Economic Growth
Economic growth and development are measured as an increase in the market value of the goods and services produced within a given economy and income per capita GNI. Conventionally it’s measured as percent increase in real gross national product a given economy. Economic development embraces economic growth measured as changes in output distribution and economic and financial structure along with technological advancement within the country. Nigeria between 1960 and 1970, recorded GDP rate at 3.1 percent annual growth propel via the agricultural sector, from 1970 to 1980 Nigeria embraces oil boom, with a remarkable increase in GDP rate at 6.3 percent annual growth. In the early 1980s, Nigeria witness decrease in growth. Therefore, driving the adoption of 1986, structural adjustment and economic reform, to boost the near collapse economy with GDP growth rate at 4 percent. The GDP growth rate in Nigeria from 2013 to 2015 averaged at 1.32 percent, with the highest growth rate achieved in the third quarter of 2015 at 9.19 percent. The services sector accounted for 50 percent of the GDP while the fastest segment is information and communication. The agricultural sector accounts for 26 percent and oil sector accounts for 11 percent. The effect of undervaluation on growth appears to be large and highly significant, also, stronger for developing countries. Exchange Rate Regime in Nigeria: Nigeria from 1959-1973 adopted British pound as an official exchange to Naira. The economy in 1971 was in devaluation dilemma either to devalue Naira or not. The Naira was not devalued during the American dollar devaluation process which results in dollar appreciation, the exchange rate at $2.80- $3.80 to the naira pound. In 1973 Nigeria devalued at the same rate with the US exchange rate at $1.52. In 1986 the exchange rate policy in Nigeria was transformed giving birth to the introduction of the structural adjustment program to address the structural imbalance in the economy . In 1994, exchange rate was fixed at $22 to a US dollar which implies a shift from the flexible regime of 1986 to fixed regime of 1994 with the foreign exchange market liberalized in 1995 paving way for the introduction of autonomous foreign exchange market (AFEM) for sale and purchase of foreign exchange dedicated by the government . On October 25, 1999, the Inter-Bank Foreign Exchange Market (IFEM) was introduced with it operation experiencing similar problems and setbacks as that of AFEM. The CBN thus, re-introduced the Dutch Auction System (DAS) to replace the IFEM . The implication of currency devaluation on the Nigerian economy: Currency devaluating totally is an end product of monetary decision to improve the nations near collapse economy. Devaluation is an attractive option for nations in a recession like Nigeria. Devaluation with its positive results also embraces negative consequences as such making imports more expensive, domestic industries are protected thereby making them become less efficient and effective without the pressure of competition. Business parameters in Nigeria are adversely affected by the increase in the rate of inflation, thus reducing the purchasing power of the populace along high unemployment rate. The 2016 cum first and second quarter of 2017 devaluation, according to CBN was to cut down negative speculations in the foreign exchange (forex) market and move the mid-point of the official window of the (forex) market by 100 basis points from 12 percent to 13 percent, to tightened monetary policy framework and allow a degree of flexibility in exchange rate, curtail speculative activities and foreign reserves depletion which, as at October, stood at N 37.1trillion. However in 2021, the CBN has decided to devalue the naira by about 7.6% against the dollar to pave way for the migration towards the single dollar rate system for the naira. The Apex bank has replaced the fixed rate regime for official transactions with the more flexible NAFEX (investors and exporter exchange rate). With this development the confusion and source of arbitrage necessitated by the fragmented foreign exchange market has been nipped in the bud. Fingers crossed as we expect there will be more twists and turns as regards the economy as it reacts to this new CHANGE.
Conclusion and recommendation
Devaluation of currency is not a bad idea to solve the economy’s balance of payment problem in Nigeria because overtime, it has been used by other countries. Sound fiscal policy should be ensured so that the resulting inflation and workers unrest in a bid to demand for higher income could be curbed. This study identified also that diversification of export is inevitable for Nigeria to achieve economic growth in the face of devalued currency. Also, in order to reduce import dependency of Nigeria, the government should step up policy to spur domestic industry as the new rebased GDP shows that in the first and second quarters of 2014, industry and construction contributed marginally (Monetary policy review, August 2014). Government procurement from domestic producers, domestic-content requirements on international producers seeking access to the country’s markets, subsidized credit for industrial development, and increased support for research and development are highly recommended. According to the speculation of J-curve of devaluation, every economy must expect deterioration at the short run of the policy but if the policy is carefully guided and mixed with sound fiscal policy, the economy will improve in the long run. However the period it takes to weather the situation differs from one country to the other. It has been established that currency devaluation can lead to economic growth for an export driven economy but the problem with Nigeria is that the nation is import-driven. The content of export has little or no value added. The export in Nigeria is predominantly crude oil whose price has dropped drastically and the currency devaluation policy can only be effective for an industrialized economy. It is recommended that naira should not be devalued further until we improve on the quality of goods being exported through industrialization so that global competiveness will be achieved and it can have a positive effect on the balance of payment. Contractionary policies should also be put in place to curb the associated increase in inflation. There is no doubt that initially a common man in Nigeria will not enjoy it because the policy is channeled towards encouraging exportation and discouraging importation. Currency devaluation has lead to inflation in many cases and Nigeria’s own may not be an exemption. Hopefully, the other policy instruments will combat inflation.