Merits of Devaluation of The Currency. Mechanism of correcting deficits - Assignment Example

? PART Exchange rate is the significant variable of macroeconomics. It is the cornerstone of the international trade. It can be defined as “The price of one country's currency expressed in another country's currency”. In other words, the rate at which one currency can be exchanged for another (investopedia). Exchange rate induces significant impact on various economic variables of an economy that include Balance of payment, Balance of trade, value of investment and inflation. There are various systems of exchange rate determination. Most commonly used systems include ‘Fixed exchange Rate System’ and ‘Floating exchange rate system’. In fixed exchange rate system a country’s exchange rate is fixed in terms of some stable foreign currency by government. On the other hand in floating or flexible exchange rate system the exchange rate of country’s currency is determined by the market forces, that is, demand and supply of currency in foreign exchange market. When a country’s exchange rate increases it is called as appreciation in value of currency and the opposite is called as reduction or devaluation in the value of country’s currency. There are several factors responsible for the changes in exchange rate and there are several policy objectives behind such changes. Many countries have been resorting to devaluation at different points in time. Following graph shows the pattern of devaluation of US dollar. Following discussion will focus on the merits and demerits for country when it devalues its currency. Merits of Devaluation of Currency: 1. Mechanism of correcting deficits Devaluation is largely believed to correct the trade deficit and balance of payment deficit. Decrease in exchange rate of a country’s currency will render its products and services relatively cheaper for foreign buyers. This is likely to increase demand for country’s goods in foreign market and hence its exports will increase. Moreover devaluation will make foreign goods relatively dearer for domestic buyers and their demand is likely to decrease. This will reduce the imports in that country. Increased exports and reduced imports are likely to correct the trade deficit. This will also improve the current account deficit in Balance of payment accounts and will consequently correct the balance of payment deficit of the devaluing country. UK suffered a huge current account deficit in 2008, as high as 3% of its GDP. Later the deficit was corrected with proper implication of currency devaluation (Pettinger 2009). 2. Mechanism of sustainable investment. Devaluation requires a higher amount of domestic currency for any foreign transaction. This makes it difficult for existing investors of country to switch or transfer their investment from the country that has devalued its currency. Because switching investment to foreign country may worth considerably lesser as compared to the current worth of investment. This will make the existing investors less likely to switch their investment. Hence devaluation ensures sustenance of existing investment in the country. 3. Mechanism of economic growth As mentioned earlier, devaluation of country’s currency results in the soaring of exports and aggregate demand of country’s goods and services. This is likely to result in economic growth of the country at higher rates. 4. Increase in flow of capital A devaluing country facilitates foreign investors in terms of its now relative cheap labor and a country that will stimulate demand, due to its strong export potential, due to devaluation. Hence devaluation provides motivation of higher profitability o the foreign investors and this is likely to result in the increase of capital flow in the devaluing country. China has long been having a devalued currency. China has become home to many manufacturing firms due its export facilitations and inexpensive production. It is mainly due to Chinese devalue exchange rate (News n economics 2010) Demerits of Devaluation of Currency 1. Increase in price of imports Devaluation of currency renders imports dearer to the buyers of devaluing country. Since a country cannot produce everything, imports cannot be avoided. However if a country is supposed to import raw material for production of its certain goods it will make the cost of production higher. As a result those goods may not compete efficiently in foreign market as well as their domestic demand will decrease. 2. Reduction in economic activity: Devaluation increases country’s exports. This means that it affects badly on the exports of other countries by making its goods cheaper in foreign market. However if other countries also retaliate by devaluing their currencies then their goods will compete with the devaluing country’s goods in foreign markets. Hence the demand for goods of devaluing country will decrease reducing the level of activity in that country. Such mechanism will also result in possible unemployment in the devaluing country due to loss of economic activity. The same case happened with China and Japan when both countries devalued their currencies in late 90’. China and Japan devalued together that affected negatively their exports to their major target—US. In contrast to their anticipation of stimulation of exports and restoration of competitiveness, these devaluations resulted in recessions ( Federal Reserve Bank Of San Francisco 1998) 3. Increase in value of domestic debt: When a country’s currency undergoes devaluation it will result in the higher value of foreign currency to be paid to settle foreign debt. This may result in a huge burden upon the economy if the economy is having substantial amount of foreign debt. This might result in the bankruptcy, in severe cases, as happened in Russia in 1998 (C Crises 2002). 4. Loss of value of investment in devaluing country The value of foreign investment that is held up in securities of devaluing country is likely to fall as a result of devaluation. This may work as a deterrent of investment in devaluing country. 5. Adverse impact on Bond market The rising value of foreign debt may necessitate the borrowings to pay off loans. This is likely to increase the money circulation in the economy and consequently inflation would rise. Due to rising inflation there is a pressure on economy to increase interest rates. Increased interest rates would diminish the price of bond because interest rates and bond prices are negatively related (Wells Fargo 2011). As a result bondholders will earn higher returns but overall value of bond market would decrease. Following figure depicts the relationship between bond price and bond yield. PART-2 Macroeconomic impacts of devaluation have been discussed. Briefly devaluation renders positive results by increasing exports, decreasing imports, raising the capital flow in devaluing country and so on. Its adverse impacts include inflation, loss of activity, decrease in value of foreign inward investment, heavy burden of debt servicing and so on. In the same way these macro factors do have significant impacts at micro level. Devaluation does count upon an industries growth or fall, its profitability and competitiveness. Indian rupee was recorded with the most significant devaluation in Nov-2011. Indian rupee has been at the severe devaluation in Asia which devalued by 17% against dollar in past 4 years. The recent devaluation of Indian rupee was expected to serve the traditional purpose associated with exchange rate devaluation. As Indian economy gains growth majorly on the basis of services sector, it also aims at promoting the manufacturing sector like China and other rapidly developing countries. But the corporate world has many vows against it (Forex news 2011) The firms that have wider exposure to international market are much affected by currency fluctuation. Indian Auto-making industry is one of the major industries which are significantly affected by the very act. Auto making firms in India has many concerns over the Indian rupee devaluation. They consider this step as discouraging. They opine that the devaluation will cause the higher input costs, which they’ll have to transfer ultimately to consumers; this cost transfer will decrease the sales, as well as production. The weak currency will raise the raw material and other import related costs that will push inflationary pressure ahead. As General Motors India Vice President Balendran said, “This is definitely putting a lot of pressure and is negatively impacting us. Obviously, we are looking at passing the extra cost to the market and now this may happen earlier than the previously-planned revision in January 2012 (Forex news 2011)”. Like Mr. Balendran, Audi India Managing Director Michael Perschkehas has similar views on the issue, “With the continuous devaluation of the rupee versus the euro and the dollar, we cannot rule out the necessity of realigning our pricing (yahoo lifestyle 2011)” Effects on Toyota Kirloskar Toyota Kirloskar Motor is like other firms that couldn’t escape the devaluation effects. While discussing the devaluation issue on Nov-23, 2011, Toyota Kirloskar’s Deputy MD Sandeep Singh put concerns regarding the government decision. The recent devaluation will surely cost Toyota much. There are various reasons behind and aspects in which the recent devaluation affected the very firm. Existing downturn in auto sales The auto market in India was already facing sales decline this year. The sales trend since the start of 2011 has been very low, compared to previous year, due to inflationary pressures and falling purchasing power; the whole Indian auto industry was the target of sales decline including Toyota Kirloskar. Kirloskar tried i hard to boost sales by promotional activities but most of its efforts went in vain. Price Hike in October Majority of the auto-making firms in India import raw material and intermediate goods from abroad. Due to inflation in and outside the country, input costs rose, that caused the increase in prices. Toyota also raised prices by 1-1.5% in October (yahoo lifestyle 2011) November 2011 Indian Rupee devaluation As Toyota has already increased prices by 1-1.5% in October 2011, the devaluation of Indian Rupee proved to be fuel on fire. There was no way than going through price hike further. For that, Kirloskar’s MD says, “The further hike could be of a similar range or even more”. Dealing with rupee devaluation was a bit comfortable problem, if China would not have overvalued its Yen. As China is the major exporter of raw material to Indian auto makers, the overvaluation of Yen sky touched the cost of production of these firms. In conclusion, the sales shrunk by a large amount. Devaluation increased the import bill of Toyota but the Overvaluation of Chinese put fuel to fire. This made the input cost much higher. Mr. Sandeep names it as ‘the double jeopardy’(Indian drives 2011). Fear to lose competitive advantage Toyota Motors is identified with a middle category car producing company that focuses on economy, efficiency and luxury too. It has a significant share in Indian auto market. But due to recent economic conditions there is a threat to Toyota economy-cum-luxury positioning, as any new entrant might grab the concept and snatch Toyota’s market share, keeping in mind the volatility of Indian market. The company has serious concerns regarding this issue. PART-3 In conclusion, we can say that every economy is vulnerable to the pros and cons of devaluation strategy. Before discussing the effects of exchange rate devaluation on various economies, we classify all the economies in two major categories; those which monetize a different currency than rest of the world--like Chinese Yen, British Pound Sterling etc.; and those which monetize shared currencies--like Euro, Franc etc. following paragraphs consists of discussion over pros and cons of a country which joining a shared currency. The effects of currency devaluation on the countries as part of any block or monetizing a different currency are equal. But the exposure to the benefits and vulnerabilities of devaluation varies. Different currency countries have narrower exposure to the impacts devaluation brings to their economy. However, countries which join shared currency are much exposed to the effects of devaluation. When a country’s currency is devalued, it affects positively on the exports and discourages the imports. So the effects of devaluation will be one-sided. When a single country’s currency is devalued against a foreign stable currency, only that single country is put before the benefits as well as costs of that devaluation. If the outcomes of very step are not serving the objective, the country might suffer huge losses, and considers it alone in that torn situation. However, when a country joins a shared currency, it will have to share the losses other countries in the block to stabilize the whole block—that is a great risk and disadvantage of joining a shared currency. Simply, the instable economic situation in rest of the sharing countries will also affect the new joining country. Beside the disadvantage of sharing losses, a common currency has also considerable benefits which motivate the countries to go for a shared currency. The most important benefit is- the decision of a block is more mature than of a single country. Shared decision contains the purpose of every country so there are more chances to effectively design the policies regarding money valuation and prevention from losses. Moreover, a country in common currency will have relatively stable currency. Because joint forces of bloc are likely to mitigate the adverse fluctuations on the currency of common bloc. Another important benefit commonly shared currencies yield is that a single country feels secure economically and politically in the block. The losses are shared and there is less economic burden over a single country. Common currency can also be the reason of economic growth. There are several cost reducing benefits that accrue to a country in the common currency bloc. These include no hedging cost and no currency valuation cost that incurs when trade takes place between the countries of different currencies. Also the people become free of various red-tapes that come in their way during travel for example currency change etc. these problems are mitigated when the country is in common currency and people travel in the common currency bloc. CONCLUSION: Devaluation of currency brings benefits as well as cost economies in different ways. It’s the important policy decision. Devaluation has macro and micro level implications for the economy. Shared or common currency decision is also the one with its blessings and curses. At one hand, common currency provides security and support to the bloc as a whole while on the other it may also render all the countries to a vulnerable situation due to some wrong policy measure in terms of currency. References 1. Investopedia, Exchange rate, accessed on November 23, 2011 from 2. Economics. Help 2009, accessed on November 23, 2011 3. Federal Reserve bank of San Francisco, 1998, accessed on November 13, 2011 < http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-34.html> 4. A case study of currency research 2002: Russian default of 1998, accessed on November 21, 2011 from < research.stlouisfed.org/publications/review/02/.../ChiodoOwyang.pdf> 5. News n Economics 2010, China’s competitive devaluation, accessed on November 19,2011 from < http://www.newsneconomics.com/2010/10/chinas-competitive-devaluation.html> 6. Wells Fargo advantage funds 2011, Relationship between interest rate and bond prices, accessed on November 23, 2011 from < http://www.wellsfargoadvantagefunds.com/wfweb/wf/education/choosing/bonds/rates.jsp> 7. Forex news 2011: Indian rupee against the dollar hit 40-year depreciation of the most significant Indian rupee against the dollar hit 40-year depreciation of the most significant, accessed on November 23,2011 from http://www.forex-news.co/indian-rupee-against-the-dollar-hit-40-year-depreciation-of-the-most-significant.html 8. Yahoo lifestyle 2011: Auto makers, Audi, GM, Toyota and Maruti Suzuki all set to hike prices, accessed on November 23, 2011 from 9. Indian drives 2011: Auto Companies Hit By Falling Rupee: GM And Toyota Mull Price Hike, accessed on November 23, 2011 from Read More