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What is devaluation and how does it affect my finances?
When a country needs its currency to lose value, it will resort to various monetary policy strategies. Sometimes, this can have a direct influence on personal finance. Here we’ll tell you why and how devaluation happens and what consequences it brings.
When money used to be gold, silver or bronze coins, it was worth the value of the metal it was made of. But as those precious metals became scarce, money needed to be made from paper, copper, aluminium, tin and other cheaper materials. Because money no longer had the same worth as precious metals, it derived its value from the wealth of the country that issued it. In other words, a euro, dollar or peso is a certificate of ownership of some of the wealth stored in a central bank.
Because that wealth can be affected by economic behaviours and trends, countries can take mitigating measures related to the value of money. One such measure is devaluation. It means the value of one currency is reduced against another.
We mustn’t confuse it with depreciation, even though both mean one currency loses value against another. On the one hand, devaluation happens when a government makes monetary policy to reduce a currency’s value; on the other hand, depreciation happens as a result of supply and demand in a free foreign exchange market.
Causes and types of devaluation
Devaluation is a decision that makes a currency lose value. Let’s look at the most common types of devaluation and what makes governments implement them.
- External devaluation. When a country’s production costs are high, its goods and services become more expensive abroad than its competitors’ and lose competitiveness. By devaluing its currency against another, it can increase exports because its goods and services will cost less in the international market. This type of devaluation is a common mechanism to revive the economy. However, in general, it can only occur in countries that issue their own currency — not in countries that share a currency (like the eurozone).
- Internal devaluation. Internal devaluation can happen in many cases — especially when a country is a member of a common currency area (like the eurozone). Because the area cannot devalue its currency to be more competitive, it will directly reduce its production costs through such measures as lowering taxes, salaries or the price of public services. While economists’ opinions about internal devaluation vary, it ultimately has the same purpose as external devaluation: making goods and services cheaper to increase exports.
- Competitive devaluation. Competitive devaluation is when two or more countries compete to improve their position in international markets. Each country tries to devalue its currency to be more competitive in terms of exports and foreign investment; this scenario is often known as a “currency war”. Overall, its economic impact is temporary and loses effectiveness when other countries implement devaluation policies.
- Fiscal devaluation. Fiscal devaluation aims to lower taxes — especially ones related to productivity — so local industry will be more competitive against foreign industry, without direct currency devaluation. In order to work and make exports more attractive, a direct tax and an indirect tax must be changed at the same time. If companies pay lower taxes for their employees, their production costs will decrease. However, to offset the lower tax revenue, a government an raise the value added tax (VAT), which isn’t charged on exports but rather on internal consumption.
Other ways to devalue a currency include purposefully printing more money, as more paper and coin money in circulation reduces its value because it isn’t backed by enough national wealth. Issuing more money has high economic risks because it causes inflation and can add great pressure to increase salaries and interest rates drastically, while causing a country’s external debt to be more expensive and creating doubt about its financial stability.
How does devaluation affect me?
It’s impossible to tell if devaluation has a positive or negative effect on everyone (in absolute terms) because it depends on a country’s economy and the targets it aims to achieve.
In general, when a currency loses value, people’s purchasing power declines as well because products — especially imported ones — cost more money. And when that causes a general rise in prices, it’s called inflation.
We can also feel the effect of devaluation when travelling to another country with a stronger currency because we need more of our local currency to match it. Some types of devaluation can cause salaries and savings to be worth less, which is certainly not good.
Still, in a country whose economy is mainly based on tourism, the exchange rate attracts visitors. The same goes for remittances, which increase in value and mean more money arriving from other countries with a stronger currency. Also, devaluation can cause people who produce and sell things abroad or earn money in a different currency to make more money because of the better exchange rate with their local currency.
If you want to learn more about devaluation, read this content (in Spanish) by Finanzas para Mortales (Finance for Mortals).
© Banco Santander S.A. All rights reserved. Corporate Headquarters: CGS Av. Cantabria s/n 28660 Boadilla del Monte, Madrid (Spain)
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