3 Tools Countries Use to Devalue its Currency
In a previous article, we examined why a country may voluntarily devalue its own currency. In this article, we will explore the the three main ways, historically, that countries have used to devalue its own currency: a) lowering interest rates; b) printing money; and c) intervening in markets directly.
1. Lowering interest rates:
- Generally speaking, the strength of a country's currency is based on the country's credibility (credit rating, credit worthiness, or more generally "trust" in its government). For example, the less likely an investor thinks the US government is going bankrupt, the higher probability its currency should retain value, hence the lower interest rate the investor is willing to accept to hold US dollars.
- However, if an investor thinks the US government has a high chance of going bankrupt, then the investor will demand an higher return for holding its currency (usually in the form of higher interest rate) in order to compensate for the additional risk.
- Therefore, given the US dollar's risk of default is the same but the US government decides to lower its currency's interest rate (hence lowering expected return), the demand for US dollars should decrease. In this case, some investors may sell USD in order to move into a currency with better risk-return profile.
2. 'Printing Money': increasing the monetary base, in effect debasing the national currency. For simplicity, let's assume:
- There are 1 trillion US dollars (1,000,000,000,000 units of US dollars) in existence.
- There are 100 trillion yen (100,000,000,000,000 units of yen) in existence.
- The current exchange rate is 100:1 (1 dollar exchanges into 100 yen).
- In a purely hypothetical scenario, the US government decides to increase its monetary base by 20% (note: different from a 20% devaluation), from 1 trillion units of dollars to 1.2 trillion units of dollars (hence total supply increasing to 1.2 trillion dollars).
- In a vacuum, due to the increased supply of dollars, the exchange rate will drop from 100 trillion:1 trillion to 100 trillion:1.2 trillion (again, this is overly simplified).
In effect, where previously one dollar will convert into 100 yen, after debasing, it will only convert into 83.3 yen (100/1.2). Put in another way, a Tesla that was priced at $100,000 may stay at the same price domestically, but due to the change in exchange rate, the price to its Japanese consumers is reduced from 1 million yen to 833,000 yen - a ~17% discount.
3. Intervening in markets directly: the US government could go to the exchange markets directly and sell USD for another currency (eg. JPY). For example, if the current exchange rate is 100:1, the US government selling USD into JPY will could the exchange rate to drop to 95:1. Put another way: Before selling, it is $0.01 per yen. After selling, it could be $0.0105 per yen. Having a more dominant position in the world markets, the US government could theoretically take the exchange rate down a significant amount purely using this method, if it chooses to.
Conclusion
There are three main ways that a country could devalue its currency vs. another currency: lowering interest rates, printing money and intervening directly. However, each comes its own drawbacks, which we will examine in more detail in another article.
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