Can a Central Bank Devalue its Currency on Purpose?

My politically opinionated father asked me worriedly, “Why has the INR depreciated since the current government took over?” I first said, “Go back a little farther, and you will see that the INR has been depreciating, irrespective of who was running the government.” But is that a bad thing?

The words “depreciating” or “falling” INR tend to suggest that it is essentially a bad phenomenon. But it depends.

Suppose you are an exporter selling shoes to an American firm. Let’s say you charged $1 per pair in 2020. So, for every pair of shoes, you got roughly ₹75. You are still charging the same. But now you are making ₹83 for every pair. You are making almost 11% more while not increasing the dollar price of your shoes. As an exporter, isn’t INR depreciation good for you?

Now consider this. Suppose you had imported a machine worth $1,000 in 2020 to manufacture those shoes. You must have paid roughly ₹75,000 (1,000*75). You plan to replace this machine next year. You can still buy it for $1000, but at the current exchange rate, you will pay almost ₹83,000. Here, you will pay 11% more even when the machine seller has not increased the price. As an importer, you may not like INR depreciation.

A weaker currency has pros and cons, but central banks, especially in developing countries, prefer a weaker currency. They might even intervene in the forex markets to devalue the currency. 

Vietnam devalued its Dong by 5% each in 2009 and 2010, followed by a 9% devaluation in 2011. Indonesia devalued its Rupiah multiple times in the 1970s and 1980s. China devalued its Yuan by ~4% as recently as 2015.

But why would countries devalue their currency? I can think of three primary reasons:

To increase exports – A developing country could devalue its currency to boost exports, thereby increasing the earnings power of its population. 

But why is it so important to increase exports? For a country as large as India, manufacturers can earn well by just catering to the domestic demand. However, the purchasing power of an average person in a developing country is too low. While businesses may have the capacity to produce, the population may not have the capability to consume.

If the businesses find foreign buyers, they can increase their revenues and profits by exporting their goods. In doing so, they might employ more workers, thereby increasing the purchasing power of the domestic population. 

There is a catch, though. While developing countries can offer cheaply priced goods owing to their low labor costs, meeting the quality standards required by developed countries could be challenging. In fact, they might want to import the right kind of machinery to be able to deliver the required quality. Basically, a devalued currency must be complemented by policy support from the government to compete in the global markets.

To decrease imports – A devalued currency makes imports more expensive. When a central bank devalues its currency, it hopes people will demand fewer foreign goods. This could work in a country where a lot of consumer goods are imported.

Only three commodities – oil, coal, and gold – make up over 50% of India’s total imports. These imports are inelastic, meaning oil and coal are India’s primary fuel sources. And the demand for gold stems from the long-lived cultural beliefs that are hard to change. So, devaluation may not help reduce India’s imports. 

While the INR has depreciated 47% since 2000, the share of imports and exports in the total foreign trade has largely remained constant.

Even for a country mainly importing consumer goods, reducing imports may take time to happen. Come to think of it, why would a country depend on imports for basic consumer goods to begin with? Perhaps because they don’t have the skills or resources to produce good quality products. For imports to reduce, it is imperative that good quality and affordable substitutes are available domestically.

To improve balance of payments – Countries often run trade deficits for prolonged periods. A trade deficit is when imports are more than exports. Basically, a country is running a trade deficit if it is buying more than it is selling. This excessive buying is funded by loans.

Increasing exports and reducing imports would reduce the trade deficit and, hence, loans. When a government’s debt for foreign trade reduces, it can, if needed, take on more debt to finance other fiscal spends for its citizens.

However, if the loans were borrowed in foreign currency, the country would have to shell out more domestic currency to repay the loans. India does a lot of foreign trade in the USD, even when trading with countries other than the USA. So, a USD-denominated debt becomes expensive when the INR depreciates.

How do central banks devalue their currency? What are the tools they use?

By declaring the exchange rate – Unlike the USD and Euro, China’s Yuan Renminbi is not a free-floating currency. The People’s Bank of China declares an exchange rate for Yuan each day based on pre-set criteria. In 2015, China shocked the world markets by announcing a lower exchange rate than its usual range. They justified that the devaluation was an outcome of their new criteria, which reflected free-market forces more appropriately.

However, this is not a tool available for most major currencies. The US, UK, Australia, Canada, EU, etc do not set exchange rates. They let the market forces arrive at a rate. That is why you will see how exchange rates fluctuate throughout the day.

That is not to say that central banks do not intervene in the currency markets. There are other ways (the following ones) in which central banks can influence their free-floating exchange rates. 

By selling own currency – A central bank can buy forex in the open market. The RBI might buy forex from institutional sellers and banks by paying with freshly minted INRs. Effectively, the RBI brought more INR into circulation and took out some forex.

Think of it as a demand-supply situation. More INR in circulation means a higher supply. Higher supply leads to a decline in value. Buying more forex suggests a stronger demand for forex, which can lead to its higher value.

By decreasing interest rates – Investors from developed countries often invest in the debt issued by developing countries to take advantage of their higher interest rates.

If a developing country slashes interest rates, it could lose its attractiveness as an investment. Existing foreign investors might want to exit their investments. In doing so, they will take away their foreign currency in exchange for the domestic currency. Again, the demand for foreign currency will rise, and the supply of domestic currency will increase, possibly leading to depreciation.

By imposing capital controls – Capital controls are any restrictions that limit the free exchange of foreign currency. For example, under the RBI’s Liberalized Remittance Scheme, Indians can remit abroad only up to $250,000 in any financial year. This is a capital control. Another example is that at the industry level, Indian mutual funds cannot invest more than $7 billion in securities outside India.

Many countries impose stricter capital controls such as minimum or maximum investment amounts, specialized tax rates, additional compliance requirements, sector-specific restrictions, etc.

Too many and too frequent capital controls discourage foreign investors even when interest rates are attractive. When newer capital controls are imposed, foreign investors might flee, causing a depreciation of the domestic currency.

Every Central Bank Thinks Like That

When a central bank is trying to devalue its currency, others are observing it. In a counter-move, other central banks might also take measures to devalue their own currencies. In order to not trigger a currency war, central banks take prolonged and gradual steps to drive their currency to a desired level.

Safe to say, a central bank’s intervention in the currency market might not guarantee a favorable trade balance, but not participating in it ensures an unfavorable balance.