What Is Competitive Devaluation?
Competitive devaluation is a theoretical scenario in which one nation matches an abrupt devaluation in another country’s currency, often in a tit-for-tat manner. In other words, one nation is matched by a currency devaluation of another, which in turn devalues their currency in response. The goal of devaluation in this case is to make a country’s exports more attractive on the world market.
This occurs more frequently when both currencies have managed exchange-rate regimes rather than market-determined floating exchange rates.
Competitive devaluation involves one country strategically devaluing its currency in response to another country’s own devaluation.
The response is intended to keep the second country’s exports competitive in international trade but can lead to a tit-for-tat destructive spiral.
The result of competitive devaluation can lead to trade wars or negatively impact trading partners that are not directly involved in the tit-for-tat devaluations.
Understanding Competitive Devaluation
Competitive devaluation is a series of reciprocal currency devaluations between two or more national currencies as a result of these nations making tit-for-tat moves in order to gain an edge in international export markets. Economists view competitive devaluation as harmful to the global economy because it may set off a round of currency wars that could have unforeseen adverse consequences, such as increased protectionism and trade barriers.1 At the very least, competitive devaluation can lead to greater currency volatility and higher hedging costs for importers and exporters, which can then impede a higher level of international trade.
Many economic scholars consider competitive devaluation a “beggar-thy-neighbor” type of economic policy since, in essence, it amounts to a nation attempting to gain an economic advantage without consideration for the ill effects it may have on other countries. Economists use the term “beggar-thy-neighbor” for economic policies enacted by one country in order to address its own economic situation, while it, in turn, makes the economic situation worse for other countries, turning those neighboring countries into “beggars.” Though economists usually deploy the term in reference to international trade policy that ends up hurting a country’s trade partners, in competitive devaluation the term applies primarily to currencies.2 Economists trace the origin of such policies to attempts to combat domestic depression and high unemployment rates through increasing the demand for the nation’s exports via trade barriers and competitive devaluation.
The Appeal of Competitive Devaluation
A country may engage in competitive devaluation because the act of strategic currency depreciation will often improve a nation’s export competitiveness. By lowering the cost of goods exported from that nation, the country becomes more appealing to overseas buyers. Because it makes imports more expensive, currency devaluation can positively impact a nation’s trade deficit. Currency devaluation forces domestic consumers to look for local alternatives to imported products, which then provides a boost to domestic industry. This combination of export-led growth and increased domestic demand usually contributes to higher employment and faster economic growth.
However, a country should be wary of 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.