A Myth: Devaluation helps exports

Author: Nayan Saraf

The conventional wisdom says, “If you devalue your currency, then it will give a boost to your export as it would look cheaper in the global market.” This wisdom has been running through the veins of economists and governments from many decades and played a vital role in determining the government’s economic policies. But over the years, with the increase in globalization and development of the financial market, this wisdom appears to be a myth now.

The first reason is the availability of derivative instruments such as Currency Swaps, Futures and Forwards, which helped importers as well as exporters in hedging the currency risk. This reduces the immediate impact of devaluation.

Second reason is that many exporters import their raw materials from across the world. For example, a car manufacturer imports different parts such as engine from one country, steel from another country and so on. In one way, he might think that his cars would be cheaper in the global market due to devaluation; on the other hand, his input costs have gone up since the cost of imported raw materials would be higher. Hence, he wouldn’t be benefited much from this currency devaluation, as he needs to maintain his profit margins.

Third reason is the increase in the labor cost, due to prevailing inflation in the economy. Currency devaluation leads to higher import costs that will eventually cause inflation. Hence, the work-force have to pay more for the same goods which will reduce their real wages, and soon they will demand for higher nominal wages which will eventually increase the labor costs for a firm.

Devaluation also leads to law of unintended consequences. Suppose China devalues Yuan to make its exports attractive abroad, it might get competitive advantages by doing so, and will help its economy and exporters to grow. But over the time, the manufacturers in other country will largely suffer due to the loss of market share. It will cause closure of plants, layoff, bankruptcy, and eventually, recession in those countries. And due to the spillover effect, a wider recession may result which might cause in declines in the sales of Chinese goods itself because of lack of demand abroad.

At last, other countries might use “Beggar thy neighbor Policy” of competitive devaluation or can put capital controls and other currency restrictions or can provide subsidies to protect their exporters.

All these practical implications don’t allow a country to boost its exports when it devalues its currency. Though there would always be short-term benefits, but in the long term, the country with low labor cost and efficient manufacturing would boost exports.