What is Devaluation?
Devaluation is an intentional downward adjustment of the value of a country’s currency compared to a foreign currency. Countries that deal with a fixed exchange rate or semi-fixed exchange rate often use this monetary policy to control demand and supply. In other words, nations use this tactic to boost exports and reduce trade deficits.
How Devaluation Affects Trade, Debt, and Inflation: An Indian Context
Devaluation has significant ramifications for trade, debt, and inflation, depending on specific economic circumstances and policies. India has experienced three considerable devaluations since 1947: in 1949, 1966, and 1991, each with distinct impacts.
Trade: Devaluation can boost exports by lowering their prices and making imports costlier, reducing the demand for foreign goods. In India, however, the impact on the trade balance has been limited due to inelastic demand for exports and imports, insufficient domestic production of import substitutes, and drastic competition from low-cost global competitors. Moreover, the rising costs of imported inputs such as raw materials and oil have damaged the competitiveness and profitability of domestic producers.
Debt: Devaluation's influence on debt is two-fold. It strengthens the burden of foreign currency-denominated debt, making it more difficult to repay. Nevertheless, it can also ease the debt burden by maintaining nominal income and tax revenues. In India, the effects of devaluation on the debt burden have been complex, hinging on the scale and composition of foreign currency debt, economic growth, and government fiscal policies. Notably, the 1991 devaluation initially heightened the debt burden due to substantial short-term foreign currency debt, but this was later reduced through economic recovery and careful fiscal management.
Inflation: Devaluation impacts overall inflation rates by affecting the prices of imported and exported goods. It can cause inflation by escalating prices of imported goods and stimulating demand for domestic products, leading to supply constraints. In India, devaluation has generally contributed to inflation, driven by the rapid increase in prices of crucial imported commodities such as oil and food, coupled with sluggish domestic sector responses. Additionally, inflation expectations and wage demands have set the stage for a potential wage-price spiral