Countries devalue their currencies only once they have no other way to correct past economic errors – whether their own or mistakes committed by their predecessors. The ills of the devaluation are still at least add up to its advantages. True, it can encourage exports and discourage imports for some extents and for a limited period of time.
As the devaluation is manifested in an increased inflation, this temporary relief is eroded even. In the previous article in this paper I described WHY governments resort to such a drastic measure. This short article shall offer with The way they do it. A government can be forced into a devaluation by an ominous trade deficit.
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Thailand, Mexico, the Czech Republic – all highly devalued, or unwillingly willingly, after their trade deficits exceeded 8% of the GDP. It can opt to devalue as part of an economic deal of methods which are likely to add a freeze on income, on authorities expenses and on fees charged by the national authorities for the provision of public services. This, partly, has been the situation in Macedonia.
In extreme cases and when the government refuses to respond to market indicators of economic stress – it may be compelled into devaluation. International and local speculators will buy more from the Federal government until its reserves are depleted and it has no money even to transfer basic staples and other needs.
Thus coerced, the federal government has no choice but to devalue and purchase back dearly the forex that it has sold to the speculators cheaply. Generally, there are two known exchange rate systems: the floating and the set. In the floating system, the neighborhood currency is permitted to fluctuate openly against other currencies and its exchange rate depends upon market pushes within a loosely controlled foreign exchange domestic (or international) market. Such currencies need not necessarily be completely convertible however, many measures of free convertibility is a sine qua non.
In the set system, the rates are centrally determined (usually by the Central Bank or investment company or by the Currency Board where it supplants this function of the Central Bank or investment company). The rates are motivated periodically (normally, daily), and revolve around a “peg” with very tiny variants. Life is more difficult than any financial system, there are no “pure situations”.
Even in floating-rate systems, Central banks intervene to protect their currencies or to move these to an exchange rate deemed favorable (to the country’s overall economy) or “fair”. The market’s invisible hands are often handcuffed by “We-Know-Better” Central Bankers. This usually leads to devastating (and breathtakingly costly) outcomes. Suffice it to say the Pound Sterling debacle in 1992 and the billion dollars made overnight by the arbitrageur-speculator Soros – both the result of such misguided policy and hubris. Floating rates are considered a protection against deteriorating conditions of trade.
If export prices fall or transfer prices surge – the exchange rate will adapt itself to reveal the new flows of currencies. The ensuing devaluation will restore the equilibrium. Floating rates are also good as a protection against “hot” (speculative) foreign capital looking to make a quick killing and vanish. As the money is purchased by them, speculators will have to pay more expensively, due for an upward modification in the exchange rates. Conversely, when they shall try to cash their earnings, they will be penalized by a fresh exchange rate.
So, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most of the emerging economies (also known as the Third World). It looks astonishing that only an extremely small minority of the states have them until one recalls their high rates of inflation. Nothing like a fixed rate (coupled with consistent and wise economic guidelines) to quell inflationary targets. Pegged rates help maintain a constant level of foreign exchange reserves also, at least so long as the government does not stray from sound macro-economic management.