Terms Beginning With 'd'

Devaluation

  • January 11, 2020
  • Team Kalkine

What is Meant by Devaluation?

Devaluation refers to the act of deliberately decreasing the value of the domestic currency with respect to the currency of a trading partner. It is different from depreciation in the sense that it is done on purpose by the domestic monetary authority. The opposite of devaluation is revaluation, where the value of the domestic currency is deliberately increased.

Countries having a fixed exchange rate system, or a semi-fixed exchange rate system can use devaluation. The decision to devalue or revalue the currency is taken by the central bank of a country or the monetary policy authority.

How do Countries Devalue their Domestic Currency?

Consider the following example showing the determination of the exchange rate of Dollar in terms of Euro. In other words, the exchange rate here represents the Dollar-Euro exchange rate. The supply of Euro refers to the quantity of Euro available as foreign exchange, while the demand for the Euro reflects its demand in the domestic country.

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Considering the above diagram, the supply of Euro in the economy is increasing, while the demand for Euro remains the same. As more and more units of Euro are accumulated as foreign exchange, Euro depreciates while Dollar appreciates.

Now consider the following example when the domestic demand for Euro rises. Here the increased demand for Euro leads to Dollar depreciating with Euro appreciating. Thus, the Dollar-Euro exchange rate rises.

Therefore, it is possible to change the value of the domestic currency with respect to foreign currency by changing the supply of foreign exchange reserves of the latter. This method is used by central banks of various countries to devalue or revalue their domestic currency.

If the current exchange rate is maintained at 2:1, then the home country can just announce that the value of the domestic currency will be devalued to 10:1. This further decreases the value of the domestic currency.

Why do Countries Decide to Devalue their Currency?

Devaluing domestic currency decreases its value with respect to a foreign currency. This means that if previously, 20 Dollars could be bought in exchange for 1 unit of the domestic currency, after devaluation, one unit of domestic currency would be equal to less than 20 Dollars.

Devaluation is a quick and risky way for countries to come out of debt. It is also done to boost exports, as the domestic goods become relatively cheaper as compared to the goods of the trading partner. Further, it makes imports more expensive, as the foreign currency seems to have gained value with respect to domestic currency. This urges domestic consumers to prefer domestic goods instead of imports.

As imports fall and exports rise, the current account strengthens and deficits in the Balance of Payments can be recovered. Moreover, devaluation allows countries to make the domestic products competitive with respect to foreign produce. It offers an edge over internal devaluation which relies on implementing a deflationary policy.

These advantages offered by devaluation can be misused by countries as they try to reduce the debt burden on them.

As countries usually borrow from each other, the amount of interest that they must repay to the lenders depends not only on the interest rate but also on the foreign exchange rate. As the domestic currency becomes cheaper, the foreign country can repay a larger amount of debt with the same amount of foreign currency.

For instance, as the USD becomes cheaper, the European nation can repay a larger amount of debt with the same amount of foreign currency.

What are the Challenges Faced by the Economies which Devalue their Currency?

  • Inflation: The biggest issue that arises because of devaluation is inflation. As the aggregate demand increases in the economy because goods become cheaper, demand-pull inflation takes its course. This may also lead to lack of productivity in firms as they enjoy price competitiveness due to devalued currency.
  • Travel: Foreign travel is hampered as it becomes relatively more expensive to go on a foreign tour. This may affect the tourism industry in the home country along with the foreign country.
  • Real Income: Inflation and devaluation both reduce the purchasing power of domestic consumers.
  • Investment: Foreign investors would be wary of depositing funds in the home country as they would not enjoy the same amount of returns as before.

How should Devaluation be Implemented?

Under tight circumstances when a boost to aggregate output is much needed, then devaluation can be implemented. However, an economy that sees prolonged devaluation can be an underperforming economy.

Devaluation is used as a regulation tool; however, if it is misused by one country, other countries might be tempted to retaliate. This could lead to a trade war, which would further be a threat to global economic growth. International asset market would take a hit, and it may lead to a global recession.

The Year 2019 observed escalation of a trade war between the US and China. To Read More on the US-China Trade War, Click Here!

The devaluation could prove to be more harmful than beneficial as it can cripple the domestic markets. Thus, implementing it for a short period of time could be a good solution; however, in the long run, other alternatives should be adopted.

What is an impairment? Impairment is accounting write off of a company’s asset, which can be an intangible asset as well as a fixed asset. An impairment loss is incurred when the fair value of the asset is lower than the carrying value in the balance sheet.  Alternatively, impairment charges can be incurred when the recoverable value of the asset is lower than the book value. Impairment charges are recorded in the income statement of the company as an expense.  Image Source: © Kalkine Group 2020 A widespread economic crisis is followed by a recession, which usually impacts the value of assets held by a company. Such events force companies to test the value of assets in the balance sheet, and this often leads to an impairment charge.  IFRS accounting standards ensure that a company’s carrying value of assets depicts a value which is not in excess of the recoverable amount.  Why are impairments charged by companies? As per the accounting rules, a business is often measured by its book value of assets. Specifically, the assets of the company carry the capability to generate future cash flows for the firm.  When the ability of an asset to deliver expected future returns is hampered, the value of assets is decreased. Therefore, it becomes an ethical responsibility of the companies to show a fair picture of the assets.  Goodwill generated at the time of business combination is required to be tested for impairments annually. Companies are required to assess any indication that could cause a potential devaluation to the asset.  When a company is holding intangible assets with an indefinite life, they are required to test the assets for impairments annually.  Cash generating units are often valued on the discounted value of future cash flows. Consequently, when market interest rates are rising, it impacts the discount rate used in estimating the recoverable amount.  Assets can be impaired because of other reasons as well. Suppose the plant and machinery of the company were damaged due to earthquake, it would result in a reduction in the value of an asset or even full write-off of the asset.  Image Source: © Kalkine Group 2020 Companies often avail consulting services to improve the performance of the business. Consultants may advise companies to shut down operations at any plant, which could result in the sale of the asset at a consideration lower than carrying value.  Oftentimes, internal reporting of the companies indicate that the performance of the asset may not yield expected benefit. This would force the management to undertake impairment testing for the asset.  Impairment vs amortisation  Amortisation is a systematic decrease in the value of an intangible asset. Amortisation of intangible assets is a process of capitalising the expense incurred on the acquisition of the asset, and then periodically recording the expense on the income statement. Impairment, on the other hand, is an irreversible decrease in the value of the asset, which is shown as an expense in the income statement. It is charged when the recoverable amount from the asset is lower than the carrying value of the asset.  Impairment vs depreciation  Depreciation is a periodic devaluation of fixed assets. It is undertaken by the companies to account for the wear and tear caused to the asset during its useful life. When a firm seeks to sell an existing asset, the buyer of the asset will deduct the depreciation from the cost of the asset before adding any premium or discount to the value for arriving at the purchase price.  Impairment on fixed assets could be related to an unusual fall in the fair value of the asset. For instance, the fair value of the machinery could be impacted significantly when a new and more efficient machine is available in the market. Similarly, an earthquake or fire can also devalue the value of the fixed asset in the balance sheet.  Reversal of impairment loss Under the reversal of impairment loss, the approach used to determine reversal is similar to the approach used in identifying the impairment loss. Reversal of impairment loss cannot be undertaken for goodwill, and it is prohibited. Companies assess whether any impairment loss recognised in the prior periods may no longer exist or have decreased. Impairment losses can only be reversed when the estimates used in determining recoverable amount are changed.  Individual asset  Previously incurred impaired individual asset can be reversed only when the estimates used in calculating the recoverable amount have changed. For instance, the changes in market interest rates could impact the discount rates used in calculating the recoverable amount.  Unless the reversal relates to a revalued asset, the reversal of impairment loss is recognised in the income statement. The revalued asset should not be more than depreciated historical cost without impairment.  Cash generating unit  In a cash-generating unit, the reversal of impairment loss is allocated on a pro-rata basis with the carrying amounts of the assets. The carrying value of an asset must not be increased above the lower of: recoverable amount and  carrying amount should have been determined without any prior impairment loss, net of amortisation and depreciation. 

What is meant by Balance of Payments or BOP? Balance of Payments refers to the record of transactions maintained by a country with the rest of the world. It is a detailed list of international transactions that a country has with its trading partners. These transactions can be made by the residents, domestic businesses or by the government. In an ideal situation, the sum of all the elements of BOP should be zero. However, this is rarely witnessed as most countries do not have the exact same amount of inflow as that of outflow. The inflow and outflow from the rest of the world, can be with respect to goods, services, assets, investments, etc. Notably, a deflection from the ideal zero BOP state may not always be harmful. A surplus (positive BOP) might indicate a strong economy as it means exports are greater than imports. While, a deficit (negative BOP) might point to an increased debt on the home country. The Balance of Payments is highly reflective of the economic strength of a country. Most of the impacts of BOP are indirectly observed on various macroeconomic indicators. What are the Components of BOP? BOP comprises of two broad components, namely, Current Account and Capital Account. Sometimes the Capital Account is referred to as the Financial Account, along with a separate capital account. The Financial Account includes transactions in financial instruments and central bank reserves. While the capital account includes transactions in capital assets. A balance in inflow and outflow of all these accounts makes for a BOP equal to 0. CURRENT ACCOUNT: In technical terms, Current Account is the sum of Balance of Trade, Factor Income (net income from foreign investments) and unilateral transfers (net gifts and grants received). Put simply, current account records the transactions done in goods and services, investments and the net transfer payments or unilateral payments. Exports are maintained as credits, while imports are maintained as debits in the balance of payments. A positive current account balance means that the domestic country is a net lender, while a negative current account balance indicates that the home country is a net debtor. According to the double-entry accounting method, any entry on the export side would be adjusted with an appropriate entry on the import side. For example, for a good exported by the home country to a foreign country, the corresponding import transaction would be the inflow of foreign currency received in exchange for the good exported. CAPITAL ACCOUNT: The capital account involves all transactions relating to international asset It involves transactions made in the reserve account as well as loan payments and investment made across nations. These loans, however, do not include the future stream of interest or dividend payments as they are a part of current account. This is so because they form a part of nation’s spending or income, depending on the type of flow. A capital account is said to be in deficit when a country purchases more assets than the assets it sells to the rest of the world. An increase in assets is followed by a corresponding decrease in cash and vice versa. In some countries, the capital account is known as the financial account and has separate component called the capital account. This capital account records the transactions that do not affect the income, production or savings like international transfer of trademarks and rights, etc. What do BOP deficit and surplus mean for the home country? In layman’s language, BOP tells us whether the country is earning enough to meet its expenditure. If there is a deficit, then it can point towards the country’s growing expenses which are not sufficed by the income generated. Thus, there is a need to generate debt in order to fund the current requirements. Many a times the need to repay current debt gives rise to more debt. Therefore, an endless cycle of financing previous debt with current period loans takes place. The credit received from the rest of the world is generated either by taking a loan, which adds as a liability in the accounts or by selling off the assets currently possessed by the country. These assets can be natural resources, land, commodities, etc. A surplus on the other hand means that a country is exporting more than it is importing in all its existing BOP accounts. This can be a positive sign in most instances as it points towards stronger economic movements. A surplus can encourage the home country to invest in production of goods and services and in turn promote GDP growth. However, an export-driven growth in the long run could point to lack of sufficient demand in the home country. In such a case, the government should boost consumer spending in home country in order to become more self- reliant.   What are the factors affecting BOP? BOP depends on various factors. These include: The domestic exchange rate: Exchange rate is a measure of foreign currency with respect to the domestic currency. Governments can revalue or devalue the exchange rate with the help of appropriate policies. This affects the BOP by making exports cheaper as the exchange rate falls and making imports cheaper when the exchange rate rises. The spending capacity of domestic consumers: As businesses and households are left with greater disposable income, they can spend more on imports and this can affect the BOP. Price competitiveness offered by domestic goods: For a country that is going through higher rates of inflation than its trading partner, the goods and services offered by it would be relatively more expensive. Thus, the country becomes less competitive in terms of price competitiveness. The country with lower inflation would thus have cheaper exports. In such a case, domestic consumers would prefer foreign goods and services causing increased imports and eventually a BOP deficit. Domestic policies: Trade based taxes and tariffs are a huge influencer on the BOP. Policies boosting exports are always beneficial to a country. It is important to pay attention to imports by imposing restrictions using tariffs or quotas. Apart from trade centric policies, domestic policies aimed at economic growth may cause changes in BOP. For instance, increased interest rates can promote FDI in the home country, which would affect the Current Account in BOP.

What is meant by revaluation? Revaluation refers to deliberately exerting an upward pressure on the prices of goods, assets and even currencies. In accounts, revaluation may refer to readjustments made to the prices of commodities and assets. For a central bank, revaluation refers to applying an upward pressure to the exchange rate. Countries that maintain a fixed exchange rate can adjust the value of their currency against a baseline. This baseline can be another currency or the value of a commodity like gold. Revaluation can be understood as the opposite of devaluation, wherein countries deliberately decrease the value of their domestic currency against the baseline. Revaluation and devaluation cannot occur in a floating exchange rate system where the exchange rate is determined by market forces. In a floating exchange rate system, there is minimal to no intervention by the government or central bank of a country in increasing or decreasing the value of their currency. How is revaluation carried out? If the exchange rate of Country A is maintained at 10:1, then the home country can simply announce that the value of the domestic currency will be revalued to 2:1. This would increase the value of the domestic currency. Further, if the central bank announces that the exchange rates are being maintained at 12:1, then this is called devaluation. Countries may also choose to revalue their currency by changing the supply of foreign currency reserves in their country. Changing the supply of foreign currency affects the exchange rate. Consider the following example depicting the exchange rate determination of Dollar in terms of Euro. The supply of Euro is the quantity of Euro available as foreign exchange with the US, while the demand for Euro reflects its demand in the US. Here, Dollar is the domestic currency and Euro is the foreign currency. In the above diagram, the supply of Euro in the economy is increasing, while the demand for Euro remains the same. As more units of Euro are kept as foreign exchange, Euro depreciates while Dollar appreciates. This is how countries can influence the value of the currency by changing the supply of foreign exchange reserves. What is the effect of a revaluation? If the exchange rate of country A is maintained at 7:1, then it can be said that 7 units of domestic currency are required to get one unit of foreign currency. However, when the exchange rate is revalued to 5:1 then it means that now only 5 units of domestic currency are required to get one more unit of the foreign currency. This means that the foreign currency has lost its value as it has become cheaper, while the domestic currency has gained value as it is more expensive. Lesser units of domestic currency must be foregone to get the same amount of foreign currency. A revaluation would impact the domestic currency in the following ways: Exports become more expensive: As the value of domestic currency rises compared to a foreign currency, exports become more expensive. This would end up hurting the country as exports would decline. Imports become cheaper: Domestic consumers would prefer cheaper imports over domestic goods because the value of foreign currency is less. Thus, there would be a decline in net exports. Lower inflation: Inflation would decline as lesser amount of cash would hold greater value than before. Therefore, purchasing power of domestic currency would increase and lesser units of currency would be required to purchase the same amount of money. Lower Economic Growth: As the demand for domestic goods falls domestically as well as internationally, the overall output in the economy would also fall. This could lead to lower productivity and therefore, lower economic growth and lesser number of jobs would be available in the economy. Current Account Deficit: As imports increase and exports decline, the current account balance would decrease. This would have a negative impact on the Balance of Payments of the domestic country. Why do countries revalue their currency? Interest Rates: Interest rates are a major factor influencing the demand and supply of foreign exchange reserves with a country. As the interest rates in a country increase, there is greater demand for the currency of that country. This happens because investors would have an incentive to invest in that country rather than in their own. Interest rate changes between countries could lead to one country revaluing its currency to keep it at par. Consider the case when interest rates in the UAE are higher than in Saudi Arabia. Then the demand for UAE’s Dirham would increase, thus, Dirham would appreciate, and the Saudi Riyal would depreciate. To increase the value of the Riyal, the Saudi Arabian government, under a fixed exchange rate system, would revalue their currency. Current Account Surplus: Countries might look at revaluation when they experience a current account surplus and want to reduce it. A current account surplus could lead to lower domestic employment if it is caused by a recession or a lack of demand. Containing Inflation: Currency revaluation can be used to countries to contain inflation. Revaluation reduces the value of currency, thus, leading to a downward pressure on prices.

Inflation is perhaps one of the worst blows for any economy. For time immemorial, economists have regarded inflation to cause economic catastrophe, devaluing everything and everyone. ‘As violent as a mugger’, ‘as frightening as an armed robber’ and ‘as deadly as a hit man’- is how the 40th President of the US, Ronald Reagan describes inflation. On the flip side, Austrian economist Ludwig von Mises considers inflation to be a ‘policy’- ‘not an act of God’, ‘not a catastrophe of the elements’, not a ‘disease that comes like the plague’! Clearly, though high rate of inflation is an immediate economic trigger, a little dose of inflation seems absolutely essential. What Is Inflation? Simply put, inflation refers to the rise in the prices of most goods and services of daily or common use- such as food, clothing, transport, housing etc. From an economic perspective, inflation refers to the long-term uptick in the prices of goods and services, and thus in turn leads to the devaluation of currency and decrease in the purchasing power of an economy’s currency. Read: China's Consumer Price Inflation, CPI Rose by 2.5% in June Breaking it down further- inflation is a quantitative measure of the rate at which the average price level of goods and services in an economy increases over a period of time. It, therefore, denotes the rise in the general level of prices, where a unit of currency effectively buys less relative to prior periods. Inflation Is Not Always Bad! An optimum level of inflation is required to encourage outlay as against saving, and in the process aid in economic growth. In a healthy economy, prices usually inch up. This is not good for a consumer, nonetheless, reasonable price rise is a indication of a healthy, budding economy. Also read: Australia's Consumer Price Index: 3 things to watch What Are the Types/ Causes Of Inflation? Ideally, inflation is broadly classified into three types- demand-pull inflation, cost-push inflation, and built-in inflation- It is widely acknowledged belief that the nature of inflation is not uniform in an economy all the time. Consequently, it is classified beyond these key types. Let us cast an eye on few other types of inflation- Currency inflation- caused by the printing of cur­rency notes. Credit inflation- credit expansion wherein profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs may lead to a rise in price level. Deficit-induced inflation- the government may ask the central bank to print additional money as the budget of the government reflects a deficit when expenditure exceeds revenue. Pumping of additional money may meet the budget deficit, though price rise is also likely. Creeping/ Mild Inflation- This occurs when the rise in price is very slow. Such an increase in prices is regarded as safe and essential for economic growth. Walking Inflation- Walking inflation occurs when prices rise moderately, and the annual inflation rate is a single digit. It is a warning signal for the government to tame it before it turns into running inflation. Running Inflation: Price rise is rapid and has tremendous adverse effects on the poor and middle class. Its control requires strong monetary and fiscal measures. Hyperinflation: This occurs when prices rise very fast at double- or triple-digit rates. It could lead to a situation where the inflation rate can no longer be measurable and becomes uncontrollable. Prices could rise many times every day. Such a situation brings a total collapse of the monetary system owing to a continuous fall in the purchasing power of money. Low Inflation vs High Inflation Extremely low inflation demonstrates that demand for goods and services is lower than it should be. This tends to slow economic growth and depress wages and can lead to an recession with increase in unemployment. A classic example of this is what the world witnessed over a decade ago- the Great Recession of 2007-2009, that created the largest economic upheaval in the United States since the Great Depression of the 1930s. Rising inflation was initially a concern with rising energy and commodity prices temporarily pushing inflation up in the first half of 2008. Since then, drop in those prices temporarily led to deflation (falling prices) at the end of 2008. Post that, very low inflation is witnessed across many large economies, and many central banks are now setting inflation targets. Good read: RBA Governor Firm on Inflation Target, Signals Further Rate Cut Experts regard high inflation as a ‘destructive force’. If inflation becomes too high, and persists, it can have a rather dramatic effect on the econometric-social structure of an economy. High inflation, one could say- harms everyone, not just because of increased costs and increased unemployment but also due to the time lag before one gets a cost of living increase. High inflation also encourages people to spend money before it loses its value, so they tend to buy things they don’t need-as a method of preserving value. Subsequently, people may go into debt and fail to save. MUST READ: Canada’s inflation leaves negative territory, increases 0.7 percent in June How Is Inflation Measured? Inflation is measured in percentage, by a government authority. The inflation rate is, therefore, the percentage increase or decrease in prices during a specified period and explains how quickly prices rose during the period. Ideally, inflation is calculated using the Consumer Price Index (CPI). Mathematically- Subtract the starting date CPI from the later date CPI and divide it by the starting date CPI. Multiply the results by 100. The answer is the inflation rate as a percentage. Let us take an example- Suppose a fruit basket costs $5 in 2018 and $5.60 in 2020: Measuring inflation is deemed vital as it is believed to be a key economic indicator that helps to determine an average citizen's financial health. Further, central banks use this data to formulate their policy rates. What Are Adverse Effects Of Inflation? Quite naturally, rising prices decrease investment nationally, and also lowers international competitiveness. Persistently high inflation can have damaging economic and social consequences- Higher inflation tends to have a regressive effect on lower-income households and older people in society. Those who possess cash may see the value of their cash erode. If interest rates on savings accounts are lower than the rate of inflation, people who rely on interest from their savings will be poorer over time. High inflation may lead to higher borrowing costs for the section of people/ businesses needing loans and mortgages. Besides, lenders tend to protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is pressure on the government to increase the value of the pension, unemployment benefits, other welfare payments as the cost of living soar. Exports may become less price competitive in world markets, worsening trade balance while adversely impacting national income and employment. High and volatile inflation may not prove good for business confidence as they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending. Read: RBA's rate cut cycle - Where do we stand and what it means for consumers Is Inflation Always Devastating? When the price level goes up, there is both a gainer and a loser. Interestingly, inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change. Let us take a case of people who own tangible assets, like property. Inflation may raise the value of the property, which they can sell at a higher rate and earn a good margin (though buyers of such assets may not be happy with inflation!). Besides, inflation promotes investments, both by businesses in projects and by individuals in stocks of companies, as they expect better returns. Breaking it down further- a moderate amount of inflation is generally considered to be a sign of a healthy economy. As the economy grows, demand for goods and services increase, pushing prices higher, thus incentivizing the producers to meet consumers demand. Subsequently, workers benefit because this economic growth drives an increase in demand for labour, leading to an increase in wages. Thereafter, these workers (with higher wages) consume more, and so this “virtuous” cycle continues. ALSO READ: Better-Than-Expected Inflation Figures Lower Expectations of February Interest Rate Cut How do Policy Makers Manage Inflation? It is imperative for a country’s financial regulator to keep inflation in check. This is done by implementing measures via monetary policy wherein a central bank or other committees determine the size and rate of growth of the money supply. The aim should ideally be to maintain price stability— a relatively constant level of inflation. Other goals include moderate long-term interest rates and maximum employment that promote a stable financial environment. Monetary authorities too can contribute towards managing inflation via quantitative easing- keeping interest rates near zero, pursuing a bond-buying program. The central banks take into consideration both the micro and Macroeconomic Indicators while making any decision. The government also plays a part in keeping inflation under check by maintaining a healthy balance of payment figures. Good read: Understanding Australian Monetary Policy

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