In case tariffs, quotas and exchange controls fail to achieve equilibrium in balance of payments, a country might be compelled to adjust its exchange rate. An upward adjustment is called revaluation and may be resorted to by a country having persistent balance of payments surplus. A download adjustment is called devaluation and is often resorted to by countries suffering from deficit in their balance of payments. As a deficit in balance of payments creates serious problems, devaluation is frequently resorted to and we will deal with devaluation in detail.
It means a reduction in the exchange value of the domestic currency of any country. For example, before 1966, one rupee was worth 21 US cents; in 1966, its value was reduced to 13.33 US cents.
When maintenance of domestic currency at an overvalued rate becomes difficult and the trade gap assumes threatening proportions in spite of exchange control, a country may be forced to devalue its currency. As the value of the domestic currency is considered to be a matter of prestige for the Government, attempts are made to avoid or postpone devaluation as far as possible.
Devaluation makes a countryâ€™s exports cheaper for foreigners. Hence its exports tend to increase. For example, a shirt worth Rs. 10 in India was worth $2.10 before the 1966 rupee devaluation. After devaluation, it cost only $1.33. Hence the demand for Indian shorts was expected to increase in the USA. On the other hand, imports became costly to the Indian consumers. Hence Indian imports tended to decline. For example, goods worth $1,000 were equivalent of Rs. 4,762 before 1966. After devaluation, they cost Rs. 7,500. Hence foreign goods became more costly and less attractive.
Exchange controls import quotas, tariffs etc are all selective measures but devaluation is a general measure. It affects buyers and sellers of all goods and services entering into the international trade of a country. To a country which depends heavily on imports, a heavy devaluation will bring serious hardships in the form of a substantial increase in the cost of imported items which will inflate the cost of living. In a country with large foreign debts, it may involve an excessive burden of interest charges. Hence, before deciding to devalue, all pros and cons must be fully examined.
Efficacy of Devaluation:
The efficacy of devaluation towards the restoration of balance of payments equilibrium is, however, dependent on many factors. Much will depend upon the structure of the countryâ€™s internal economic conditions e.g. capacity to produce more. The most important variables are, however, the values of the export and import elasticityâ€™s of the devaluing country.
Increase in Exports: The increase in the volume of exports due to their lower foreign process consequent on devaluation must be such that it more than offsets the loss in foreign exchange earnings due to lower per unit realization. This can be so when the foreign demand for devaluing countryâ€™s exports is relatively elastic i.e. the elasticity of import demand for the products of the devaluing country is more than unity. Then only foreign expenditure on devaluing countryâ€™s exports will increase as their prices fall. This elasticity will be higher if the devaluing countryâ€™s exports have a high degree of substitutability. Then foreign buyers will spend more on devaluing countryâ€™s exports as these can be substituted for goods supplied by other countries which have not devalued and therefore are relatively costly. The value of this elasticity will still be higher if the share of the devaluing country in the export markets is low. In order to derive the maximum advantage out of devaluation, it must be ensured that additional production will be generated to meet the additional foreign demand. This will happen only when the domestic elasticity of supply is high. This will moderate the rise in home prices, maximize the fall in foreign process and call the impact of the favorable demand fully into play.
If the elasticity of foreign demand or the domestic supply is lower hand unity, the increase in devaluing countryâ€™s exports will not be sufficient to offset the decline in foreign earnings due to devaluation. The balance of payments deficit will be greater than before.
In general, a nation which turns out a large number of products that are sold in large number of markets is more likely to experience elastic demand conditions than a nation which sells a relatively small number of products in only a few markets. The greater the number of products apparently the better are the chances of increasing export receipts.
Decline in Imports: The decline in the volume of imports due to their high prices must be such that it more than offsets the increase in foreign exchange expenditure due to the increase in per unit price. This can be so when the domestic demand for imports are relatively elastic i.e. more than unity.