Competitive Devaluations?

Competitive Devaluations?

Kazakhstan’s central bank devalued the tenge by 18 percent yesterday. The central bank is letting the tenge weaken for the first time since it started managing the currency in 2007. Kazakshstan joins Russia, Ukraine, and Belarus in abandoning attempts to prop up exchange rates as currency reserves dwindle and economies stagger. A number of other resource-rich countries have also seen their currencies fall substantially against the dollar over the last few months, including Brazil, Mexico, and South Africa.

Maintaining a currency’s value under pressure is costly. Kazakhstan spent $3.5 billion, or 16 percent, of its foreign-exchange reserves supporting the tenge. Russia spent between $7 and $8 billion in one day last month defending the already weakened ruble. And the longer the process lasts, the more money that goes down the drain. Argentina’s net reserves fell by $20 billion in 2001 before the currency board eventually collapsed the following year.

Some countries attempt to maintain currencies because of a history of inflation. Sudden and large depreciations can be destabilizing, leading to inflation and higher interest rates. Depreciations also increase the cost of foreign currency debt. But depreciation is not necessarily bad for growth. Depreciation mimics an export subsidy and import tax, boosting exports and consumption of domestic goods. This can help countries to grow when domestic demand is weak or declining.

But what happens if many currencies collapse simultaneously? This puts downward pressure on import prices, fueling deflation in foreign markets. Kindleberger has argued that such competitive devaluations are part of what led to the Great Depression.

Volatile currency movements are already aggravating uncertainties in global financial markets. But at least so far, most of the these currency declines are understandable. Sharp declines in commodity prices have worsenened the terms of trade of the resource exporters at the same time as western capital has dried up. If depreciations spread to the large manufacturing countries then there could be real trouble.


Posted by Caroline Freund on February 6, 2009 in Currency markets, Eastern Europe | Permalink