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The thinking behind devaluation

By Brian Francis

Six months ago I wrote a column on the issue of devaluation from the perspective of the Eastern Caribbean Currency Union (ECCU) and extrapolated to the rest of the Caribbean. In that column, I explained that the key rationale for devaluation was the notion that a country’s exports become relatively more attractive to the rest of the world while simultaneously its imports become more expensive and hence less attractive to domestic residents.

The net effect, therefore, of devaluation is to increase exports, reduce imports and, by extension, improve a country’s current account position on the external side.

Furthermore, I implied that “. . . therein lies the problem for most countries in the Caribbean. Do our countries have the ability to really increase exports because they are now cheaper to the rest of the world?
 
Is there sufficient domestic production capacity to replace imported commodities that are now more expensive as a result of devaluation? 

In most Caribbean countries, the answers to both of these questions is no. Hence, devaluation is generally likely to do more harm than good and must therefore be avoided as much as possible!”

Given the continued insistence by Moody’s that the ECCU member countries should seriously consider the option of devaluation, I think it is important to clarify my position that such a move would do more harm than good to those countries. And that clarification is based on a set of technical relationships summarised as the Marshall-Lerner Conditions.

According to the Marshall-Lerner Conditions, given an initial position of balanced trade, a devaluation will improve the trade balance if the export and import elasticities of demand sum to more than one.

A devaluation will worsen the trade balance if the export and import elasticities of demand sum to less than one. When the two elasticities sum to one, a devaluation will have no effect on the trade balance. 

You see, devaluation is generally considered when the trade balance is in deficit, not when it is zero. In these circumstances, the value of imports is initially larger than the value of exports. While a one per cent increase in the exchange rate may still be offset by a one per cent increase in the quantity of exports, it can now be offset by less than a one per cent decrease in the value of imports.

The condition for an improvement is relaxed: the sum of the elasticities may be smaller. A one per cent fall in the quantity of imports, which surely reduces the value of imports by one per cent, has a larger effect on the trade balance than a one per cent rise in the exchange rate, which reduces the (smaller) value of exports by one per cent.

Take the case of Barbados in 1991. Had the government devalued the local currency, that would have raised the exchange rate from US$1 = BDS$2 to some higher amount.

The domestic supply price of exports would have remained the same, but in the foreign country it would have fallen in proportion to the devaluation.

The price of imports would have remained unchanged in foreign currency, but would have risen in Barbados, leading to an excess supply of foreign exchange and a trade surplus.

That is likely to persuade consumers to buy fewer imports and more domestically produced goods and services.

Given the economic characteristics of Caribbean countries, will this scenario play out in most regional economies? Can it happen? I doubt it very much! Devaluation is not a sensible option for ECCU member countries or most other regional economies, with the possible exception of Trinidad and Tobago.

• Brian M Francis, PhD is a lecturer in the Department of Economics at the University of the West Indies Cave Hill Campus

• Courtesy Barbados Nati
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