Currency Devaluation Why Money Loses Value and Policy Responses
Currency Devaluation Why Money Loses Value and Policy Responses.
Published on: wapdat25.blogspot.com
Currency devaluation is a significant economic event a country can go through. If a currency becomes undervalued in relation to other currencies, it can cause a change in the prices of goods and services to the national debt. It is crucial to have an understanding of the reasons why this occurs and the actions taken by policymakers in response.
What is Currency Devaluation?
Devaluation of money is deliberate reduction of the value of a country's currency in relation to the value of another currency, group of currencies or standard. It is unlike depreciation which is brought about by a market forces process, not a policy.
The most eye-catching move for Nigeria was the withdrawal of the country's long-standing currency peg in June 2023. In mere months, the naira dropped from N465 to more than N1,600 to the dollar, one of the biggest currency changes in years, anywhere in the world.
Why do money values decrease?
Foreign Exchange Market Distortions in Developing Countries
If a central bank artificially inflates its currency to stave off inflation, there are distortions. An overvalued exchange rate runs down foreign reserves and imposes capital controls, thus repelling foreign investment.
The growth of the money supply is too fast.
Causes of sharp devaluation frequently can be traced to excessive money supply growth. Governments that actively borrow money from the central bank to cover their budget deficit created inflationary liquidity.Inflationary money creation by government involves the active borrowing of money from the central bank to fund the budget deficit, which results in a growth of liquidity and erodes the value of the currency.
External Shocks
The world events, including the Ukraine war and the Corona virus infected pandemic, also impacted Nigeria's economic outlook and oil & fertiliser prices. Commodity-dependent economies were most affected by these external shocks.
Declining Export Revenues
If the production falls, as in the case of an oil-based country such as Nigeria, fewer dollars are generated. Nigeria's primary export is oil, which makes up more than 80% of the country's export, and a drop in oil production has substantially impacted the naira.
The Impact of Devaluation of the Currency
Inflation Surge
A weaker currency leads to the rise in cost of imports in the local currency. Nigeria was a net importer of food products accounting for 51% of the consumer price index basket, with the inflation rate topping 35% by the end of 2024. Food inflation exceeded 40% .
Balance Sheet Destruction
In the 2023-24 period, the foreign exchange losses for 12 large companies in Nigeria totaled N3.97 trillion. The biggest fish in the pond is MTN Nigeria whose 2024 FX losses exceeded the total annual revenue earned in 2020.
Erosion of Real Incomes
Devaluation to the naira for millions of Nigerians who have no dollar assets was a clear cut decline in their standard of living. There was an increase in poverty and millions were food-insecure.
Collapse in Corporate Tax Revenue.
Whereas previously companies had to pay billions in corporate tax, they were instead granted tax credits due to losses eroding profits. This resulted in government as another big loser.
Positive Effects: Increased Competitiveness
Not all effects are bad. With the naira's fall, Nigeria is arguably more competitive than at any time in the past 25 years. The balance of payments has now turned positive, and foreign reserves are now higher than $40 billion.
Boost to Remittances
With the liberalisation, the difference between official and parallel rates narrowed. Those who are abroad are now enjoying improved value for their remittances to Nigeria, as the total volume of remittance inflows increased by 25-30% in dollar terms.
Policy Resposes to Devaluation
Monetary Tightening
The central banks raise interest rates aggressively in order to fight the inflation and to attract foreign capital. The Monetary Policy Rate (MPR), the cornerstone of Nigeria's monetary policy framework, was increased from 12% to 27.5%, which is likely to make it more difficult and expensive for smallholders and businesses to obtain credit, but sends a clear message to investors.
Exchange Rate Reform
It is painful to shift from a fixed system to a market-determined system but it may be necessary. Nigeria's willing-buyer, willing-seller approach brought together several exchange windows to promote transparency, although there remains limited capital controls.
Improving Monetary Transmission
This mechanism will fail if policy rates are high and bank deposit rates are low. Financial inclusion, increased deposit rates and financial savings mobilisation helps reduce inflation.
Fiscal Consolidation
Eliminating expensive fuel subsidies (24% of government revenue) was not possible. The fiscal deficit decreased from 6.4% to 4.4% of GDP due to the removal of subsidies and devaluation.
Strengthening Supply Chains
Investment in agriculture and local production contributes to a vicious circle of higher input costs, less production, and then even higher input costs. Improving the farmers' competitiveness through input & extension services.
The complexity of policy decisions The complexity of policy decisions.
Policymakers are confronted with tough choices. There's the urge to let a devalued currency re-strengthen to help quell inflation, as any imports that would be less expensive would lead to lower prices. This, however, would remove the competitive advantage built up and would deter the investment of foreign capital, which is essential for productive growth.
Rather, efforts should be directed at maintaining a competitive exchange rate and combating inflation by implementing structural reforms that boost productivity; these include measures such as electricity supply, fighting corruption, lightening up regulations and making contracts more sacred.
The Bottom Line
Devaluation of currency is a crisis as well as an opportunity. The naira's meltdown was long overdue for Nigeria, but the price of the reforms has been high, adding to the already challenging cost of living. Now the challenge is whether the hard-fought stability will turn into overall prosperity or just one for those already in a strong position to profit.
How do you see the weakening of the currency impacting on you? Leave a comment about how you did it.
Comments
Post a Comment
Good
I love this