If you open your wallet and pull out a dollar bill, it doesn’t take long to see the numerical figure imprinted in each corner, on both sides: $1.
Even though the dollars in your wallet have fixed values ($1, $5, and so on), currency is a relative means of exchange. In other words, a single US dollar might buy 20 Mexican Pesos or 7 Chinese Yuan today, but that might not hold true tomorrow.
While many factors influence the strength of the world’s monies, sometimes nations actually want to devalue their currencies relative to others. And it can affect the economy (and your portfolio) in complex ways.
We’ll break down currency devaluation, why it happens, and what it means for the economy and your investments.
What Is Currency Devaluation?
Currency devaluation is when a government intentionally reduces the value of its currency relative to others. In essence, it’s a way to make domestic products more appealing to the rest of the world, like a coffee shop lowering prices to attract more customers.
The increased demand from other nations should, in theory, boost exports and balance trade deficits. For example, in 2015, China’s economy was growing at its slowest rate in 25 years. In an effort to spark foreign demand for Chinese exports, the People’s Bank of China devalued the yuan relative to the US dollar.
While the devaluation helped Chinese exports in the following years, it spread immediate concern across the globe. That’s because more demand for Chinese exports means less demand for those of other countries — akin to a coffee shop beating competitors by slashing prices. In the ensuing months, the devaluation fueled tensions between the US and China, contributing to the start of what would later escalate into a more extensive trade conflict.
Currency devaluation can help manage economic goals, but it also comes with risks — including inflation and investment uncertainty. For instance, China’s monetary intervention kindled fear among foreign investors. As yuan-based investments became less attractive, investors pulled out almost $700 billion worth of capital from China in 2015, according to the Institute of International Finance.
How Countries Devalue Their Currency
Countries can devalue their currency in a few different ways, depending on whether their exchange rate is fixed, semi-fixed, or floating.
In a fixed exchange rate system, a country’s currency is pegged to another currency or a basket of currencies. For example, Hong Kong pegs its dollar to the US dollar, so any change in value of the US dollar will be generally mirrored by the Hong Kong dollar.
To devalue a fixed currency, a central bank can adjust the pegged rate by formally lowering the value of its currency relative to the foreign currency it’s linked to.
A semi-fixed exchange rate is more flexible but still managed within a narrow band. For example, China maintains a semi-fixed rate, meaning the yuan can float within a set range against the US dollar. To devalue in this system, a country might widen the band or adjust it downward.
In a floating exchange rate system, like in the US or eurozone, currency values fluctuate naturally based on market forces. Still, central banks can take alternative measures to control currency value, such as adjusting the money supply or interest rates.
Increasing Money Supply
Free-floating rates respond to supply and demand. So, a government can reduce its currency’s value by increasing the amount of currency in circulation, typically by printing money or purchasing financial assets to inject cash into public markets.
When more currency is circulating, its purchasing power can fall, potentially weakening it against foreign currencies.
Lowering Interest Rates
On the other side of the equation, a government can indirectly devalue its currency by lowering interest rates. Consequently, interest-bearing assets have less appealing returns, which can discourage foreign investment and possibly weaken the domestic currency.
Pros and Cons of Devaluation
Pros of Devaluation
The primary reason countries devalue their currency is to balance trade and support economic growth. Assuming market participants behave rationally and seek the most cost-effective solution, devaluation should generate an increase in export demand — because the country’s goods and services are relatively cheaper than other options. It may even stimulate production and employment within export-focused industries.
Devaluation can also protect domestic companies. A weaker currency means imported goods are more expensive. As a result, consumers are more likely to purchase from domestic producers, which can help support local businesses and jobs.
Cons of Devaluation
Devaluation has its fair share of drawbacks. When a currency loses value, the cost of imported goods rises. This can drive inflationary pressures within the economy and erode the purchasing power of consumers.
Additionally, devaluation can sow uncertainty. Investors tend to be cautious about investing in a country with a devaluing currency, as it can diminish the value of their returns.
Finally, competitive devaluation — when countries devalue their currencies to secure trade advantages — can incite currency wars. This situation can destabilize international markets and create economic tensions between trading partners, which may ultimately harm global trade.
How Does Currency Devaluation Affect Investment Portfolios?
Currency devaluation has sweeping effects on economies — and, in turn, portfolios. For starters, it prompts volatility. Research has found that markets generally decline both leading up to and immediately after a devaluation announcement. Revisiting our example, returns of the MSCI China index were -7.6% in 2015 and only 1.1% in 2016.
However, the impact on your portfolio depends on a host of factors, such as the devaluation method, broader economic conditions, and portfolio composition.
For instance, if a free-floating country indirectly devalues its currency by lowering interest rates, it can significantly affect bond values. Let’s assume you hold a high concentration of bonds with a fixed interest rate of 6%. As rates decline, your bonds become more attractive relative to newly issued bonds, which now yield lower returns. This could increase the value of your bonds.
Moreover, lower interest rates can be favorable for stocks, as cheaper borrowing costs encourage businesses to invest in growth initiatives. That said, sectors that are reliant on imports, exports, or foreign currency transactions would likely see mixed results, depending on their exposure to international demand.
It’s important to be wary of currency devaluation. Excessive and unchecked devaluation can spur market turmoil, trade wars, and inflation — none of which are conducive to portfolio growth. Maintaining a diversified portfolio can help mitigate the risks (and capture opportunities) that a devaluing currency may present.
