What devaluation actually means

12/2/2013

By Buttonwood

The opening paragraph of Bloomberg's news story on Venezuela's currency move is a classic example of what devaluation actually means.

''Venezuelans lined up to purchase airline tickets and TVs this weekend in a bid to protect themselves from price increases after ailing President Hugo Chavez devalued the bolivar for a fifth time in nine years.''

The official rate is falling from 4.3 to the dollar to 6.3; a 32% devaluation. Foreign goods will cost more. In other words, a devaluation is a decline in the country's standard of living. Traditionally, it is a tool used by a desperate government with a poor economic policy. Venezuela, despite its oil wealth, has a 22% inflation rate, even before the latest move. Sometimes countries get trapped in a dismal cycle in which high inflation causes the country's exports to be uncompetitive, prompting a devaluation that only leads to more inflation and so on.

Competitiveness is usually only restored by a decline in real wages. This can be achieved by having nominal wages fall while the exchange rate is unchanged (call it plan A), or by having wages fail to adjust to the inflationary effects of a devaluation (plan B). Either way, we come back to a standard of living decline.

Traditionally, central banks saw themselves as guardians of the currency and preferred plan A to plan B. Nowadays, they seem more relaxed about a currency's decline, witness the Bank of England's insouciance as sterling fell in 2007 and 2008 (see chart).

And that brings us to Japan. The G7 came out with a careful statement this week that said:

''We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate''

Of course, Japan's domestic target is to get the inflation rate up, and the real interest rate down. With interest rates already at zero and with a long history of fiscal stimulus that has driven gross Japanese government debt up to 200% of GDP, a weaker currency might be the best way in practice of getting inflation higher. Mr Chavez has shown the way. Other governments don't seem to mind as long as the yen doesn't fall too fast and the Japanese don't say they are trying to weaken their currency. Or as Chris Turner, the head of FX strategy at ING, put it ''It's fine to devalue, just don't talk about it''.

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