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What is the Devaluation of Currency?

By Louis Holding-Parsons on July 24, 2019

5 (100%) 1 vote[s]

For an economist devaluation of currency is a basic theory, for the rest us, it’s another term a teacher used to try and convince us was important! Yet in a world where untried economic solutions are the rage, devaluation of currency has been used by different countries for different reasons. 

Pricing power!

Devaluation of Currency is caused by price competitionWhen you want to sell something, price is often the determining factor in getting a successful outcome. This applies to a country’s economy. If the goods a country produces are cheaper than an equivalent country, then it’s more likely to win orders. This in turn creates wealth and leads to a successful growing economy. As a result national governments will try, through artificial practices, to make their economies goods more attractive by influencing the price of their currency.

Devaluation of currency for political reasons

China’s recent emergence as an economic superpower has been on the back of making cheap goods. The “made in China” label so often seen in the western world is testament to that. As a result, a strong and expensive currency was the last thing Beijing would want. The Renminbi has been accused of being cheaper than its actual value. More recently as the Chinese economy transitions to an inward consumption one, Beijing has been happy to let the Renminbi appreciate. China has often faced accusations of currency manipulation, something Donald Trump has regularly tweeted about.

Devaluation and Trade wars

Could the gold price benefit from a Chinese US trade war?

The economists among you will appreciate that trade wars and Forex are part and parcel of devaluation of currency. The current diplomatic spat between the USA and China is an example of a currency based trade war. Donald Trump feels Chinese factories are getting an unfair advantage through the Chinese devaluation Yuan. By increasing tariffs on Chinese goods he hopes to influence Beijing to stop this devaluation of currency.

An eye for eye

The problem is, most countries do not like being told what to do and will strike back. In China’s case by slapping tariffs on US goods! Before long, both increase the tariffs and the number of goods involved, and a full blown out (trade) war has occurred! 

Swiss timing is not perfect

Sometimes an economy is forced to defend the value of its currency because of unwanted popularity. The Swiss are seen as a model of financial prudence. As a result, Swiss Franc (CHF) is considered a safe place to hold your cash. With the Euro seen as undesirable from 2010 onwards when it looked like the single currency would fall apart, CHF became popular, i.e. expensive.  This was unacceptable for the Swiss National Bank (SNB) because the Swiss economy is reliant on exports, such as luxury watches. As a result the SNB chose to defend a cap at 1.20 Swiss Francs per Euro.

Devaluation of Currency can be painful

Yet suddenly on the 15th January 2015, the SNB stopped defending the cap causing the CHF to gain 20% in a matter of minutes. Many institutional traders lost millions as they had not prepared for such an eventuality. Any retail Forex trader looking to profit from a devaluation should heed the example of the Swiss National Bank changing its currency strategy. Currency trading tips are useful but applying sound risk management and using the risk reward ratio will reduce your loss in such a Black swan event.

True or False?

The official reasons for devaluation of currency are not always trueIt can be difficult to work out if a currency devaluation is for political or economic reasons. The Chinese communist party wants to stay in power, and achieves this by ensuring economic growth to keep its subjects happy. (No-one is quite sure how accurate the Chinese economic figures are, especially around growth). To ”keep times good” Beijing has been keen to keep the Renminbi from appreciating too strongly, so as to cushion the effect. 

On the other hand the Swiss National Bank realised that Mario Draghi and the ECB were likely to introduce Quantative easing. This would have the effect of pushing down the value of the Euro and increase the attractiveness of the Swiss Franc. This would encourage more people to change their Euros into Swiss Francs. The SNB could not keep defending their CHF EUR cap against so many buyers. In effect their hand was forced by economic imperative.

Conclusion:

Due to the 2008 financial crisis stopping growth, many countries have resorted to devaluing their currencies to kick-start their economies. The fear of another 1929 depression was foremost in many central bankers’ minds. The stakes are therefore high. Understanding Forex involves knowing your way around the vocabulary, concepts and how the market places importance on Forex news. Devaluation of currency and how it drives news and Forex markets is a vital one in today’s increasingly politicized global economy.  This knowledge should ensure that you are not surprised by seemingly odd events!

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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