Currency devaluation and appreciation has been a debatable issue in macroeconomics. Currency devaluation means a reduction in currency value and currency valuation is the increase in the value of a currency (Zelkó 1980, p. 110). There are many factors that determine a country’s currency value.
The most influential determinant is the economic performance of a country (Mathur 2009, p. 1). However, certain macroeconomic parameters such as inflation, interest rates and trade deficit balances also determine a currency’s strength. Close to these currency determinants are the social and political environments of a country because a stable social or political environment amounts to a stable currency.
High inflation and poor economic performances are characteristic of a devalued currency. In situations where there is high inflation, currency instability is likely to be realized as well. For instance, in America, interest rates and crude oil prices significantly determine the value of the US dollar (Mathur 2009, p. 1).
If the value of crude oil prices falls, there is bound to be a resultant valuation of the dollar because crude oil is valued in American dollars. Moreover, America is known to rely on a lot of crude oil imports to sustain its economy. Similarly, if the interest rates rise, the value of the dollar increases. Budget deficits also impact the value of a country’s currency because a growing budget deficit results in the weakening of a currency’s value.
Similarly, if a government’s policies and societal beliefs are viewed negatively by international investors, a slide in currency value is likely to be witnessed (Mathur 2009, p. 1). Equally, fluctuations in exchange rates also affect a country’s balance of payment.
A balance of payment normally refers to the volume of monetary transactions that occur between one country and another (import and export balances). A favorable balance of payment is witnessed when a country’s export exceeds its imports and an unfavorable balance of payment is witnessed when imports exceed exports.
Currency valuation/ devaluation have a profound impact on a country’s import and exports because it determines a country’s purchasing power (Zelkó 1980, p. 110). If a country’s currency strengthens, its purchasing power equally strengthens because more goods can be demanded from the international market.
Conversely, the strengthening of a currency’s value improves a country’s import because more goods and services can be bought from the international market. In such a situation, a country is likely to increase its imports at the expense of its exports. An increase in imports amounts to an unfavorable balance of payment.
If a country experiences an increase in its currency strength, its exports are likely to be affected because there will be an imbalance in currency strength between the producing country and the purchasing country.
In such a situation, the producing country is likely to be paid in a weak currency (compared to the producing country) and if the currency is exchanged, losses may be incurred (Pettinger 2009, p. 1). Factors of production may also be expensive to purchase using the high currency because returns may not be as profitable as they should.
However, in cases where currency devaluation is experienced, there is likely to be an export boost because exports are cheaper when a country’s currency is devalued. Foreign buyers find such a situation very competitive for business. A boost in domestic supply is therefore likely to be realized.
An improvement of a country’s export is bound to cause a favorable balance of payment because it improves the current account deficit. Countries which have an unfavorable balance of payment therefore stand to gain from a devalued currency. For instance, in 2008, United Kingdom (UK) stood to benefit from a devalued sterling pound because its deficit was more than 3% of the country’s gross domestic product (GDP) (Pettinger 2009, p. 1).
Apart from causing an increase in exports, a devalued currency may stimulate economic growth because more local companies would embark on producing more goods and services to meet the growing international demand (which is supported by a devalued currency). However, a devalued currency is likely to cause inflation because devalued currencies increase money supply in the economy (Pettinger 2009, p. 1).
This situation is best remedied through an increase in the supply of goods and services but a devalued currency does not support this either. Instead, a devalued currency makes imports very expensive, and if the aggregate demand for goods and services increases, there will be a demand-pull inflation.
In such a situation, there will be less incentive among producers to increase their levels of innovation (for competitiveness) because they can count on the devalued currency to increase their profit margins. The purchasing power of citizens is also likely to be eroded with a devalued currency. For instance, it would be cost more to go for a vacation in the US if the British pound is devalued because the British pound is stronger than the US dollar (Zelkó 1980, p. 110).
The flow of capital investments in an open economy is also affected by the value of a given currency. In instances where a currency’s value is low, there is likely to be a huge flow of capital investments in the country. This observation is true because investors are going to get more value for their money by investing in a country that has a devalued currency.
The opposite is also true because a low flow of capital investment is often characteristic of economies that have a highly valued currency. This analogy is true because investors are bound to get less value for their money if they invest in economies that have a highly valued currency. In such economies, the cost of purchasing goods and services (like paying employees) would be higher.
The profit margin for investing in economies with highly valued currencies is therefore low. Since investors are not attracted to low profit margins, they would avoid such economies. This situation results in low capital inflows for economies that have a strong currency.
Tesco is a global company engaged in the sales of books, electronics, furniture, and other home merchandises. Tesco is considered to be the third largest retail store in the world. Its main competitors are Wal-mart and Carrefour (Humby 2008, p. 1).
The retail giant is subject to fluctuations in international exchange rates because it has an international presence in 14 countries across three continents. Most of its markets use different currencies. Considering Tesco’s operations are centered in the UK, there are several advantages and disadvantages to be realized from a valuation or devaluation of international currencies (McLoughlin 2010).
For purposes of this paper, we will analyze the advantages and disadvantages Tesco may realize from a devaluation (or valuation) of the American dollar because this is the main currency in its North American market. The macro effect of a devalued dollar has far-reaching implications on the profitability of Tesco Plc because Tesco’s profitability is exposed to exchange rates fluctuations.
As mentioned in previous sections of this paper, a devaluation of the dollar is likely to lead to increased capital inflows into the US economy because international investors are likely to realize increased profitability from a devalued currency.
In situations where the dollar is devalued Tesco is likely to experience increased profitability because its host market (UK) trades with the British pound (which is stronger than the dollar). Therefore, a consistent decline in the value of the dollar means that Tesco has more dollars to invest in the US market (Windsor Brokers 2011, p. 1).
Furthermore, if the value of the dollar decreases, Tesco is likely to enjoy increased profitability because there will be an aggregate surge in aggregate demand for its US market. This situation implies that many Tesco customers will have more money to purchase goods and services in the company’s North American markets because of an increased flow of money in the US economy. Tesco is therefore bound to increase its profitability index because of increased sales (arising from increased demand).
If increased dollar devaluation is realized, Tesco has the opportunity to increase its prices to cope with increased demand of goods and services. This price increase may happen because a devalued currency leads to an inflationary type of economy. Goods and services are therefore likely to be highly priced if the American dollar is devalued and Tesco can enjoy increased profitability as a result (Owen 2005, p. 10).
However, with a strong dollar, Tesco is likely to experience reduced profitability. A strong dollar would mean Tesco has to pay more for buying its stock and running its operations. For instance, a strong dollar would mean that, Tesco employees operating in the North American market would have to be paid more money.
A consistent increase in dollar value would mean higher wages for Tesco employees and increased cost of doing business for the management (Humby 2008, p. 1). Obviously, such a situation would lead to decreased profitability because increased business costs lead to decreased revenue.
A strong currency is also characteristic of less money circulation in the economy and therefore, less goods and services will be demanded in such an economy. For Tesco’s operation in the American market, there will be lower sales realized from an increased currency strength (coupled with an increase in cost of doing business), resulting to reduced profitability.
An increase in the value of the dollar would also result in a loss of competitive advantage for Tesco because American companies that use their local unit (dollar) to trade would be in a position to reap more benefits from the currency strength. This loss in competitive advantage would be realized because Tesco would suffer a decreased loss in value after the pound weakens against the dollar. In such a situation, Tesco would be competitively weaker to its American rivals.
A situation where the dollar loses its value would be more ideal for Tesco because it will be able to have a strategic advantage over its American rivals (with a strong pound). A strong pound would mean that Tesco has a stronger financial muscle over its rivals (Humby 2008, p. 1).
Nonetheless, there are several strategies that Tesco can adopt to shield itself from the disadvantages of exchange rate fluctuations. The best strategy that Tesco can use is to hedge the exchange rate risks so that it offsets all (or part) of currency risks (Commonwealth of Australia 2005, p. 1).
Hedging can be done in several ways such as the use of derivatives where forwards, futures, options and swaps are employed. Futures would be the best strategy to use because Tesco can contract against the US dollar and UK pound for a value that is close to the change in currency exchange rates (Investopedia 2010). This contract is expected to have a currency exchange impact where Tesco recovers its losses from decreased revenues brought about by unstable exchange rates.
From a macro perspective, currency devaluation has both positive and negative effects on an economy. These positive and negative effects are known to be seen from the balance of payment figures of a country. In recent times, the Euro debate has been a central issue of modern economics because it characterizes the amalgamation of economic fundamentals. European countries that have joined the euro zone have contended with the effects of a shift in their local currencies to the Euro currency.
As explained in the Tesco example, the decision to use the euro (as opposed to a country’s local currency) is subject to the same “export-import” dynamics of currency valuation. UK is likely to experience decreased economic gains because the Euro has a lower value than its local currency (pound).
This is why the UK has been hesitant to adopt the Euro and eliminate the British pound (Mahmood 2011). Also, countries such as the UK which have retained their domestic currencies viz-a-viz the Euro are set to suffer decreased volumes of trade because of a strong currency.
In UK, where the British pound is stronger than the Euro, importers would shy away from buying goods from the local market because they will be forced to pay more for the goods. In this regard, UK exports are likely to be expensive for European traders. In such a case, many traders would rather trade with countries that use the Euro. This situation is disadvantageous for the UK.
Strong currencies in the world (such as the American dollar and the Japanese yen) have also perceived the Euro to be a threat to their countries because the Euro represents a wider economic block. Investors willing to do business in Europe would therefore seek the Euro as opposed to other currencies. This demand for the Euros is likely to support its increase in value.
For countries that wish to abandon the Euro and use their local currencies, there are lots of disadvantages to be realized (especially if such countries do business with other European states). If such countries have a weaker currency than the Euro, they will be subject to the disadvantages and advantages of a devalued currency.
To highlight the advantages, countries that wish to abolish the Euro and trade in their local currencies (which are weaker) are likely to improve their exports because a devalued currency results in cheap exports. However, to show the dangers of moving from a strong currency to a weak currency, experts use developing countries as examples of a high-risk group that should be cautious about the implications of using devalued currencies.
The experts note that, most developing countries have an elastic export market and an inelastic import market (Mahmood 2011). Most of these countries are known to be in strong need of an economic boost, which often requires an entrenchment of the right market fundamentals to spur economic growth.
The domestic economies of such countries therefore require the importation of goods and services to improve the macroeconomic fundamentals. For instance, most developing countries lack the required expertise to boost their economic growth and therefore, they are forced to imports such manpower from western countries. The oil drilling business is one such example where expatriates have been imported into countries like Libya and Nigeria to drill oil because there are no domestic expatriates who would do the job.
Most of such expatriates come from developed countries like Britain and the US which have stronger currencies. At the same time, the developing economies are required to pay the expatriates using their home currencies. If the domestic currencies (for the developing countries) are weakened or devalued, the cost of paying the expatriates would be expensive. However, this situation does not only apply to human resources.
For instance, certain production inputs (like machinery) which are not produced locally need to be imported at a high value if the domestic currency is devalued. Comprehensively, weak economies do not benefit (a lot) from a devalued currency. Only strong economies which have a vibrant export industry are bound to enjoy the benefits of a devalued currency.
Nonetheless, comprehensively, we have established that, countries can enjoy and still lose from a fluctuation in exchange rates. Depending on the economic circumstances of a country, an economy seeks to benefit more from a devalued currency if its economy is strong (as a result of a vibrant export sector).
Similarly, a country is likely to realize strong and negative effects of a devalued currency if it does not have a strong export sector. A devalued currency is therefore appropriate for a country that seeks to stabilize its balance of payments but such a measure should be corrected with other macroeconomic fundamentals because currency devaluation is a temporary measure of correcting balance of payment deficits.
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