A country that intentionally lowers its currency value by altering the exchange rate with other currencies can benefit from improved export competitiveness. However, it can also lead to higher prices and less purchasing power domestically, and it often sparks trade wars.
Devaluation is distinct from appreciation, which happens naturally due to market forces in floating exchange rate systems. Rather, it’s a policy decision made by a central bank or government to reduce the value of a currency in order to stimulate economic growth or address trade imbalances.
For example, say Panama pegs its currency (the balboa) to the US dollar at a fixed rate of 10 units to 1 USD. When Panama decides to devalue its currency, it would change that fixed ratio and make the dollar worth fewer balboa. Consequently, the price of Panamanian goods in foreign markets would decline and its exports more competitive globally. This improves its balance of trade (exports minus imports) and helps reduce its deficit with other countries.
But a devaluation has its risks, especially for a nation that has significant foreign-denominated debt, as servicing those obligations becomes more expensive when the currency loses value. In addition, the increased cost of imports can trigger inflation, leading to wage demands and straining the local economy. Lastly, it’s critical to be aware of the implications of a currency devaluation as you plan international investments, trade, and business expansion.