Why Currencies Devalue, and Why It Matters to U.S.

A year ago, as Asia’s economic nightmare was just beginning, Wall Street spent a lot of time wondering which countries might be next to devalue their currencies.

Today, the more appropriate question seems to be: Are there any countries that can avoid a devaluation?

From Indonesia to Mexico to Russia, over the last year one country after another has either officially devalued or allowed market forces to do the same. On Wednesday, rumors swept markets that Venezuela would be next.

But what is a “devaluation,” exactly? What makes currencies decline, and who wins, and loses, when devaluations occur? And is this ongoing wave good or bad for the U.S. economy?

Here’s an explanation of what’s happening, why, and where it might lead:

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Q: Russia said this week that it would allow its currency, the ruble, to fall as much as 40% versus the U.S. dollar. What does this mean, exactly?

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A: Since 1995, the Russian government has managed to keep the ruble’s value in the range of 5 to 6 rubles to the U.S. dollar. This week, faced with an increasingly dire budget crisis and plunging financial markets, the government said it would let the ruble fall as low as 9.5 to the dollar.

Russia had prized the relative stability of its currency, for all sorts of reasons. A stable currency denotes confidence in a country. What’s more, it greases the wheels of commerce, because businesses, investors and consumers can feel free to make decisions without worrying whether those decisions will be undercut by currency gyrations.

Indeed, stability and the enhancement of commerce are among the main reasons Europe plans to unite under a single currency beginning Jan. 1.

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Q: What makes currencies rise or fall in value?

A: Many factors can influence currency values, but on some level a currency’s “price” ought to reflect the demand for that paper. A currency is in demand when assets denominated in that currency are in demand--a country’s stocks and bonds, for example, or its physical assets (such as land). By contrast, if people are selling a country’s securities or assets--perhaps because they lack confidence in the economy--its currency is likely to decline in value as those investors seek to cash out and move into another currency.

Therefore, a currency ultimately can be expected to reflect a country’s economic fundamentals, including interest rate levels, growth expectations and the relative appeal of the nation’s assets.

The current wave of devaluations began when debt-laden Asian economies began to slow, dimming their appeal to investors. Since then, devaluations have hit major commodity-exporting economies such as Canada, Russia and South Africa, as commodity prices have fallen with weaker global economic growth.

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Q: Weren’t currency values much more stable in the past?

A: Yes. After World War II, major governments attempted to fix currency exchange rates, relative to the benchmark of the dollar, for the sake of economic stability.

But over the last 10 years, as the global economy has become interlinked on an unprecedented scale--thanks to booming trade and the massive flow of investment capital across borders--most governments have been forced to accept fluctuating currency values as a price of open markets.

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Q: Aren’t speculators also to blame in devaluing currencies?

A: To some extent. Some large investment funds have been accused of “shorting” some currencies to depress them, forcing governments into official devaluations. Shorting means selling borrowed currency at current rates, in anticipation of paying back the “loan” later with currency purchased at a cheaper value.

Governments often have tried to fight such speculators--as the Hong Kong government is trying to do today to keep its currency stable versus the dollar--by spending national reserves to buy up the currency on the open market as speculators short it.

But speculators argue, and many economists agree, that an “attack” on a currency can succeed only if the currency’s fundamental underpinnings are weak to begin with.

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Q: Is there a good side to a currency devaluation?

A: Yes. It can make a country’s exports that much cheaper in dollar terms or in terms of other strong currencies, thereby increasing the country’s competitiveness. In the long run, that can boost the country’s growth prospects.

A devaluation also makes a country cheaper for foreign investors looking to build new plants or buy undervalued stocks.

When China devalued its currency, the yuan, in 1994, it sparked faster export growth and fueled a jump in foreign investment. And Mexico’s 1994 devaluation, while initially causing a deep recession there, has since boosted export growth significantly.

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Q: And what’s the downside of a devaluation?

A: There are many. Most important, a devaluation slashes a people’s purchasing power.

In Thailand, where the Asian economic crisis began 13 months ago, it used to take about 25 baht to buy $1. Now it takes about 42. That is roughly a 40% loss of purchasing power for a Thai who would like to buy a product priced in dollars.

While Mexico’s economy has recovered since 1994, the loss of purchasing power to the average Mexican remains enormous.

A devaluation also can dash confidence in an economy, both among locals and, initially, foreigners. (Foreigners who own assets denominated in a devalued currency face an immediate loss.)

What’s more, to protect a weakened currency from falling even further, a government may need to take drastic measures--such as pushing interest rates sky-high--to lure wary investors to the country’s bonds or bank accounts.

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Q: The U.S. has benefited from others’ devaluations, hasn’t it?

A: To a large degree, yes. As the dollar has strengthened relative to other currencies, we have enjoyed lower prices on many imported goods, such as from Asia.

In addition, the continuing wave of devaluations has driven more investors into the “safe haven” of dollar-denominated securities, such as U.S. Treasury bonds. That buying, in turn, has pushed long-term interest rates lower--also lowering mortgage rates for home buyers.

But as the devaluation contagion spreads from Asia to Latin America to Russia and other developing nations, the risk to the U.S. grows. Each devaluation erodes the potential purchasing power of foreign buyers who want our exports. That has begun to show up in the U.S. economy in the form of depressed corporate profits.

That, in turn, has triggered another form of devaluation--the devaluation of U.S. stock prices. What the stock market fears, even as the dollar remains strong, is that the devaluation wave among smaller countries will turn into a vicious circle, with governments opting to devalue again and again to keep rivals from gaining export-price advantages. The longer this wave goes on, it benefits few countries--and threatens nearly all.

What is needed most is the thing in increasingly short supply worldwide: confidence.