Revaluation Essay

Revaluation occurs when a government or its central bank increases the official price at which its currency can be bought on the foreign exchange (Forex) market. For example, suppose that the current U.S. dollar (USD)/British pound (GBP) exchange rate was 2:1, meaning that $2 had to be given up for each £1 or, equivalently, that £1 was worth $2. If the GBP was revalued, this would mean that more USD had to be exchanged for each GBP, meaning that GBP had become more expensive in dollar terms.

Revaluation occurs under a fixed exchange rate regime. This was the traditional regime for most countries between 1945 (the Bretton Woods system) and the early 1970s, after which many countries moved to floating exchange rate regimes. Under such a regime, the government is committed to a particular exchange rate and manages its foreign exchange reserves (holdings of foreign currencies and gold) to ensure that this rate is maintained. Because a country’s holdings of foreign exchange reserves are closely related to its balance of payments, the extent to which a government is able to maintain a fixed exchange rate is also affected by the balance of payments. For example, a country that had a surplus on its external account would face a positive net demand for its currency as foreigners seek to pay for their net imports. This, in turn, would place upward pressure on the exchange rate and the government would intervene to defend the exchange rate by selling its domestic currency on the Forex markets. This mechanism works in the opposite direction in the case of a devaluation.

The operation of this balance of payments mechanism is not costless: as the central bank increases the supply of domestic currency, inflationary pressures can develop. In more serious cases, and to avoid a conflict between external policy objectives (surplus on external account) and internal policy objectives (price stability), countries can revalue their currency.

The advantage of revaluation in this case is that by making the currency more expensive, inflationary pressures are subdued because the central bank now only requires a more limited increase in the supply of its currency to the Forex markets.

Historically, countries that have revalued their currencies have benefitted from relatively higher rates of growth in productivity; this, in turn, has caused significant surpluses on the external account to emerge. This was the case with West Germany in 1961 and 1969. In 1985 Japan revalued in response to U.S. concerns that trade with Japan accounted for almost 50 percent of the U.S. trade deficit during the 1980s. In 2005 China revalued its currency at a time when it had accumulated approximately $700 billion of foreign reserves. It is often the case that heavy international speculation precedes a revaluation. This is because speculators hope to benefit from purchasing a currency at a lower price and selling it after revaluation.

In a global context, revaluation can help to improve relations between the country accumulating substantial foreign reserves and its main trading partners. In the cases of China and Japan referred to above, there were fears that they had adopted a deliberate policy of maintaining their exchange rate at an artificially low level—in direct conflict with Article Four of the Charter of the International Monetary Fund, which states that countries should avoid deliberate manipulation of their exchange rates to secure an unfair competitive advantage. It is also the case that revaluation can help to reduce the concentration of foreign direct investment in countries that have an undervalued currency. This is because it is relatively cheaper for multinational corporations to acquire assets in these countries by purchasing their currencies.

Countries that revalue their currency may incur a number of macroeconomic costs. For example, by making imports cheaper, revaluation will lead to deterioration in the trade balance; revaluation can cause expenditure-switching effects in favor of imports, which will exacerbate domestic unemployment. Finally, revaluation can reduce and/or reverse inward foreign direct investment. This is because acquisition of assets in another country becomes more expensive if that country revalues its currency.

 

Bibliography:

  1. Richard G. Lipsey and Alec Chrystal, Positive Economics (Oxford University Press, 2007).

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