FOR MANY YEARS, devaluations have been advocated and implemented as means of boosting the external price competitiveness of an economy. However, due to the peculiarities of each individual country, such devaluation episodes have not always been successful. The elasticity of demand of imports and exports is an important element that must be examined in the context of devaluation.
For a devaluation to have a positive impact on the balance of payments, the so-called Marshall-Lerner conditions must hold, that is, the sum of the imports and exports elasticity must sum to more than one. The impact of a devaluation on a small economy relative to a large economy may differ owing to differences in trade, production and consumption. Exchange rate devaluations can also have differential effects depending on the amount of external debt a country holds.
If a country has borrowed extensively from foreign countries, a devaluation would make it more expensive for loans to be serviced in local currency, and the devaluation therefore aggravates fiscal challenges. Moreover, efforts to attain fiscal consolidation targets may worsen the recession. In the event that the fiscal strategy is undermined, money creation may increase foreign exchange demand, and a currency crisis may occur when reserves decline to a level at which investors realise that if they wait any longer to trade in their domestic currency for foreign, there won’t be enough to go around.
In light of the above, a fall in reserves would trigger the perception of investors that a devaluation is likely, which would leave to speculative attacks were speculators would sell the domestic currency in exchange for the country’s foreign reserves, thereby depleting the money supply.
In small economies, devaluation invariably causes high inflation and often results in economic contraction, rather than economic growth.
The small economy has very limited prospects for import substitution, if there is an increase in the relative prices of imports relative to domestic production. Small countries tend to have smaller import substitution possibilities, averaging about 16 per cent, while larger countries could on average substitute almost one third of their imports with domestic production.
The combination of high import content and exchange rate depreciation has a severe impact on inflation in the small open economy, far greater than the larger economies. The combination of high export concentration, limited import substitution potential, and a high import propensity, all of which appear to be common characteristics of small economies, implies that devaluation in small economies is inflationary, and is not growth promoting. There are insufficient domestic producers to substitute efficiently for imports, and therefore there is no possibility to mitigate the inflationary impact of devaluation or imports.
Exports are constrained by supply because the country is an atomistic producer, domestic consumption of exportables offers no scope for expansion, and domestic production of non-tradeables become less productive with devaluation, so there will be no expansion of output as a result of devaluation.
Reprinted from the Central Bank working paper entitled Size Structure and Devaluation. It was authored by Central Bank Governor Dr DeLisle Worrell, University of the West Indies senior economics lecturer Dr Winston Moore and UWI graduate Jamila Beckles.
