What is devaluation or devaluation risk? Devaluation takes place when a country deliberately adjusts its country’s currency downward relative to another country’s currency.
Devaluation is a monetary policy tool utilized by countries that have a fixed rate of exchange. Devaluation is determined by the government which issues the currency and is the direct result of governmental activity. One of the primary reasons a country devalues its currency is to prevent trade imbalances. When a country devalues its currency it reduces the value in the country’s exports which makes the exports less expensive and in turn makes the exports more competitive on the open global markets.
If a country devalues its currency downward the country may have to raise its interest rates to control inflation. Devaluation makes the items sold in another country more attractive as the price of the item declines relatively in their currency.
Another significant FX risk associated with devaluation is psychological in nature. Devaluation can be viewed as as a sign of economic weakness which can lead to jeopardizing the creditworthiness of a country. At times, devaluation can lead to a domino effect in which other countries devalue their currency in response to the neighboring country devaluing its currency. This type of situation only exacerbates economic problems in the global markets. When trading the forex markets, it is your responsibility to be aware of which countries are devaluing their currency and how you can take advantage of this situation.