Academic journal article Atlantic Economic Journal

Effects of Currency Devaluations on the Economic Growth in Developing Countries: The Role of Foreign Currency-Denominated Debt

Academic journal article Atlantic Economic Journal

Effects of Currency Devaluations on the Economic Growth in Developing Countries: The Role of Foreign Currency-Denominated Debt

Article excerpt


Assuming that a developing country needs capital inflows from foreign investors, either to pursue economic growth or as a result of trading activities, and that to access international capital markets it has to denominate its debts in the currencies of the principal creditor countries and financial centres (i.e., U.S. Dollar, Yen, Euro, Sterling, and Swiss Franc), how do these assumptions affect the country's economic performance when a currency devaluation occurs?

In economic textbooks, the conventional answer to currency devaluations is analyzed within the Mundell-Fleming model and the result is a positive effect on the current account. Thus, devaluation is expansionary in terms of GDP since exports increase more than imports. This model might be naturally extended by considering many other important features, which determine the degree of the reaction of the current account, such as: (i) the price elasticity of world's (country's) demand for tradable goods, i.e., the variation of the exports (imports) in response to a real exchange rate variation; and (ii) the presence of supply shocks effects due to the presence of intermediate inputs and raw materials, e.g., oil, which might generate inflationary pressures.

Nonetheless, given the fact that the country's debt is denominated in foreign currencies, a real exchange rate variation can also cause some important balance sheet effects. First, government spending can be significantly reduced if constrained by rules aimed at avoiding a deficit increase, since a larger amount of money would then be required for interest payments over sovereign debt. Second, private investment and consumption can diminish, given that debt service costs increase, profits shrink, and bank lending is constrained (since it relies on the collateral that the firm can provide, i.e., the firm's value calculated as the net present value of its future returns). The result is a level of investment that is negatively affected. Moreover, the banking sector can be negatively hit by currency devaluation because of the currency mismatches between its assets and liabilities; hence the probability of a financial crisis increases, a fact that would severely worsen the country's economic condition. Finally, a negative wealth effect on national investors, who mainly have assets denominated in national currency and debts denominated in foreign currency, might amplify the volatility of capital flows and introduce the possibility of sudden stops, current account reversals, and self-fulfilling crises. This paper evaluates the net effect of a real exchange variation, focusing on the impact of balance sheet effects and demonstrating that currency devaluations can be contractionary.

Different aspects point out the importance of this issue: a better understanding of the Asian financial crisis of 1997 and the way it was managed; the rising importance of developing countries in the global financial system and their relationships with debt; the currency in which it is denominated; the consequences of the existence of some currencies that are more important than others; and the increasing amount of global debt. Moreover, it may suggest some indications about the current Greek debt crisis, since some have argued that a hypothetical solution is a temporary exit from the Eurozone, which would then allow them to devaluate the currency and improve its competitive problems, thus avoiding a default on its debts. But are they denominated in Euros, a forthcoming foreign currency, or not?

The rest of this paper is organized as follows. In the next section, a review is presented in brief of the literature that focuses on the causes of foreign currency debt, then the strand of literature that introduced the contractionary effects of devaluations is explored, and finally the third generation of currency crisis models is presented. In following section, there is a detailed description of the model, mainly based on Aghion et al. …

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