This article appeared originally in Gulf News: link to original article
What does it mean for a country to float its currency? The obvious meaning is to unpeg it from whatever internationally-believed-to-be-sound kind of currency. But other than that, what does it really mean to float a currency?
A depreciation in the floated currency’s value has been the natural result of many currency floats. The relationship, however, is more complex. In this article, I would attempt to breakdown that relationship by identifying the different connections in a country’s economy, its GDP components, as directly or indirectly affected by floating that country’s currency.
Currency value and consumption
A currency’s depreciation accompanied by low interest rates means lower saving rate and higher domestic consumption, including spending on imports. The currency’s appreciation paralleled with higher interest rates would result in a higher saving rate, domestic investment that is, and lower consumption.
However, there could be higher spending on imports. This will be subject to the individual’s preference towards saving or spending.
Currency value and government spending
Floating the currency means freeing up cash that could be used to spend domestically, which needs to be controlled to not push inflation beyond its targeted rate. This is regardless of whether the currency appreciates or depreciates in value.
Government revenues could be positively or negatively affected here, in accordance with other GDP components discussed below. That will be in terms of the revenues collected by the government, linked to other GDP components, which could increase or decrease its spending.
Also, if the US Fed decides to raise interest rates, all countries that are net exporters of oil with currencies pegged to the dollar will be in a very tough position to support a fixed rate and wither the effects of low oil prices on their economies.
Currency value and investments
If the floated currency’s value went down versus investment currency, investments in capital will be encouraged as long as the depreciation of the floated currency does not cause an inflation outbreak. This could include real estate or even stocks.
If the currency appreciated in value versus the investment’s currency, then investments in the given country will be discouraged. However, investments – or inflow of foreign currencies – will be encouraged to reap the benefits of the currency’s appreciation, whether by realizing gains from further appreciation or because of higher interest rates.
Currency value and trade balance – exports
For oil exporters in times of low oil prices, a devalued currency would encourage exports from other sectors given that those are developed and are competitive. Take the examples of Azerbaijan and Kazakhstan, when they floated their currencies that were previously pegged to the dollar amid low oil prices.
Eventually, market conditions do determine the true value of the currency. Another example is that of Nigeria, which is also an oil exporter and is still maintaining a peg to the dollar by artificially keep the value of its currency higher. This and low oil prices are draining Nigeria’s foreign currency reserves.
If for some reason the currency’s value appreciated, which would be the case if China unpegs yuan from dollar, then exports will be discouraged.
Currency value and trade balance – imports
If a floated currency’s value goes down, purchasing power of that country’s citizens is reduced, and imports become more expensive and less affordable. This is the case in Egypt as of the time of writing this article.
If the currency’s value went up when floated, let’s say in China’s case, then its citizens would realize a higher purchasing power that would encourage them to spend more, whether domestically or on imports, or internationally by travelling more and spending more abroad.
Pressures on China to float its yuan is to curb at least one exporting advantage.
The last thought that I want to leave you with: can exports from non-oil sectors be promoted without floating or devaluing the currency? (Hint: Iran and sanctions.)