Settling trade scores via currency devaluations

This article appeared originally in Gulf News: link to original article

Work done by Adam Smith and David Ricardo has been long accredited for understanding the framework behind the old international trade system. Where countries trade the commodity that they produce — at a relatively lower cost of production — for what would have required additional allocation of resources to produce.

In other words, the country has a comparative advantage in that production. As the system evolved and trade became much more inter-related and inter-dependent, variations between one comparative advantage in production and another became almost negligible. Countries therefore resorted to tools that will safeguard their comparative advantage in trading the commodity even in the absence of a comparative advantage in producing it.

Key among these is currency devaluation, the subject of today’s article.

In his book “On the Principles of Political Economy and Taxation”, Ricardo elaborates on the comparative advantage concept with an intricate focus on a two-country, two-commodity model in international trade. What is normally missed here is that Ricardo’s model was unintentionally extended to three commodities when he started discussing the value of a commodity in regard to what it’s being measured against.

That is, Ricardo was indirectly referring to the monetary value of commodities, with gold being the third commodity in his model. With reference to the impact of trade on the monetary value of a commodity, measured in gold, and vice versa, it was only a matter of time before which monetary devaluation was used to skew trade accounts in favourable directions.

In today’s world, trade relations between countries are no longer as simple as Ricardo explains in his Principles book or in other writings. Neither as the model was expanded and further debated by other political economists or international trade theorists such as Malthus. While a country’s production comparative advantage could be calculated in the past using straightforward inputs such as labour, land, and capital, the calculation today is far from simple.

Not just due to the variety and complexity of production inputs, but also because a country at a production disadvantage could manipulate its currency downwards to gain an undeserved advantage over others. And that leads to other trade discriminatory actions such as imposing tariffs.

International trade today is as integrated as it can ever get, with bilateral trade relationships forming a sophistically, intertwined multilateral trade network. Despite it being easy for a country to devalue its currency and secure comparative advantage in such a trade network, such a devaluation could be problematic for a country’s domestic economy and damaging to its fiscal position.

All the while, the perceived benefits of a devalued currency in attracting investments and increasing exports are fairly debatable.

Egypt, as an example, floated its currency in 2016 to avert a fiscal crisis, leading to a significant currency devaluation that had ostensible positive effects on its economy and fiscal position. This was exemplified by multiple oversubscriptions for Egypt’s government debt and a significant increase in the central bank’s reserves as foreign direct investments started flowing again into the economy.

Additionally, exports went up and the trade deficit — when imports exceed exports — went down. On the not too bright side of the equation, inflation skyrocketed, diluting Egyptians’ purchasing power before it was partly reined in. Also, any debt held in Egyptian pounds became more expensive to pay back.

In conclusion, there should be no broad assumption that currency devaluation is automatically beneficial for a country’s trade, or fiscal status. In fact, a country with a significant comparative advantage does not need to expend much effort in managing its currency’s value except perhaps when faced with unfair trade restrictions.

Even then, today’s international trade system is not as modest as the one that Ricardo envisioned for his two-country, two-commodity (or three-commodity) model. Neither are today’s strenuous currency devaluations as unpretentious as his unintended reference to monetary devaluation.

The last thought that I want to leave you with: can comparative advantage be re-conceptualised for today’s trade?