Intro: Artificially weakening a country’s currency may appear to be beneficial for economic growth as it often leads to higher exports in local currency terms. However, while exports as a share of GDP may rise due to higher profitability in that sector, this is typically more than offset by the losses in the domestically-focused industries, which see profits undermined by higher import costs.
Central banks often try to weaken their currencies as a way of boosting export demand, which is seen as a driver of growth, particularly in countries with a high level of exports relative to GDP. However, artificially weak currencies tend to increase exports only at the cost of higher import costs and overall economic weakness. The reason is that overall profit opportunities tend to be reduced and economic distortions build.
Even if exports rise in local currency terms in response to purposeful currency weakness, this does not necessarily mean that the dollar value of exports will increase, particularly if the country’s exports are highly specialized and not particularly price sensitive. Similar to a company cutting its sales prices to boost sales volumes, it is far from guaranteed, and actually rather unlikely, that overall revenues will increase.
In cases where the dollar amount of exports rises, the overall dollar cost of imports will likely rise by more, at least in the short term. This is because it takes time for lower export prices to benefit export volumes while the impact of the price changes immediately lead to higher import costs and lower export revenues (the J-curve effect).
Even in the case that efforts to support exports by artificial currency weakness actually leads to an improvement in the country’s trade balance as exports increase more than imports, this does not mean that the policy is positive for the economy overall. In order for exports to increase, more resources end up being pulled from other sectors of the economy, which means that the increase in exports is offset by the impact of reduced output elsewhere, all else equal.
The Visible Versus The Invisible Impact of Currency Weakness on Economic Output
There seems to be a widespread misunderstanding that higher import costs and lower export prices as a result of currency weakness are positive for economic growth as they improve the competitiveness of domestic businesses. While it is true that higher import costs benefit some businesses that compete with importers, and lower export costs benefit some export-oriented businesses, to focus on only the beneficiaries is a case of not seeing the wood for the trees.
From an economy-wide perspective, growth is supported when import prices are cheap and export prices are expensive. The reason being that a smaller amount of export shipments can generate the revenue to purchase a larger amount of imports. This is why oil exporting countries benefit when the price of oil rises as it allows a greater amount of imports to be purchased for any given amount of oil production. As imports are key inputs into the domestic production process, this allows for an increase in domestic output across the rest of the economy.
Central bank currency manipulation efforts effectively force the economy to run to stand still by offering up its exports at artificially discounted values. Additionally, over time, artificially weak currencies will tend to result in excessive reliance on external demand to drive growth, leaving the country exposed to a painful rebalancing when the currency eventually finds its fair value.
It can appear, at least in the short term, as though efforts to weaken currencies can boost growth, but in the instances where currency weakness does appear to support growth this tends to be caused by other factors that simultaneously support near-term growth and weakness the currency. Specifically, monetary and/or fiscal stimulus measures can lead to a rise in asset prices which provide a short-term stimulatory impact on economic growth. In such cases though, the currency weakness actually tends to act to offset the positive short-term impact of asset prices increases on economic growth.