Internal Devaluation Defined

There is a certain symmetry to the Swedish oeuvre – boxy Volvo’s, Bjorn Borg’s headband, ABBA’s white jumpsuits, losing the kids in Ikea… and now ‘internal devaluation’.

It’s a term that appears to be gaining some traction (albeit that it is yet to register a tremor on the Google Trends Richter scale). I wouldn’t be surprised to hear it used by mainstream media in relation to the US-China relationship sometime soon.

If it sounds like an oxymoron that’s because, strictly speaking, it is. (Perhaps that is why I like it so.) ’Devaluation’ refers to a process whereby a certain thing reduces in value relative to another thing – by definition this other thing is external to the first. It typically refers to a country’s currency reducing in value relative to others.

The Swedes first coined the phrase back in the late 90′s when exploring mechanisms to manage their economy should they join the Euro. It has gained in prominence in recent times as a way to describe the adjustment process that Latvia has adopted to gain access to IMF supported funding. No surprise that Swedish banks are the biggest creditors to Latvia.

Anyway, the essential thrust of the concept is that a country in a fixed exchange rate regime can still manage its relative competitiveness by reducing its labour costs through fiscal measures. For example, a country could finance a decrease in payroll taxes through increased income taxes. Such a shift reduces real labour costs and therefore increases the competitiveness of exports – while also being budget neutral and reducing consumer demand in that country. In theory, it, therefore, achieves a similar outcome as a currency devaluation. (And to be fair, as the objective is to reduce the labour costs relative to that country’s trading partners, there is some internal logic to calling it an internal devaluation.)

In Latvia’s circumstances, it seems that the term has departed somewhat from its original meaning. The IMF sponsored plan calls for 20% cuts in public sector wages, 20% cuts in pensions, an increase in VAT from 21% to 23%, rise in the average effective rate of personal income tax etc… There isn’t much focus on labour productivity or unit costs. It simply reduces the budget deficit at all costs.

From this distance (which admittedly is a long way) it seems that Latvia has been bent over in an attempt to save some of those Swedish bank loans – there is a general consensus that a devaluation of its currency would wipe out a great swathe of what’s left of the private sector given the impact this would have on EUR denominated debt.

The people of Latvia aren’t happy.

Now while this is all very interesting (or not) what has it to do with the price of fish (outside Riga)? The answer is that some pretty important currency relationships around the world are effectively fixed – think the EUR countries and the exchange rate between the US and China. And some of the countries in these relationships are straining from imbalances similar to those that have impacted Latvia.

Consider the US-China pairing. A Fistful of Euros has already suggested that China has applied its own unique brand of ‘internal revaluation’. Rather than let the RMB appreciate, it will apply ‘rebalancing measures’ to increase domestic consumption by increasing social security and healthcare benefits (thereby increasing disposable income as consumers don’t have to save for emergencies).

And to flip it around the other way, with China pegging the RMB to the USD, the US is faced with the same obstacles in trying to engineer greater competitiveness for its goods. Its market can respond in the only way it can – increase the ranks of the army of the unemployed, thereby forcing labour market reform. I can almost hear Keating saying “It’s the internal devaluation we had to have”…

The funny thing is that the US is doing the exact opposite of the IMF prescribed medicine for Latvia. Everyone knows that there is a logical limit to the amount of debt the government can issue…the question remains how close are we to it?

This website does not offer financial advice. You should assume that the author has positions in any securities mentioned in this article.

In-house Analyst
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