Devaluation Won't Fix the Current Account, Danish Study Finds
(Bloomberg) -- Bad news for proponents of competitive devaluation: it won’t help fix a current account deficit.
That’s the conclusion of a study by the Danish central bank, which found that a strengthening of the krone equivalent to 1 percent would, in the long run, weaken the country’s current account by “approximately 0.1 percent” of gross domestic product.
The krone is pegged to the euro, the common currency used by Denmark’s biggest trading partner, with the central bank officially defending a 2.25 percent band around an exchange rate of 7.46038 against the euro. In practice it has only tolerated moves within 0.1 percent, though economists have started speculating that the bank is now willing to live with a weaker krone, making Wednesday’s findings all the more relevant.
As a small and open economy, Denmark is highly reliant on trade, meaning fluctuations in the effective exchange rate should affect imports and exports.
However, Danmarks Nationalbank found that while the krone is today trading at similar levels to where it was in 1980, the country’s current account deficit has since been transformed into a surplus (it peaked at nearly 9 percent of GDP in 2014).
A big reason for the tenuous link between the exchange rate and the current account is that while there may indeed be a so-called “pass-through” effect on the price of imports and exports, this effect is only temporary. Eventually, “exporters and importers will respond to exchange rate fluctuations by changing their behavior,” the central bank said. For instance a weakening of the krone may prompt importers to buy the goods elsewhere, and such shifts are easier in a globalized world. Alternatively, increased competition at home may prevent them from passing on the higher costs to consumers.
|The central bank’s view on the effects of devaluation:|
|“Viewed in isolation, a weakening of the exchange rate boosts a country’s competitiveness by making domestically produced exports cheaper and imports more expensive,” the bank said. “But a weaker krone will also make imports of raw materials and intermediate goods more expensive. So overall Danish firms experience only a modest improvement in competitiveness. Consequently, the impact of the exchange rate on the trade balance is small.”|
This argument is particularly relevant for countries with a relatively high level of imported components in their exports. In Denmark, that’s at approximately 50 percent, the central bank said.
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