NCPA - National Center for Policy Analysis

Devaluation Hurts in the Long Term

February 28, 2003

Over the past decade, many countries like Brazil and Argentina have devalued their currency to spur growth. However, researchers say this strategy only works for labor-intensive firms in the short term and could have many long-term consequences.

When a country devalues its currency, its goods are cheaper on the world market, which boosts exports and profits. However, all imports become more expensive, making importing capital more expensive.

  • Immediately following devaluations, firms in the crisis countries expended their output by an average of 21 percent, compared to output growth of 8 percent in non-devaluing countries.
  • Profits followed a similar pattern; growing by 23 percent in devaluing countries versus 8 percent in non-devaluing countries.

In the long run, however, these profits may be illusory because of the higher capital costs.

  • Firms with higher capital/labor ratios showed an average return of negative 34 percent.
  • Returns for companies with lower ratios averaged a negative 21 percent.

Ultimately, a key factor that determines whether the firms benefit from devaluation is whether the cost advantage from cheaper labor outweighs the disadvantage from expensive capital.

Source: Carlos Lozada, "Impact of Devaluations on Commodity Firms," NBER Digest, December 2002. Based on: Kristin Forbes, "Cheap Labor Meets Costly Capital: The Impact of Devaluations on Commodity Firms," National Bureau of Economic Research, Working Paper No. 9053, July 2002.

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