Devaluation means decreasing the value of the country’s currency in terms of other currencies. Devaluation largely applied to exchange rate reduction of national currencies which are pegged to USD, other currencies, The Special Drawing Rights (SDR) of IMF and other composite currencies.(Teklebrhane, 1992:27)
There are many reasons as to why a country seeks to adopt the policy of exchange rate devaluation; the main reason is the need to overcome economic difficulties caused by over valuation of exchange rate.
According to World Bank (1992:22): ¨…an over valuation of exchange rate imposes an implicit tax on export and hence discourages the production of exportable goods. It also sets an implicit subsidy on imports and hence encourages imports worsening the current account.¨
The other argument of devaluation is that it normally creates investment opportunities in the devaluating country by improving the situation for foreign investors inviting an inflow of capital (World Bank, 1992). Especially in the countries whose demand for export is relatively income elastic, this means that a percentage increase in income of the country’s trading partners increases the export demand of the devaluating by a larger percentage. As a result of this the nation’s income from export rises following devaluation. This calls forth investors to the export sector of the country. Devaluation is sometimes adopted to correct the inflationary situation caused by overvaluation.
That means devaluation is expected to increase the price of exportable relative to that of non-tradable there by shifting aggregate supply to the tradable and aggregate demand to non-tradable. And hence export earnings would increase resulting in the improvement of current account and hence balance of payments. In addition to the shift in production from home goods (non-tradable) to tradable, the shift also occurs from import to import substitution.
Devaluation may be able to reverse the imbalance of trade balance by lowering its price so that exports are encouraged while imports are made to decline. One way of accomplishing this is by adjusting the exchange rate through currency devaluation. Devaluation of a currency may improve or worse the trade balance the ultimate outcome of currency devaluation depends on the nation’s price elasticities ((responsiveness)) of demand for exports and imports. (Baker, 1995) 
Devaluation increases the relative prices of foreign goods (imports) in the devaluing country; as a result the demand for home goods in both countries (the devaluating and its trading partners) will increase. An increase in demand for home goods, increase the exports and decrease imports of the country. The increase in the relative prices of imports makes the imports more expensive in terms of exports which cause the deterioration of the trade balance. From these two effects we cannot say that devaluation is way to improve or worse trade balance. To conclude the total effect of devaluation, we have to compute the price elasticities (responsiveness) of demand for exports and imports.
There are a number of studies regarding the impact of devaluation on the Ethiopian trade balance with opposing results. While some of them identified devaluation to have a positive impact on the trade balance, other studies do not seem to support the positive impact of devaluation on the trade balance.
Historical Background
From the late 1940s through the early 1990s, the Ethiopian currency, the Birr, remained rigidly pegged to the US dollar. During 1945-71 the Birr/US$ rate remained unchanged at 2.5. It was revalued to 2.3 in December 1971 and then to 2.07 in February 1973 and remained at that level until October 1992. The natural outcome of this passive exchange rate policy was the development of an illicit parallel market for foreign exchange, where at times the foreign exchange premium (the spread between the two rates) reached as high as 230 percent. The overvalued official exchange rate, coupled with stringent foreign exchange rationing, provided fertile ground for illicit cross border trade, particularly in coffee and live animals.
As part of the overall reform program of the new government, the exchange rate was adjusted from Birr/US$2.07 to US$5.00 on 1 October 1992 (a 142 percent devaluation). Following the devaluation, the exchange rate was allowed to be determined according to demand and supply conditions in the foreign exchange market, with the National Bank of Ethiopia (NBE, the Central Bank) intervening only to smooth out erratic fluctuations in the rate. By the end of 2002, the rate was around Birr/US$8.75. What exists today can be broadly described as a managed float.
The NBE has taken a number of initiatives to improve the functioning of the foreign exchange market with a view to helping to keep the exchange rate at realistic levels and to gradually harmonize the official and parallel foreign exchange markets. These included eliminating foreign exchange rationing, inaugurating a foreign exchange auction in May 1993 (on a fortnightly basis to begin with and on a weekly basis since September 1998) , permitting commercial banks to open foreign exchange bureaus to engage in retail foreign exchange trading (October 1996), and permitting inter-bank foreign exchange trading (September 1998).
The annual increments between the year 1964 and 1971 was zero as shown in the table above. This indicates that there was no misalignment of exchange rate or no exchange controls in this period. However, there was over time increase in the premium from 1972 until 1991, on average. Consequently, there was rapid expansion of in illegal trade and smuggling. The smuggling of major exports had its own implication for the continuous decline in the trade balance and for the shortage of foreign exchange.
In a desire to solve the problems related to the fixed exchange rate the EPRDF led Ethiopian government devalued the Ethiopian Birr by 241.5% in 1992 in nominal terms. After this massive devaluation the price of one US dollar raised from Birr 2.07 to Birr 5.00 in nominal terms. This was 42% devaluation of Birr in nominal dollar terms; this is the decline of the Birr in nominal dollar terms from 0.48 before devaluation in 1991 to 0.2 in 1992 which is after devaluation. As a result of this, as we can see from table 1 that premium decreases from 3.38 in 1992 to 1.48 in 1992. Therefore devaluation of the country’s currency helped to reduce the gap between the official exchange rate and parallel exchange rates but did not remove the premium.
Foreign exchange shortage
A common retort to sustained foreign exchange shortages is to devalue the currency. This lowers demand for imports as import prices rise in domestic currency terms, while at the same time foreign exchange earnings from exports rise as demand for more competitively priced exports rises. When the devaluation is large enough, demand for and supply of foreign exchange will return to equilibrium. This may lead to imported inflation, especially in import-intensive countries such as Ethiopia. When monetary authorities deem a foreign exchange shortage to be short term in nature (for example, until such time as exports recover from a shock), they may attempt to maintain the level of the nominal exchange rate by borrowing in the international market and buying local currency to prop up the exchange rate. While this is an effective strategy in the short run to limit exchange rate volatility, it raises government debt and is therefore not sustainable in the long run.
Under a fixed exchange rate regime any excess demand for foreign exchange will lead to the development of a parallel market for foreign exchange, where foreign exchange is sold at a premium (and often illegally so). Foreign exchange shortages may be the result of insufficient export revenues or declines in foreign exchange from other sources such as donor grants or foreign direct investments. Under a fixed exchange rate regime, a typical response to foreign exchange shortages is for monetary authorities to ration the supply of foreign exchange available to the “regular person on the street.” This is often done in order to prioritize the importation of essential goods such as fuel or medical supplies. If those with access to foreign exchange at the official exchange rate are importers, the limited supply of imported goods means that the importers can charge a premium for the goods they bring into the country.
Similarly, if those with access to foreign exchange are currency traders, they can sell the acquired foreign exchange to importers, who then have no choice but to price the imported goods at the parallel exchange rate rather than at the official exchange rate. “At the height of the foreign exchange rate crisis in Malawi, a premium of up to 100 percent over and above the official exchange rate existed.”1 This scenario appears unlikely in the absence of a forex market and in a tightly controlled forex regime like Ethiopia.
On the socioeconomic front, the most profound outcome of the devaluation is its impact on the distribution of income. It is probably very safe to assume that it is not the poor that benefit from rents associated with the exchange rate premium. The poor are, however, affected by rising prices. Under a flexible exchange rate regime, wealthier households no longer capture the rents, while rural households (and farm households in particular) benefit from improved export opportunities and lower domestic prices. This result challenges the perception that devaluation will harm the poor more than will a fixed exchange rate regime. Many of the poor live in rural areas and are employed in the agricultural sector, a sector that has suffered losses in recent times due to an uncompetitive exchange rate and falling international prices.
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References:
* Karl Pauw, Paul Dorosh and John Mazunda, Exchange Rate Policy and Devaluation in Malawi, IFPRI Discussion Paper 01253, 2013
* Haile Asmamaw, The Impact Of Devaluation On Trade Balance: The Case Of Ethiopia, Department Of Economics University Of Oslo, MAY 2008
* Baker, J.M, 1995, International Economics. New York, McMillan publishing company.
* Befekadu, D. and Kibre, M., 1994, Post devaluation Ethiopian economy, Ethiopian economic association, Addis Ababa.
