Can devaluing a country’s currency increase its foreign reserves?

My answer on Quora:

It depends on the size and direction of the pressure on the currency before the devaluation, and how close the new value of the currency is relative to its market value.

First, a devaluation implies that a central bank is moving its currency from one fixed exchange rate to another one where it is worth less, relative to the currency it is pegged to. So, let’s say the central bank of Macronia (made up country!) devalued its currency, the lira, by moving its fixed exchange from 5 liras per dollar to 10 liras per dollar, for example. What happens to its foreign exchange (FX) reserves after the devaluation?

Let’s look at 4 possible devaluation scenarios, holding all else constant. In Example 1, FX reserves decline. In Example 2, they rise. In Example 3, they stop declining. In Example 4, they stop falling and start rising.

  1. Before the devaluation, there was downward pressure on the lira (vis-à-vis the dollar), and after the devaluation there is still downward pressure, albeit smaller. This means that before the devaluation, the central bank of Macronia was intervening in the foreign exchange market to prop up the value of the lira to keep it at the overvalued old exchange rate. To prop up the lira, the central bank would step in and buy lira from the market to create more demand for it (pushing up the value). It would buy the lira with the dollars it has in its foreign exchange reserves (because it is the lira-dollar exchange rate it is interested in), increasing the supply of dollars, lowering its value relative to the lira. The result is a propped up exchange rate, which requires the central bank to reduce its FX reserves. Now comes the devaluation. Let’s say the central bank devalues the lira (say, because it is running low on reserves or because it wants to lower import costs), but not by enough to lower it down to its true market value. So, there is still downward pressure, but not as much as before. In this example, FX reserves are still declining, but at a slower rate.
  2. Before the devaluation, there was upward pressure on the lira, and after the devaluation, there is stronger upward pressure. In this case, Macronia’s central bank had been intervening to keep the value of its currency lower than it otherwise would have been if left to the market (this may be a desirable policy if Macronia wants to boost its exports or lower the value of its debt, for example. Though, other countries might have something to say in response). So, the central bank would sell its own currency (to increase its supply and lower its value) for dollars (reducing supply of dollars in the market/increasing demand for dollars). So, its FX reserves increase when it intervenes. Now comes the devaluation. Let’s say Macronia wants to take its monetary policy a step further by devaluing the lira even more, moving it further away from its stronger market value, adding to the upward pressure on the lira. In this example, FX reserves are still increasing, but at a faster rate.
  3. Before the devaluation, there was downward pressure on the lira, and after the devaluation it is close to its market value. In this case (which is analogous to a flotation of the exchange rate, or a shift from a fixed to floating exchange rate regime), the central bank no longer needs to intervene (give or a take a few transactions within range) because its desired exchange rate is being set by the market already. So, it no longer needs to prop up the value of the currency and relieves the downward pressure. In this example, FX reserves stop declining.
  4. Finally, there are the situations where the devaluation brings the exchange rate to a level that reverses the direction of the pressure. Let’s say Macronia’s currency is overvalued (there is pressure for it to depreciate), and the central bank devalues it so much that the new exchange rate is undervalued (there is pressure for it appreciate). Before, the central bank was intervening to prop up the value by drawing on its reserves. After, the central bank intervenes to keep the value lower than it ought to be (relative to the market value) by buying more reserves. In this example, FX reserves stop declining and start risingNote that the alternative situation where the exchange rate goes from undervalued to overvalued is not a devaluation, it is the opposite!

Of course, there is much more to monetary policy and a country’s economy than its exchange rate and level of reserves. A variety of factors can influence a central banks monetary policy, including its exchange rate policy and FX reserve management. These include a country’s balance of payments (is it a net lender or borrower?), domestic credit conditions (are banks healthy with enough deposits to cover their lending activities), inflation, open or closed capital account, and more.

 

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