Effects of currency devaluations on the economic growth in developing countries

Assuming that a developing country receives capital inflows from foreign investors, either to pursue economic growth or as a result of trading, and that to access international capital markets it has to denominate its debts in the currencies of the principal creditor countries, how the country’s economic performance is affected when a currency devaluation occurs? The aim of this paper is not only to prove that a devaluation can be contractionary, but also that its occurrence can be the result of a self-fulfilling prophecy. Using a framework based on the existence of credit constraints on firms’ borrowing capacity and on nominal price rigidities, we present a model where after a sharp change in the nominal value of the domestic currency, an increase in the debt service cost of foreign currency denominated debt follows. Hence the firms’ profits fall, reducing their borrowing capacity, so that investment and output decrease in the following period. The focus is on the expectations about future output and the fact that a change of theirs can trigger a currency devaluation that will actually confirm the initial expectations in a self-fulfilling way. Finally, it is presented an empirical analysis regarding the impact of devaluation on the economic growth in a sample of five countries, considering as a key factor the amount of debt denominated in foreign currency relative to GDP.