Currency Depreciation

Currency depreciation refers to the exchange value of a country’s currency compared to other currencies in a floating rate system. Currency depreciation rate  is determined based on trade imports and exports for a particular country. Demand for foreign products results in more bring-in, resulting in foreign currency investment and domestic currency depreciation.

The value of a specific currency is determined based on the economic situation. It further impacts other economic decisions and/or the value of its products and output. It directly affects the financial markets of that country's securities. An increase in demand for products is experienced as a part of the currency depreciation effects.

• Currency depreciation refers to the country’s fall in exchange value compared to the other currencies in a floating rate system. 
• It is calculated based on trade imports and exports for a specific country.
• Debt instruments become cheaper due to the rise in interest rates. Therefore, if the depreciation is due to factors other than inflation, interest rates may not be affected adversely. Hence, it may not wholly impact debt instruments.
• In the case of inflation, interest rates may increase. Therefore, the government may try to control it by implementing curbs on interest rates.

Currency depreciation is the decline in the value of the currency of a particular currency in comparison with other countries' exchange rates. Fluctuations in import & export, political instability, and macroeconomic factors can cause a decline in the currency depreciation graph.

Depreciation in currency refers to an increase in imports. It is directly proportional to domestic balance outflow. It denotes the situation of increasing inflation in that home country. It denotes higher interest rates prevalent during that period in the home country. Therefore, it directly impacts the financial markets.

Currency appreciation, the opposite situation of currency depreciation, gives the opposite scenario to the above as currency depreciation has both advantages and disadvantages. However, appreciation and depreciation are required to maintain the right balance based on different situations.

Currency depreciation and its impacts greatly depend upon the situation and current condition of the country's economy. For example, during a recession, devaluation can bring economic growth by impacting industrial output due to competitiveness, and the opposite impact may be in the case of rapid development. On the other hand, if there is depreciation, the economy may experience a slowdown due to increased inflation.

It is clear that markets are hit at once during the prevalence of either situation and investments made into individual securities. In such cases, the right hedges are required, and an accurate market view helps meaningful returns to investors.

Let us understand the currency depreciation rate with the help of a couple of examples.

Example #1

Country A has currency ABC trades, with Country P having a currency PQR. In the present scenario, in exchange for 1 unit of ABC, you are paid 2 PQR So now, in exchange for 1 unit of ABC, you are paid 1.8 PQR.

Country A has currency ABC and country P has currency PQR. One unit of ABC is equal to two units of PQR. However, due to certain industrial setbacks and other political events in country A, the exchange rate for its currency got affected. Therefore, for one unit of ABC, an individual gets 1.8 PQR. Can this shift be related to the depreciation of the currency? If so, which currency got depreciated, and by how much?

Let us understand through the calculation below:

Solution:

In the above example,

Initially, 1 unit of ABC = 2 units of PQR or ABC / PQR = 2

In the next scenario, after a change in the currency exchange rate

1 unit of ABC = 1.8 units of PQR or ABC / PQR = 1.8

Only 1.8 PQR is paid now vs. 2 PQR earlier for every ABC. Hence ABC has depreciated, and PQR has strengthened.

Depreciation % = (2 – 1.8)/2

= 10%.

Example #2

Brexit is a scenario that has impacted the currency depreciation of GBP (Great Britain Pound or Sterling) with USD. But, then, Britain’s decision to exit itself from the European Union (EU) had a huge impact on GBP. Till recently, Britain has been a part of the European Union, and hence EUR is prevalent in the UK. However, with Brexit, the UK will have its official currency as GBP (and not EUR).

GBP has depreciated from 1.32 USD to 1.27 GBP within one year, with intermediate ups and downs included.

Source: www.xe.com

GBP/USD trades at 1.27 (as of Jun 30, 2019).

When compared with its value in 2008, one can see how sharply it fell in these years: -

Source: Bloomberg & BBC

Thus, GBP suffers a loss in value due to adverse political conditions prevalent in the country. Due to this, the currency value gets affected and the country's economy due to more expensive imports, currency relationships with other countries following EUR (which would have been parred when the UK was following EUR), contingent futuristic planning, etc.

Let us understand the effects the currency depreciation rate can have on imports, exports, individuals, and the economy on the whole.

• Debt instruments may become cheaper due to the rise in interest rates. However, if the currency depreciation is due to other factors (and not inflation), interest rates may not be adversely affected. Therefore, it may not impact debt instruments completely.
• In the case of inflation, the interest rate may rise. However, the government may try to control the same by imposing curbs on interest rates. Hence, interest rates may face cuts; thereby, the economy may get balanced eventually.
• Currency depreciation may result in more supply of foreign products in domestic markets. Ideally, it should increase the prices of such products in the country's marketplace. However, this will also result in the emergence of domestic production to compete with such foreign products. Hence, eventually, prices of such products will go down, thus helping the economy in both ways – increasing industrial output and balancing costs.
• As industrial output increases, the country's overall demand for products rises. Thus, gradually, this leads to better growth for the country.
• With an increase in industrial output, the country experienced increased employment opportunities.

Despite being one of the most sought-after metrics globally, it has its share of factors that are not welcomed by investors in the economy, world leaders, or even citizens. Let us discuss its advantages and disadvantages through the points below:

Advantages

• Devaluation in terms of prices increases the export value for the country as the cost of products or services becomes cheaper.
• The interest rates also become cheaper, making it easier to repay loans or pay interest in a timely manner.
• The devaluation's effects ultimately act as a mechanism to improve the economy overall.
• A trade deficit of the country is minimized through a high volume of exports.

Disadvantages

• Inflation rises due to currency depreciation. Depreciation results in more imports, due to which prices of commodities rise, resulting in an overall increase in prices.
• Financial instruments get more expensive at the time of prevalent currency depreciation. As interest rates go up, investment in financial instruments becomes more costly.
• Depreciation in the currency may impact the country's overall growth, including employment, financial markets, trade deficit, increased foreign direct investments (FDIs), etc.
• The decrease in currency value impacts its performance in international capital and industrial markets. Most of the currencies are internationally traded and have foreign exchange value. Hence, the depreciation of currency regarding another particular currency impacts its worth with other ready money.
• Currency depreciation impacts future decisions for the country's industries and other markets. Therefore, it becomes difficult to make future projections in unclear futuristic conditions most of the time.
• Depreciation for even a single day can cause great impacts on financial markets if unexpected, especially for securities that are not hedged completely or accurately.

This article has been a guide to what is Currency Depreciation. Here we explain its examples along with the effects, advantages, and disadvantages. You can learn more about macroeconomics from the following articles: -

• Depreciation for Rental Property
• Economic Depreciation
• Full Form of FDI
• Formula of Balance of Payments