Currency Depreciation (Definition, Causes) | Economic Effects & Examples

Currency Depreciation

“Currency Depreciation” is the fall in the exchange value of a country’s currency in comparison to other currency in a floating rate system and is determined based on trade imports and exports for that country. Increase in demand for foreign products results in more imports, which in turn results in investing in foreign currency thereby resulting in domestic currency depreciation. Value of a particular currency is determined based on the economic situation and it further impacts other economic decisions and/or value of its products and output. It directly impacts financial markets of that country’s securities.

Currency Depreciation Example

Given below are the examples of currency depreciation.

Currency Depreciation – Example #1

Country A which has currency ABC trades with Country P having currency PQR. In the present scenario, in exchange for 1 unit of ABC, you are paid 2 PQR. Due to certain industrial setbacks and other political events in country A, the exchange rate for its currency got affected. Now, in exchange for 1 unit of ABC, you are paid 1.8 PQR. Can you relate this with depreciation of currency? Which currency got depreciated and by how much?

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

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which means for every ABC, you are paid only 1.8 PQR now vs 2 PQR earlier. Hence ABC has depreciated, and PQR has strengthened.

Depreciation % = (2 – 1.8)/2 = 10%

Currency Depreciation – Example #2

Brexit is the most recent scenario which has impacted currency depreciation of GBP (Great Britain Pound or Sterling) with USD. With Britain’s decision to exit itself from European Union (EU), there was 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, UK will have its official currency as GBP (and not EUR).

Within a 1-year span, it can be noticed that GBP has depreciated from 1.32 USD to 1.27 GBP, with intermediate ups and downs included.

Source: www.xe.com

Currently, GBP/USD trades at 1.27 (as on 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, not only does the currency value get affected but also the economy of the country due to more expensive imports, currency relationships with other countries following EUR (which would have been par when UK was following EUR as well), contingent futuristic planning, etc.

Effects of Currency Depreciation

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, and debt instruments may not be impacted 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 rate may face cuts, thereby the economy may get balanced eventually.
Currency depreciation may result in more supply of foreign products in domestic markets. This ideally should increase the prices of such products in the country’s markets, however, with time this will also result in the emergence of more domestic production to compete with such foreign products. Hence, eventually, prices of such products will go down, thus helping the economy in both ways – increase in industrial output and balance in prices.
As industrial output increases, the overall demand for products rises for the country. Thus, gradually, this leads to better growth for the country.
With an increase in industrial output, the country experiences an increase in employment opportunities.

Disadvantages of Currency Depreciation

Inflation rises due to currency depreciation. Depreciation results in more imports due to which prices of commodities rise which results 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 expensive.
Depreciation in the currency may impact the overall growth of the country, which includes employment, financial markets, trade deficit, increased foreign direct investments (FDIs), etc.
The decrease in value of currency impacts its performance in international capital and industrial markets. Most of the currencies are internationally traded and have foreign exchange value. Hence, depreciation of currency regarding another particular currency impacts its value with other currencies as well.
Currency depreciation impacts future decisions for the country’s industries and other markets. Most of the times it becomes difficult to make future projections in case of unclear futuristic conditions.
Depreciation for even a single day can cause great impacts on financial markets if unexpected, especially for securities which are not hedged completely or accurately.

Limitations of Currency Depreciation

Currency depreciation and its impacts greatly depend upon the situation and current condition of the country’s economy. In case of a recession, depreciation can prove to bring growth to the economy by impacting industrial output due to competitiveness. The opposite impact may be in case of rapid development, if there is depreciation, the economy may experience a slowdown due to increased inflation.

Important Points to Note

Depreciation in currency refers to an increase in imports. This 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. This directly impacts the financial markets.

Conclusion

Currency appreciation which is the opposite situation of currency depreciation gives exactly the opposite scenario to the above. As currency depreciation has both advantages and disadvantages, for an economy both appreciation and depreciation are required to maintain the right balance, however, based on different situations.

It may be clearly understood that during the prevalence of either situation markets are hit at once, and so are investments made into respective securities. In such cases, right hedges are required and accurate market view helps meaningful returns to investors.