What Is Currency Depreciation?

Currency Depreciation Explained

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 inthe currency depreciation graph.

Key Takeaways

  • 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.

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 appreciationCurrency AppreciationCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more, 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.

We may clearly understand 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.

Examples

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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. Can you relate this with the depreciation of currency?

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 which has impacted 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 par when the UK was following EUR), contingent futuristic planning, etc.

Effects

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

  • Debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more 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.

Disadvantages

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 citizen. Let us discuss them through the point below:

  • 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 instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more becomes more costly.Depreciation in the currency may impact the country’s overall growth, including employment, financial markets, trade deficitTrade DeficitWhen the total sum of goods or services that a country imports from other countries is higher than the total sum of goods or services that a country exports to other countries, this is referred to as a trade deficit, which is the opposite of the balance of trade theory.read more, increased foreign direct investmentsForeign Direct InvestmentsA foreign direct investment (FDI) is made by an individual or an organization, into a business located in a foreign country. The host nation receives job creation prospects, advanced technology, a higher standard of living, infrastructural development, and overall economic growth.read more (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, 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 Currency Depreciation and its meaning. Here we discuss examples, effects, and disadvantages. You can learn more about macroeconomics from the following articles: –

The capital outflow is the asset’s movement out of the country. It is considered undesirable as it happens due to political or economic instability. At the same time, currency depreciation refers to the country’s value exchange value compared to other countries in a floating rate system.

The trade deficit causes currency depreciation. When domestic production of commodities is more expensive than exporting them, a nation may have a trade deficit. It follows that consumer products and service prices might go down.

The currency depreciation weakens the domestic currency making the exports more competitive in the global markets and, at the same time, making the imports more costly.

The effect of currency depreciation on business is as per the transaction type. However, it may also positively affect sales made to foreign parties, irrespective of the currency involved.

  • Depreciation for Rental PropertyEconomic DepreciationFull Form of FDIFormula of Balance of Payments