What is currency depreciation?
Currency depreciation is a decline in the value of a currency relative to its exchange rate against other currencies. Currency depreciation can occur due to factors such as economic fundamentals, interest rate spreadspolitical instability or investor risk aversion.
Key points to remember
- Currency depreciation is a fall in the value of a currency in a floating exchange rate system.
- Economic fundamentals, interest rate differentials, political instability or risk aversion can lead to currency depreciation.
- An orderly depreciation of the currency can increase a country’s export activity as its products and services become cheaper to purchase.
- The Federal Reserve’s quantitative easing programs used to stimulate the economy in the aftermath of the 2007-2008 financial crisis caused the US dollar to depreciate.
- Currency depreciation in one country can spread to other countries.
Understanding Currency Depreciation
Countries with weak economic fundamentals, such as the current account deficits and high inflation rates, usually have depreciating currencies. Currency depreciation, if orderly and gradual, improves a country’s export competitiveness and can improve its trade fails overtime. But a sharp and large depreciation of the currency can scare off foreign investors who fear that the currency will fall further, causing them to pull their portfolio investments out of the country. These actions will further downward pressure on the currency.
Easy Monetary Policy and high inflation are two of the main causes of currency depreciation. When interest rates are low, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a phase of currency depreciation. Central banks raise interest rates to fight inflation, as excessive inflation can lead to currency depreciation.
In addition, inflation can lead to higher input costs for exports, making a country’s exports less competitive in world markets. This will widen the trade deficit and cause the currency to depreciate.
Quantitative easing and the fall of the dollar
In response to the global financial crisis of 2007-2008, the Federal Reserve embarked on three rounds of quantitative easing (QE), which sent bond yields to historic lows. Following the Federal Reserve’s announcement of the first round of QE on November 25, 2008, the American dollars (USD) began to depreciate. The US dollar index (USDX) fell more than 7% in the three weeks following the start of QE1.
In 2010, when the Fed embarked on QE2, the result was the same. During the depreciation of the dollar from 2010 to 2011, the dollar reached historic lows against the Japanese yen (JPY), the Canadian dollar (CAD) and the Australian dollar (AUD).
Political rhetoric and currency depreciation
While economic fundamentals mostly determine the value of a currency, political rhetoric can also cause a currency to fall.
Between 2015 and 2016, the United States and China were repeatedly in a battle of words regarding the value of each other’s currencies. In August 2015, the People’s Bank of China (PBOC) devalued the country’s currency, the yuan, by around 2% against the US dollar. Chinese officials said the move was necessary to prevent a further drop in exports.
In 2019, the Trump administration called China a currency manipulator, saying Chinese authorities were deliberately devaluing its currency, resulting in unfair trade advantages.In 2018, US-China political rhetoric turned to protectionism which has resulted in a long-term trade dispute between the world’s two largest economies.
Currency volatility and depreciation
Sudden episodes of currency depreciation, especially in emerging markets, inevitably heighten the fear of “contagion“, where many of these currencies are plagued by similar investor concerns. Among the most notable is the 1997 Asian crisis which was triggered by the collapse of the Thai baht which caused a sharp devaluation in most Southeast Asian currencies.
In another example, the currencies of countries like India and Indonesia traded lower in the summer of 2013 amid growing concerns that the Federal Reserve was about to terminate to its massive bond purchases. Developed market currencies can also experience periods of extreme volatility. On June 23, 2016, the Pound sterling (GBP) depreciated more than 10% against the US dollar after the United Kingdom voted to leave the European Union, called Brexit.
Example of currency depreciation
The currency of Turkey, the lira, lost more than 20% of its value against the USD in August 2018. A combination of factors led to the depreciation. First, investors began to worry that Turkish companies might not be able to repay dollar and euro-denominated loans as the lira continued to fall.
Second, President Trump approved the doubling of steel and aluminum prices imposed on Turkey at a time when there were already fears of the country’s struggling economy. The lira fell sharply after Trump announced the news via a tweet.
Finally, Turkish President Recep Tayyip Erdogan did not allow Turkey’s central bank to raise interest rates, while at the same time the country did not have a sufficient supply of US dollars. to defend its currency foreign exchange markets. Turkey’s central bank eventually raised interest rates in September 2018 from 17.75% to 24% to stabilize its currency and curb inflation.
More recently, in 2020, the lira depreciated significantly due to geopolitical risks resulting from Turkey’s policies in the Middle East and elsewhere. In October 2020, the lira reached historic lows. It fell past 8.05 for the US dollar. The lira has lost 26% of its value in 2020 and more than 50% since the end of 2017.
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