What is Currency Appreciation and Depreciation?
You lay comfortably on your couch skipping channels on your TV, when you stumble on a headline that the dollar has become expensive compared to the Indian Rupee. You think to yourself:
Why is this news? What does the dollar becoming expensive to have to do with India? Why did the dollar become expensive in the first place?
This event of the US Dollar becoming expensive is called currency appreciation where the value of one currency increases in relation to another currency. When a currency appreciates in relation to another currency, it follows that it will now cost fewer Indian Rupees to buy one US Dollar on the foreign exchange market.
On the other hand, currency depreciation is the decrease in the value of one currency in relation to another currency. This means that your currency has depreciated relative to the US Dollar and it will now cost more Indian Rupees to buy one US Dollar of your currency.
Currency appreciation and depreciation is possible in a floating exchange rate system only. When currencies are left to market forces of foreign exchange, the exchange rates fluctuate depending on the demand and supply of the currency. When a currency is in high demand, the exchange rate will appreciate as there are now additional buyers of the currency. Conversely, when the currency is in high supply or low demand, the exchange rate will depreciate as there are fewer buyers of the currency.
What causes Currency Appreciation or Depreciation?
The simple answer is anything that causes the demand and supply of currencies to fluctuate will automatically affect the exchange rate. Some of the major reasons are:
Inflation: Inflation leads to depreciation of the exchange rate. If a country is experiencing high domestic inflation, it follows that the currency is getting weaker. This will trigger a sell-off reaction among owners of the currency who would like to buy other currencies in order to avoid a further decreases in the value of their savings.
Interest Rates: Interest rates set by central banks are directly proportional to the value of a currency. Hence, higher interest rates lead to appreciation and vice versa. If the interest rates are high, more people will be interested in preserving their savings in that currency for the reward of a lucrative saving rate. As more people demand dollars, this will automatically push up the exchange rate for dollars. Similarly, lower interest rates will lead to depreciation of the currency due to lower demand of the currency.
Speculation: In the foreign exchange market, what’s said is done. So if financial experts speculate that the pound sterling will fall in the near future, it is bound to happen. This is because as this news breaks into the foreign exchange market, speculators will haphazardly sell their currency reserves to maximize their own profits. As the supply of the Pound Sterling increases due to excessive selling, this will automatically lead to depreciation of the Pound Sterling.
In 1992 for example, there was a recession in UK. In order to avoid losses on the currency, speculators sold huge reserves of the pound sterling on the foreign exchange market. This automatically led to a depreciation of the Pound Sterling and the UK government was forced to intervene in the foreign exchange market.
Other factors that can lead to movements in the exchange rate are the political and economic climate of the country. For example, healthy news by the central bank will lead to an appreciation of the exchange rate whereas bad news like imposition of martial law will lead to depreciation of the exchange rate.
What are the effects of Currency Appreciation/Depreciation?
The singular effect of currency appreciation is that imports become cheaper and exports become expensive. However, this singular effect has the ability to trigger a chain of consequences that can prove detrimental to a country’s economy.
There is a high possibility of a balance of payments deficit as imports are now cheaper for the local market. As exports become expensive, their demand in the global market will fall which will lead to a fall in the quantity of exports (aggregate demand) and local industries will decrease their production. As aggregate demand falls, this will consequently result in a fall in the GDP of the country.
On the other hand, the immediate effect of currency depreciation is that exports will become cheaper and imports will be expensive. Consequently, the balance of payments will go in surplus and aggregate demand will rise to correspond to the global demand for exports.
Devaluation and Revaluation of Currencies:
Devaluation/revaluation is the deliberate depreciation/appreciation of a currency. When a fixed exchange rate system is in place, the exchange rate is decided by the central bank keeping in view the economic policies of the government, and not the free the market of foreign exchange. When the central bank of a country deliberately increases or decreases the exchange rate of a country by controlling the demand and supply of currencies, it is called revaluation and devaluation respectively.
So for example, if the Qatari government wants to increase exports, it will devalue its currency by injecting riyals from its central bank reserve into the foreign exchange market. As the supply of the Qatari riyal increases, the value of the riyal will automatically decrease.
However, governments that practice devaluation and revaluation have to maintain a foreign exchange reserve of currencies in their central bank at all times which can be utilized as and when required to control the exchange rate according to their wish.
From 2003 to 2013, China was actively devaluing its currency by buying US dollars on the foreign exchange market. As the demand for US dollars increased, the price for the Chinese yuan consequently decreased. This was done to make Chinese exports cheaper for the US market.