What is Currency Depreciation and How Does It Affect Foreign Exchange Rates

You’ve probably come across the term currency depreciation and have wondered, “What is currency depreciation?”

Currency depreciation is a decline in the value of a particular currency against another. For that reason, you can also call it currency devaluation.

Currencies that depreciate use a floating exchange rate system that sets a currency’s value based on its demand and supply in the foreign exchange market. It means that such currencies can also increase in value (appreciate) when the market is favourable.

If you are not familiar with the concept of currency depreciation, worry no more. This guide explores the basics of currency depreciation and its implications on foreign exchange rates. You’ll also learn what causes depreciation of currency.

That said, let’s get started.

What is Currency Depreciation?: Understanding the Basics

Simply put, currency depreciation is the decline of a currency’s value due to floating exchange rates.

When a currency depreciates, it can affect the exchange rates in many ways. Economic fundamentals like international trade also contribute to the fluctuations.

An excellent example of what can cause a currency to depreciate is when the demand for foreign products increases. As a result, the number of imports will increase, raising the demand for foreign currencies. Consequently, the domestic currency will depreciate.

Countries with unstable economic fundamentals, like high inflation rates, tend to have depreciating currencies when it comes to economic stability.
Other factors that can affect a currency’s exchange rate are interest rates, political stability, and terms of trade.

Since currency depreciation affects foreign exchange rates directly, forex traders can take advantage of it and earn profits depending on predictions. 

What Causes Depreciation of Currency

Now that you understand the currency depreciation definition, it’s also good to know what causes depreciation of currency. Generally, there are many reasons for currency depreciation, like interest rates, inflation rates, political instability, and terms of trade.

Now, let’s look at how these factors can result in currency depreciation.

Interest Rates

Interest rate differentials can devalue a currency when the odds go against the exchange rates. Notably, the changes in interest rates call for central bank intervention. That’s because the central bank can either raise or lower the interest rates.

So, how can changing interest rates reduce currency value and affect an exchange rate?

Well, when the central bank reduces the interest rates, the country’s currency will depreciate. As a result, this will reduce the foreign capital, causing the exchange rates to fall.

Inflation Level

A country with a high inflation rate may experience currency depreciation due to the increased production costs for exports. As a result, the country’s exported products will be costly and less competitive in the global markets, resulting in a trade deficit.

If the inflation rate is high, the central bank can also use interest rates to mitigate the effects of inflation. Unfortunately, that can cause currency depreciation. That’s because when the interest rates fall, stakeholders can move money from investments paying low-interest rates to higher-yield investments.

Terms of Trade

Terms of trade refers to the ratio of export prices to import prices and relates to the balance of payments and current accounts. If a country’s export prices are higher than its import prices, the terms of trade become favourable. However, if the import prices are higher than export prices, the terms of trade will be unfavourable.

The unfavourable terms of trade imply that the demand for the country’s exports is low, reducing the revenues from the exports. As a result, the country’s currency demand will fall, reducing the currency’s exchange rate. This will eventually force the currency to depreciate. 

Political Instability

Another significant factor affecting the currency value is a country’s political stability. That’s because a country’s economic performance goes hand in hand with its political state. When a country has low risks of political turmoil, many foreign investors will be willing to invest. As a result, there’ll be an influx of foreign capital.

Implications of Currency Depreciation

You now understand all the factors that cause currency depreciation and how they affect exchange rates. However, it’s also essential to note that currency depreciation has a few implications, especially to foreign exchange traders.

So, how does currency depreciation affect foreign exchange traders?

A decline in a currency’s value can make foreign exchange traders lose or earn profits, depending on the degree of exchange rate fluctuation.

Here is an example:

Suppose a forex trader invests in USD/CAD, hoping that the US dollar will depreciate against the Canadian dollar. If the US dollar’s price falls, the trader will make profits. However, if the US dollar appreciates instead, it will result in a loss.

Now, let’s turn our attention to the other implications of currency depreciation.

Expensive Imports

When a country’s currency devalues, its imports become more expensive, whether raw materials, petroleum products, or food. As a result, the demand for imports in the country will fall. In fact, foreign countries will be more willing to buy the country’s goods.

Cheaper Exports

Depreciation in a country’s currency is always beneficial to exporters. That’s because when the currency’s value falls, the exchange rates go down, making the exports cheaper.

Cheaper Debt Instruments

Debt instruments can be cheap when the interest rates increase. However, when a currency devalues due to factors other than inflation, the effect on interest rates won’t be adverse. As a result, the debt instruments won’t get impacted completely. 

Increased Supply of Foreign Products

When a currency depreciates, the supply of foreign goods will increase in the domestic market. But as time goes by, the production of domestic products will increase to compete with foreign goods. Finally, the products’ prices will go down.

What to Do When a Currency Depreciates

Currency depreciation can sometimes devastate investors and forex traders, especially when the odds go against them. So, what must you do as an investor?

Here are the things that can eliminate the currency depreciation risks.

• Invest Overseas: If you are an investor and believe that your country’s currency is weakening, consider investing in stronger foreign markets.
• Hedge Currency Risks: When a currency depreciates, your finances can get affected significantly. Thankfully, there are many tools to hedge currency risks, including currency options, currency futures, and currency forwards.
• Invest in Multinational Companies: Companies that operate in foreign countries with stronger currencies can help you avoid the depreciation risks by increasing your revenues. 

Final Words

Currency depreciation can have significant impacts on the domestic economy and investments. That’s because a direct link exists between the currency values and exchange rates. So, when the domestic currency depreciates, it’s always good to mitigate the risks by hedging them and investing in multinational companies.