Currency Depreciation

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DEFINITION

A decrease in the level of a currency in a floating exchange rate system due to market forces. Currency depreciation can occur due to any number of reasons – economic fundamentals, interest rate differentials, political instability, risk aversion among investors and so on. Countries with weak economic fundamentals such as chronic current account deficits and high rates of inflation generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But abrupt and sizeable currency depreciation may scare foreign investors who fear the currency may fall further, and lead to them pulling portfolio investments out of the country, putting further downward pressure on the currency.

INVESTOPEDIA EXPLAINS

Easy monetary policy and high inflation are two of the main causes of currency depreciation. In a low interest-rate environment, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation.

In the 12 months ending January 2014, for example, the Canadian dollar depreciated by 10% against the U.S. dollar. This was because economists and analysts expected the Bank of Canada to relax its monetary policy in 2014, at the same time the Federal Reserve was preparing to scale back its bond purchases, which was seen as a precursor to tighter monetary policy.

Inflation can also cause currency depreciation. This is because the higher input costs for export products made in a high-inflation nation will make its exports uncompetitive in global markets, which will widen the trade deficit and cause the currency to depreciate.

Sudden bouts of currency depreciation, especially in emerging markets, inevitably raise the fear of “contagion,” whereby many of these currencies get afflicted by similar investor concerns. There have been a number of such episodes, among the most notable being the Asian crisis of 1997 that was triggered by the devaluation of the Thai baht. In the summer of 2013, the currencies of nations such as India and Indonesia traded sharply lower on concern that the Federal Reserve was poised to wind down its massive bond purchases.


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