Understanding Currency Depreciation: Causes and Effects

What Is Currency Depreciation?

Currency depreciation occurs when a currency loses value relative to other currencies. Triggered by factors such as economic fundamentals, interest rate differentials, or inflation, this decrease can enhance export competitiveness but may also displace investor confidence.

Key Drivers of Currency Depreciation

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 an abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country. These actions will put further downward pressure on the currency.

Easy monetary policy and high inflation are two of the leading 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 bout of currency depreciation. Central banks will increase interest rates to combat inflation, as too much inflation can lead to currency depreciation.

Additionally, inflation can lead to higher input costs for exports, which then makes a nation's exports less competitive in the global markets. This will widen the trade deficit and cause the currency to depreciate.

How Quantitative Easing Impacted the US Dollar

After the 2007-2008 financial crisis, the Federal Reserve started three rounds of quantitative easing, lowering bond yields to record lows. Following the Federal Reserve's announcement of the first round of QE on Nov. 25, 2008, the U.S. dollar (USD) began to depreciate. The U.S. dollar index (USDX) fell by more than 7% in the three weeks after the commencement of QE1.

In 2010, when the Fed embarked on QE2, the result was the same. From 2010 to 2011, the U.S. dollar fell to record lows against the Japanese yen, Canadian dollar, and Australian dollar.

The Influence of Political Rhetoric on Currency Value

 Although economic fundamentals mainly determine a currency's value, political talk can also lead to its fall.

From 2015 to 2016, the U.S. and China often argued about 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 roughly 2% against the U.S. dollar. Chinese officials said the move was required to prevent a further slide in exports.

In 2019, the Trump administration labeled China a currency manipulator, saying Chinese officials were purposely devaluing its currency, leading to unfair advantages in trade. In 2018, U.S.-China political rhetoric turned toward protectionism, which resulted in a long-term trade dispute between the world’s two largest economies.

Currency Depreciation and Market Volatility

Sudden currency depreciation in emerging markets often raises fears of "contagion," where these currencies face similar investor concerns. Among the most notable was the Asian crisis of 1997, 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 nations such as India and Indonesia traded sharply lower in the summer of 2013 as concern grew that the Federal Reserve was poised to wind down its massive bond purchases. Currencies in developed markets can also face extreme volatility. On June 23, 2016, the British pound (GBP) depreciated by over 10% against the U.S. dollar after the U.K. voted to leave the European Union, referred to as Brexit.

Case Study: The Turkish Lira's Decline

In August 2018, the Turkish lira dropped over 20% against the USD. A combination of factors led to the depreciation. First, investors grew fearful that Turkish companies wouldn't be able to pay back loans denominated in dollars and euros as the lira continued to fall in value.

Secondly, President Trump approved the doubling of steel and aluminum tariffs imposed on Turkey at a time when there were already fears about the country’s struggling economy. The lira plunged sharply after Trump released the news via a tweet.

Finally, Turkey’s president, Recep Tayyip Erdogan, did not allow Turkey's central bank to raise interest rates, while at the same time, the country didn't have a sufficient amount of U.S. dollars to defend its currency on foreign exchange markets. Turkey's central bank finally lifted interest rates in September 2018 from 17.75% to 24% to stabilize its currency and curb inflation. 

More recently, in 2020, the lira has been significantly depreciating due to geopolitical risks as a result of Turkey's policies in the Middle East and elsewhere. In October 2020, the Lira sank to historic lows. It dropped beyond 8.05 to the U.S. dollar. The lira lost 26% of its value in 2020 and more than 50% since the end of 2017.

The Bottom Line

Currency depreciation involves a decrease in a currency's value relative to others, often caused by economic fundamentals, interest rate differentials, political instability, or risk aversion in investors. Despite its challenges, gradual depreciation can make exports more competitive, potentially improving a nation's trade balance.

However, abrupt depreciation might deter foreign investment, exacerbating the situation. Governments may influence currency values through monetary policies, such as quantitative easing, which impact exchange rates. Understanding these dynamics is crucial for making informed economic and investment decisions.