Currency Depreciation

Currency Depreciation

• Currency depreciation refers to a fall in the value of a country’s currency relative to another currency due to market forces under a flexible or managed floating exchange rate system.
• For example: $1 = ₹85 → $1 = ₹90
• The rupee has depreciated because more rupees are now required to purchase one US dollar.

Causes of Currency Depreciation

• Higher Demand for Foreign Currency: When demand for foreign currency rises faster than its supply, the domestic currency depreciates. For example, a rise in oil imports increases demand for dollars and can put downward pressure on the rupee.
• Easy Monetary Policy: An easy or expansionary monetary policy generally involves lower interest rates and greater availability of money and credit in the economy. It can put depreciation pressure on the domestic currency.
• Lower Interest Rates: Suppose the RBI reduces interest rates while interest rates abroad remain relatively higher. Indian financial assets may become relatively less attractive to some foreign investors.
• Capital Outflows / Lower Capital Inflows: Investors may shift funds towards countries offering relatively higher returns, increasing the demand for foreign currency such as the dollar.
• Capital Outflows: Withdrawal of foreign portfolio investment or other capital outflows increases demand for foreign currency, putting depreciation pressure on the domestic currency.
  • Example: When foreign investors withdraw money from India, they sell rupees and buy foreign currency, putting downward pressure on the rupee.
• Higher Domestic Inflation: Persistently higher inflation relative to trading partners can reduce the purchasing power and external competitiveness of the domestic currency, contributing to depreciation pressures.
  • Example: If prices in India rise faster than in other countries, Indian goods become relatively expensive, which can weaken demand for the rupee.
• Higher Trade/Current Account Deficit: When a country spends significantly more foreign currency on imports and other current account payments than it earns through exports and other current account receipts, the demand for foreign currency can exceed its supply. This puts depreciation pressure on the domestic currency.
  • Example: India imports significantly more goods than it exports. Large imports of crude oil, electronics, machinery and other industrial inputs create substantial demand for foreign currency, particularly the US dollar. When this demand is not adequately matched by foreign exchange inflows, it puts depreciation pressure on the rupee.
• Higher Foreign Interest Rates: If countries such as the US offer higher interest rates, investors may move money from India to those countries, putting pressure on the rupee.
• Weak Investor Confidence: If investors become less confident about the economy or economic policies, they may withdraw their investments from the country. This increases demand for foreign currency and puts depreciation pressure on the rupee.
• Global Uncertainty and Risk Aversion: During periods of geopolitical or financial uncertainty, investors often move funds towards relatively safer assets and currencies, which can put pressure on emerging-market currencies.

Impact of Currency Depreciation

• Imports Become Costlier: More domestic currency is required to buy the same amount of foreign currency, increasing the cost of imported goods and raw materials. If the exchange rate changes from $1 = ₹75 to $1 = ₹85, an imported machine costing $1,000 becomes costlier from ₹75,000 to ₹85,000.
• Inflationary Pressure: Costlier imports, especially fuel and industrial inputs, increase production and transportation costs and can push up domestic prices. If imported crude oil becomes costlier in rupee terms, the cost of fuel, transportation and production can rise, putting upward pressure on prices.
• Foreign Currency Debt Becomes Costlier: Borrowers with loans denominated in foreign currency need more domestic currency to repay the same amount of debt. Suppose a company has to repay $1 million. At $1 = ₹80, it needs ₹8 crore. At $1 = ₹90, it needs ₹9 crore.
• Foreign Travel and Education Become Costlier: People need more domestic currency to meet expenses such as travel, education and medical treatment abroad. If the exchange rate changes from $1 = ₹80 to $1 = ₹90, foreign university fees of $10,000 increase from ₹8 lakh to ₹9 lakh.
• Remittances Become More Valuable: Foreign currency sent from abroad converts into a larger amount of domestic currency. A family receiving $1,000 from abroad gets ₹72,000 at $1 = ₹72, but ₹84,000 if the rupee depreciates to $1 = ₹84.
• Exports Become More Competitive: Domestic goods become relatively cheaper for foreign buyers, which can increase demand for exports. Suppose an Indian product costs ₹8,000. At $1 = ₹80, it costs a foreign buyer $100. At $1 = ₹100, it would cost only $80, if the rupee price remains unchanged. Thus, Indian goods can become cheaper for foreign buyers.
• Impact on Trade Balance: Costlier imports and more competitive exports can help improve the trade balance over time, provided demand for exports and imports responds sufficiently to the change in prices. If the rupee falls from $1 = ₹80 to $1 = ₹90, imported goods become costlier while Indian goods become cheaper for foreign buyers. Over time, this may discourage imports and encourage exports, helping improve the trade balance.
• Can Encourage Domestic Production: As imported goods become more expensive, consumers and businesses may shift towards domestically produced alternatives, supporting domestic producers.
• Can Support Tourism: Depreciation makes the country relatively cheaper for foreign tourists. For example, if $1 = ₹80 changes to $1 = ₹90, a foreign tourist’s $1,000 provides ₹90,000 instead of ₹80,000 for spending domestically.

Currency Depreciation vs Currency Devaluation