The depreciation of the currency is a decline in the value of a currency in a floating exchange rate system. The depreciation of the currency can be due to several reasons: economic fundamentals, interest rate differentials, political instability, risk aversion among investors, etc.
Countries with weak economic fundamentals, such as chronic current account deficits and high inflation rates, typically have depreciating currencies. Currency depreciation, if orderly and gradual, improves the competitiveness of a country's exports and can improve its trade deficit over time. However, the sharp and significant depreciation of the currency may frighten foreign investors who fear a further fall in the currency and cause a withdrawal of portfolio investment out of the country, exerting further downward pressure on the currency.
BREAKING DOWN 'Currency Depreciation'
The easy monetary policy and high inflation are two of the main causes of the depreciation of the currency. In a low -interest rate environment, hundreds of billions of dollars are looking for the highest return. Expected interest rate differentials may result in a depreciation of the currency. While central banks struggle against rising inflation by raising interest rates, too much inflation is considered a threat to stability, hence the likelihood of currency depreciation.
In addition, inflation can increase the cost of export inputs, making a country's exports less competitive in world markets, which will deepen the trade deficit and lead to a depreciation of the currency.
QE and The Falling USD
In response to the financial crisis, the US Federal Reserve embarked on three Quantitative Easing (QE) cycles, which brought bond yields to record lows. After the first round of quantitative easing in 2008, the US dollar depreciated significantly. The US dollar index (USDX) fell more than 10% in the six weeks following the start of QE1.
In 2010, when the Fed launched QE2, the result was the same. During the depreciation of USD 2010-2011, the dollar reached unprecedented lows against the Japanese yen, the Canadian dollar and the Australian dollar.
Political Rhetoric
If the fundamentals of the economy largely determine the value of a currency, political discourse can lead to its downfall.
Throughout the 21st century, the United States and China have been repeatedly in a battle of words over the monetary value of each. In the 2016 election campaign, Republican candidate Donald Trump promised to classify China as a currency manipulator, alleging that the Chinese authorities deliberately depreciated their currency, leading to unfair trade advantages.
Volatility
Sudden surges in currency depreciation, especially in emerging markets, inevitably increase the fear of "contagion", which is why many of these currencies are affected by the concerns of similar investors. There have been a series of episodes of this type, including the 1997 Asian crisis caused by the devaluation of the Thai baht. In the summer of 2013, currencies from countries such as India and Indonesia traded heavily downwards, fearing that the Federal Reserve would be willing to reduce its massive bond purchases.
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