Currency Depreciation Macroeconomics and International Business

Currency Depreciation
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“CURRENCY DEPRECIATION”
MACROECONOMICS | ASSIGNMENT 1
Submitted To,
Dr. Mala Sane
Submitted By,
Shrikant Jena | A-73
Meghna Sorut | A-70
Bharat Bhushan | A-19

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Table of Contents
Currency depreciation ..................................................................................................................................1
Causes of Currency depreciation .............................................................................................................1
Effects of Currency depreciation .............................................................................................................1
Currency depreciation and international businesses ...................................................................................3
The Indian rupee keeps on sliding. Here’s why.......................................................................................3
BREAKING DOWN Currency Depreciation ...........................................................................................4
QE and The Falling USD............................................................................................................................4
Political Rhetoric ......................................................................................................................................4
Volatility ...................................................................................................................................................4
What key economic factors cause currency depreciation in a country?......................................................5
Productivity and Absolute Currency Value .............................................................................................5
Purchasing Power Vs. Forex Value ..........................................................................................................5
The Currency Risk..........................................................................................................................................7
Geopolitical Tensions...............................................................................................................................8
India's Twin Deficit Problem .........................................................................................................................9
Conclusion...................................................................................................................................................10
References ..................................................................................................................................................11

1SHRIKANT JENA | A-73
Currency depreciation
Currency depreciation is the opposite of currency
appreciation. It is the decrease in value of one currency
against another. Currency depreciation is a fall in the value of
a currency in a floating exchange rate system. 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.
Causes of Currency depreciation
In a floating exchange rate system, a currency's value goes up (or down) if the demand for it goes
up more (or less) than the supply does. In the short run this can happen unpredictably for a
variety of reasons, having to do with trade flows, speculation, or other factors in the international
capital market. For example, a surge in purchases of foreign goods by home country residents
will cause a surge in demand for foreign currency with which to pay for those goods, causing a
depreciation of the home currency. Another cause of appreciation or depreciation of a currency
is speculative movements of funds in the belief that a currency is over or under valued, as the
case may be, and in anticipation of a “correction”. Such movements may in themselves cause the
value of a currency to change. A longer-run trend of appreciation (or depreciation) is likely to be
caused by home country inflation being lower (or higher) on average than inflation in other
countries, according to the principle of long-run purchasing power parity.
Effects of Currency depreciation
An appreciation of a country's currency makes it cheaper to buy foreign currency with which to
pay for foreign goods, leading to more of that activity, and leading to downward pressure on the
home price level as the foreign-goods component of the market basket, used for calculating the
price level, becomes less expensive. In contrast, purchases of home country goods by foreigners
become more expensive since the home country currency has become more expensive to obtain.
This then decreases the demand on the overall elastic products. A depreciation of the home
currency has the opposite effects and vice versa.
Below Chart 1 shows the annual change in prices of India’s COB in dollar and rupee terms. In 12
out of 18 years since 2001-02, the change in the rupee price of India’s COB has been unfavorable
vis-à-vis the dollar price. This means that when oil prices have fallen, the rupee price has fallen

less than the dollar price and when prices have risen, the rupee price has risen more than the
dollar price. A bigger fall in the rupee at a time of rising oil prices is bound to increase this pain.
Chart 2 plots movements in India’s non-petroleum trade balance and current account balance with the
rupee-dollar exchange rate. It does not show an improvement in trade/current account performance with
a depreciating currency.

Currency depreciation and international
businesses
If the EUR/GBP exchange rate falls from 0.75 to 0.72 the British pound (GBP) has depreciated by
£0.03. One euro now costs £0.72 pounds (or 72 pence) instead of £0.75.
A currency may depreciate for a number of reasons, including a negative trade balance, interest
rates, inflation, monetary and fiscal policies, and political stability. Central banks may even
introduce negative interest rates to force currency depreciation, often if the currency is so strong
its damaging exports.
If a central bank cuts interest rates, assets denominated in that currency will be less attractive to
investors as the interest they yield will be lower. Consequently, the announcement of an interest
rate cut normally triggers a depreciation of the currency, as investors tend to sell assets in that
currency and buy assets in currencies with higher yields before the actual interest rate cut takes
place.
Essentially, a currency depreciates because of a loss of investor confidence. Extreme losses of
confidence can have a severe effect on a currency and by extension, economic health.
The Indian rupee keeps on sliding. Here’s why
On Monday (Sept. 10), the rupee nose-dived to a new historic low, ending at Rs72.45 to the
dollar. In this calendar year alone, its value has eroded 12% against the greenback, making
it worst performing currencies. It was mostly weighed down by rising global crude oil prices—
India imports nearly 80% of its fuel needs. The higher import bill has also widened India’s current
account deficit (CAD), with imports now being much bigger in value than its exports. The CAD is
expected to widen to 2.8% of the GDP in financial year 2018, up from 1.9% last year, according
to a report by Nomura Research. This, in turn, does not augur well for the rupee. In the past
month, the rupee’s depreciation has accelerated due to many global factors. For one, the US and
China have been at loggerheads, each slapping duties on the other’s imported items. There is
speculation that China may devalue the yuan to outdo the US; this is likely to have a ripple effect
on other currencies, including the rupee. Then there is the US’s trade war with Turkey. It has
imposed higher tariffs on Turkish steel, aluminum, and other commodities, delivering a big blow
to the lira which has fallen by over 40% this calendar year. This, too, has dragged down currencies
of other emerging economies, including India.
In contrast, the US dollar has consistently gained strength this year due to an uptick in economic
growth. The country’s GDP grew 4.1% in the second quarter of this year, the fastest since late
2014.

4MEGHNA SORUT | A-70
BREAKING DOWN Currency
Depreciation
Easy monetary policy and high inflation are two of the leading 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. While higher
inflation is combated with central banks increasing interest rates, too much inflation is seen as a
threat to stability, hence the likelihood of currency depreciation.
Additionally, inflation can lead to higher input costs for export which makes a
nation's exports less competitive in global markets, which will widen the trade deficit and cause
the currency to depreciate.
QE and The Falling USD
In response to the financial crisis, the Federal Reserve embarked on three rounds of Quantitative
Easing (QE), which sent bond yields to record lows. Following the first round of QE in 2008, the
U.S. dollar depreciated sharply. The U.S. dollar index (USDX) fell by more than 10 percent in the
six weeks preceding the beginning of QE1.
In 2010, when the Fed embarked on QE2 the result was the same. During the 2010-2011 USD
depreciation, the greenback hit all-time lows against the Japanese yen, the Canadian dollar and
the Australian dollar.
Political Rhetoric
While economic fundamentals in most part determine the value of a currency, political speak can
cause a currency to fall.
Throughout the 21st century, the U.S. and China were repeatedly in a battle of words with
regards to each other’s currency value. During the 2016 election campaign, the Republican
nominee, Donald Trump vowed to label China a currency manipulator, saying Chinese officials
were purposely devaluing its currency, leading to unfair advantages on trade.
Volatility
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.

What key economic factors cause currency
depreciation in a country?
Currency devaluation can occur in absolute and relative senses. A relative devaluation occurs
when the foreign exchange value of one currency drops against the exchange value of other
currencies.
For example, the British pound sterling may trade for more U.S. dollars today than it did
yesterday. This does not necessarily mean, however, that the U.S. dollar is absolutely worth less
than the day before in terms of real purchasing power. In either case, the economic roots
of currency depreciation are dependent on the productive capacity of an economy and the size
of its money supply.
Almost every major currency is controlled like a monopoly through tender laws. For this reason,
governments and central banks control the factors that influence currency value. Even though
these are not traditionally considered to be economic factors, they are nonetheless critical
determinants.
Productivity and Absolute Currency Value
Money exists as a store of value. Employees trade the value of their working labor for a
representative amount of money (in wages) and then trade that representative value for other
goods and services in the market.
As an individual employee creates more value through increased productivity, she will see her
salary increase proportionately. Her employer (or customers) must either give her more units of
currency or more valuable units of currency.
If the money supply in a country is fixed but productivity increases, then each unit of currency
must store greater value. If the productivity of an economy is fixed but the supply of currency
decreases, then each unit of remaining currency must store greater value.
The opposite is also true. When productivity declines faster than the supply of money, the value
of each unit of currency drops. The most common monetary phenomenon, inflation, is produced
the other way around – the supply of money grows faster than productivity. There are more units
of currency around to absorb productivity, so each one ends up representing less exchange value
in the market.
Purchasing Power Vs. Forex Value
The foreign exchange markets are particularly complex. This is partly because there are two types
of forex traders. The first type of trader is looking to make a purchase in a foreign market, so he
needs to convert one currency to another. The vast majority of these transactions are performed
by banks or other major financial institutions on behalf of their domestic customers.

The second type of trader is simply looking to trade a currency with a lower expected future
value for currencies with higher expected future values. This currency speculation plays an
important function in international markets, but it is forward-looking and doesn't cleanly equate
to current purchasing power or national productivity.
The wide range of possible factors that influence currency value in international markets includes
the relative monetary policy between governments and central banks, differences in economic
forecasts between one country and another, the differences in productivity between one set of
workers and another, and the relative demand for the goods and services produced between
different countries.

7BHARAT BHUSHAN | A-19
The Currency Risk
India's macroeconomic parameters are sliding at a time when the world
is staring at a full-blown trade and currency war.
A currency war, fought by one
country through competitive
devaluations of its currency against
others, is one of the most
destructive and feared outcomes in
international economics.. Whether
prolonged or acute, these and other
currency crises are associated with
stagnation, inflation, austerity,
financial panic and other painful
outcomes. Nothing positive ever
comes from a currency war." -
Excerpted from the book Currency
Wars: The Making Of The Next Global Crises by James Rickards.
Three years after the global financial meltdown of 2008, investment banker James Rickards
penned his book on the new battleground of future wars amongst the economic superpowers. It
was not nuclear or chemical, but financial war. His subject future 'Currency Wars' is very apt in
today's context. The world actually fears one between the two economic superpowers.
Rickards linked the currency wars as a subject of national importance and security and not just a
subject of discussion for economists and investors. Call it political compulsions, or ground reality,
US President Donald Trump has been accusing its trading partners - especially China and the
European Union - of artificially depreciating their currency to render their goods more attractive
in the US.
Recent trade tariffs by the US in steel and aluminium has seen China react with similar levies on
US exports. Both are preparing their next lists to fire at each other. The trade war is already
turning into a currency war where Chinese currency saw a sharp depreciation of around 8 per
cent. This may be a Chinese tactic to neutralise the impact of higher tariffs for its exported goods
in US with a depreciated currency. "Chinese currency is dropping like a rock," said Trump,
advocating a weak dollar to gain competitiveness. Has the currency war already begun?

Geopolitical Tensions
"We are possibly at the
beginning of a currency
war," said Urjit Patel,
Governor of the Reserve
Bank of India, as he
recently released the
monetary policy. "It looks
like it will continue, but
we don't know for how
long," he said expressing
concern on the
implications of a trade
and currency war for
India's economy.
The RBI will face a serious
dilemma should
currencies of other
emerging market drop
big time. Should India join
the competitive
devaluation game to
protect exports or stay
away to boost foreign investors' confidence? Experts say the RBI will not welcome depreciation
or high volatility in the Rupee's value against the US dollar. But if the rupee value slips beyond a
point (say, beyond 70 or 72) in a very short period, it will need to consult the government. In the
past, the finance ministry has announced steps like higher import duties on gold imports.
There are actually no winners in currency wars. In a US-China standoff, there are expectations of
flight of capital, especially dollars, from Chinese equities and debt; and, the fear of competitive
devaluation by other countries to neutralise Chinese devaluation. In a competitive devaluation
scenario, India will not be a pariah.
The threat from the trade and currency wars is real. In emerging markets including India,
mounting trade tensions, higher crude oil prices, and hardening of interest rates in US has already
created an uncertain environment. The immediate reaction can be seen in global financial
markets - US rates are rising and the dollar is strengthening. The EU is likely to hike interest rates
from 2019 and collateral damage will be in emerging markets.
Currencies in emerging market are sliding down. This year, the biggest losers are the Argentine
Peso, the Turkish Lira, the Russian Rouble, the Indonesian Rupiah and the Filipino Peso. The
Indian Rupee's fall of close to 8 per cent against the US dollar is in line with this trend. Indian
currency is now being clubbed with a few other emerging markets as 'vulnerable. "We remain
bearish on the Indian Rupee, the Indonesian Rupiah and the Filipino Peso - all three economies
with twin deficit problems," says a Scotiabank report (see graph Sharp Fall In Rupee in 2018).

India's Twin Deficit
Problem
India has been living with the 'twin deficit'
problem for decades. Historically we run a trade
deficit despite numerous efforts (the latest was
Make in India) to increase exports. China
leapfrogged to become the world's export factory
in the last few decades, but India's trade deficit
widened. In 2017/18, it increased to $156 billion
from $108 billion in the previous year. Growing
imports are also hurting the trade deficit.
Surprisingly, imports of 'electronics' are growing
fast, with billions of Indians consuming all sorts of
gadgets. "We failed to grasp or promote key
industries such as electronics," a banker said.
Salil Datar, CEO and Executive Director, Essel
Finance, blames the large oil component in the
import basket. "Rising oil prices are increasing the
import bill," he says. There is also new danger
after US sanctions on Iran that begin this
November. Iran is one of the three big suppliers of
oil to India. "Financing trade deficit is a big
concern," says a forex dealer. Ever-increasing
trade deficits need dollar inflows in equity, debt,
and FDI to bridge the gap. While institutional
inflows in debt and equity are classified as 'hot
inflows' - they come and go in quick succession) -
FDI inflows are more permanent. Currently, India's
current account deficit (CAD) has jumped from 0.6
per cent of GDP in 2015/16 to close to 2 per cent
in 2017/18. Going forward, higher valuations will
mean difficulty in attracting equity market inflows.
After touching a net inflow of Rs 1.11 lakh crore in
2014/15, equity inflows are not very encouraging.
In the first four months of 2018/19, net equity inflows were in the negative of Rs17,276 crore.
The debt market saw robust inflows last year at Rs1.18 lakh crore, but the uncertain Indian
market and the higher yields in the US make things tough. FDI equity numbers though are keeping
the pace with close to Rs3 lakh crore last year, but are still nowhere close to China's figures.

Conclusion
The outlook for the rupee looks weak but it isn't as
bad as September 2013 when it was dropping like
a rock. India was among the fragile five then with
South Korea, Brazil, Indonesia, and Turkey.
Macros, especially inflation, current account
balance and foreign exchange reserves are
relatively better now. Global investment banker
UBS expects the rupee to be in the range of 68-72
against the US dollar in the short term. The RBI is
already protecting the rupee from falling 69 levels.
The signs of RBI intervention are quite visible as
foreign exchange reserves have fallen from a high
of $425 billion in April-May to $400 billion.
Meanwhile, the market is watching how long the
RBI protects the rupee, given the cost of
intervention. A large section of stakeholders have
advocated gradual depreciation of the rupee to
improve export competitiveness. Raghuram
Rajan, former RBI Governor, (rightly) argued in the
past for the need to improve productivity to
remain competitive. He also linked productivity
gains to better infrastructure facilities, improved
human capital, removing administrative obstacles
and ease of doing business.
Moreover, higher interest rates help battle
currency depreciation but arent advisable. The
RBI's decision to hike the repo rate by 25 per cent
will help. Its primary worry will be the 'currency
wars' and how to contain the likely spill-over
impact on the Indian Rupee. If the currency
weakens, it plays havoc with investments,
inflation, interest rates, and what not.
Central bankers must also remember what
Rickards wrote in his book, "a new collapse, larger
than the one in 2008, not just a possibility, but a
certainty". Time to tighten the belt.

References
 https://www.investopedia.com/terms/c/currency-depreciation.asp
 https://www.investopedia.com/ask/answers/060115/what-are-key-economic-factors-can-
cause-currency-depreciation-country.asp
 https://www.hindustantimes.com/business-news/the-pros-and-cons-of-a-depreciating-
currency/story-GvY6efO2AKOEVynZgh28UN.html
 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2847
 https://www.business-standard.com/article/current-affairs/us-mulls-removing-india-from-
currency-monitoring-list-of-trading-partners-118101800282_1.html
 https://economictimes.indiatimes.com/markets/stocks/news/good-times-for-exporters-as-
rupee-falls/articleshow/64024667.cms

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