Currency depreciation refers to a fall in value of one currency with respect to another. Value of currency depends on its demand and supply in the market. If the demand of any currency increases , its value in market also increases simultaneously.
Major Factors through which demand for foreign currency come from.
- Importers -who demand foreign currency to pay for the goods they purchase from abroad.
- Individuals -who go abroad to travel and get education.
- Foreign Direct Investments (FDI) — individuals or institutions that invest money abroad to carry on business operations there.
- Foreign Institutional Investors (FII) — individuals or institutions who buy foreign financial assets such as stocks and bonds.
- Speculation in currency market could also influence the price of the currency
Alternatively, the supply would come from the same factors located outside of the domestic country. These individuals or institutions would demand the domestic currency to transact in our country.
After depreciation of any currency , following are the Losers and gainers.
All those who have $ obligation will need more home currency to buy the same amount of dollars.
- Importers of Oil, Gems& Jewellery and other also sustain losses
- Borrowers who borrow money from foreign
- Individuals who have to go foreign for education & business travels
- Overseas investors: Investors redemptions in particular country will be lower in dollar terms
- Consumers’ inflation would rise because fuel, cooking oil, pulses will become costly
All those who receive $ payments or income will get more home currency for same amount of dollars
- Exporter of home made goods and services
- Exports with low import content
- Individual with foreign income
Country could apply the following policies to improve the value of its currency
- More attractive policies to encourage the FDIs.
- If the $ reserve of the country is good then central bank could also intervene to defend its currency.
Exchange rate systems
Fixed and Flexible Exchange Rate Systems: Theoretically, there are two exchange rate system that countries may opt for but, in practice, many economies fall somewhere between the two ends.
Fixed exchange rate is a system in which the central bank pegs the value of the domestic currency with respect to another, regardless of the demand and supply factors. For example, the RBI may fix the value of a US dollar to 55 INRs. If demand for the US dollar increases, the central bank would offset the increased demand by flooding the market with excess US dollars from its forex reserves. Thus the parity of 1 US dollar = 55 INRs would be maintained. In this system there is no currency appreciation or depreciation.
Under a flexible exchange rate system, the value of currency is determined by its demand and supply. The central bank does not interfere in the market to offset demand or supply factors. Currently, the RBI follows a policy that leans more towards a flexible system.