What is Currency Appreciation & What Causes it?

5 mins read
by Angel One

Every international transaction is facilitated by the exchange of currency for a delivery of a product or service. Their transaction is pretty direct when the currencies accepted by both the countries are the same, for example, Euro in the European Union. But, complexities creep in when a trade has to be made between countries with two different accepted currencies like the European Union’s Euro and the United States’s Dollar.

The Foreign Exchange is the third party that facilitates transactions by the exchanges between the currencies. The price of one currency w.r.t. is determined by the demand and supply for that currency and may vary at different points in time. This gain and loss in the price of a currency tell us when the currency has appreciated or depreciated.

What are Currency Appreciation and Currency Depreciation?

For ease of conversation, we would take a USD/INR currency pair, where the base currency is United States Dollar (USD) and the quoted currency needed for the base currency is Indian Rupees (INR). Furthermore, let’s also assume the current market rate as USD/INR = 75, where to buy $1, you would need to spend Rs. 75 or if you sell for $1, you will receive Rs. 75 in the exchange.

Currency Appreciation:

A currency is said to appreciate when the base currency becomes more expensive in the currency pair w.r.t. quote currency. So for the USD/INR pair where $1 = Rs. 75 previously and now is $1 = Rs. 76, the Dollar is said to have appreciated w.r.t. Indian rupees. Thus a person who wishes to buy $1 will now have to spend more rupees for the same $1 amount and vice versa.

Currency Depreciation:

Alternatively, a currency is said to depreciate when the base currency becomes cheaper w.r.t. quote currency in the currency pair. Similarly, for the USD/INR pair, where $1 = Rs. 75 previously and now is $1 = Rs. 73, the Dollar is said to have depreciated w.r.t. Indian rupees. Thus a person who wishes to buy $1 will now have to spend fewer rupees for the same $1 amount and vice versa.

Additionally, one important consideration must be kept in mind when determining the appreciation/depreciation for a currency pair. For a pair, when a base currency is said to have appreciated compared to the quoted currency, simultaneously, the quoted currency is also said to have depreciated w.r.t. the base currency. For example

When $1 = Rs. 75 becomes $1 = Rs. 76, while the Dollar is said to have appreciated, simultaneously, Indian Rupees is said to have depreciated against the Dollar. Alternatively, if $1 = 75 becomes $1 = 73, while the Dollar is said to have depreciated at the very same time, Indian Rupees is said to have appreciated. Thus for every currency pair, appreciation and depreciation occur in tandem but inversely.

Factors affecting Forex Prices:

While the Foreign exchange rates are primarily determined by Demand and Supply for a currency, understanding all the other factors is crucial, especially for international investors and Individuals who participate in international trade. The following factors affect the local exchange rates of the country and, at a macroeconomic level, affect the global exchange rates.

  1. Inflation

Inflation eats away the purchasing power of a country’s currency. At an FX level, for two countries experiencing different inflation rates in their economies, it inversely corresponds to their currency strength. For example, say for the USD/INR pair, if the USA is experiencing a lower rate of inflation in their country compared to India, in such a case, over time, USD will appreciate while INR will depreciate.

  1. Interest Rates

Every country’s central bank primarily decides on the Interest Rates for that country. They are responsible for maintaining a healthy balance between a country’s economic activities, inflation targets, and exchange rates. Say the United States Federal Reserves increased its interest rates. Due to this, many Indian International Investors looking to invest in US bonds would now buy Dollars in exchange for Indian Rupees. This exchange results from greater demand for the US Dollar; the Dollar will appreciate while the Indian Rupees will depreciate and vice versa.

  1. Public Debt

For a rapidly growing country like India, the Indian Govt. often incurs high amounts of capital expenditure to finance the different projects across the country. In such a case for every US investor who might want to invest in such a project, this will lead to greater demand for Indian Rupees than USD, leading to the appreciation of INR and depreciation of USD. The converse is also true when the debt needs to be repaid, but a government can also print money to repay the loan, increasing inflation in the country.

  1. Trade Balance

Trade balance for a country is given by Exports – Imports = Balance. For a positive trade balance where Exports exceed Imports, the inflow of foreign currency into the country is higher, leading to an increase in foreign reserves for the country and depreciation of that country currency

  1. Policies

A country’s government can buy foreign currencies in periods of economic downturn, provide fiscal stimulus by printing money, allow/restrict the flow of currency to and from a specific country and balance the flow of goods with a specific country. All these capabilities may positively or negatively affect the fx rates but can ensure a country’s economic growth.

  1. Speculation

Sometimes, the currency’s price is affected by the confidence the international community has in the said currency. Suppose a foreign currency holder believes that the USD may depreciate. In that case, they may sell the currency leading to its depreciation, or buy the same USD if they believe it will appreciate in the coming days.