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Real Causes Of Currency Depreciation
From: Dr Sampson O. Amoafo / rockvile2009@yahoo.com          Published On: August 17, 2012, 00:59 GMT
 
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Real Causes Of Currency Depreciation
In 2008, a trader paid one Ghana Cedi for one U.S. dollar, but at the beginning of April 2012, the same trader travelling to Dubai paid GH˘1.74 for one U.S. dollar.

This means that year-on-year decline in the value of cedi against the US dollar was 74 per cent over a three-year period.

A point to note is that during the global economic crises of 2008-2009, the cedi depreciated by 25 per cent against the dollar.

Between 2010 and 2011, the cedi again depreciated 18.5 per cent against the US dollar. For last month, the cedi exchange rate depreciated 4.29 percent against the US dollar.

So is the current downward slide in the cedi value as a result of the slowdown in the global economy or due to internal structural weaknesses? This question requires a detailed research work beyond the scope of this article but it is a very relevant question to ask at this time.

In economics, depreciation is basically the symptoms of an underlying problem, specifically imbalances in the Balance of Payment (BOP), emanating from excess demand for dollars. So instead of discussing the depreciating cedi, I will rather focus my attention on the causes or factors that cause currency to depreciate and what the government can do to arrest this problem in special cases.

Before then, I must let readers know the difference between currency fluctuation and depreciation. Fluctuations in currency value are a common event and are usually no cause for concern. The minor daily increases and decreases in value are generally due to “random walk” and not due to an economic event or fundamental problems.

However, changes in currency value become significant when the decline in value of the currency is an ongoing trend. Technically, when currency depreciates, it loses value and purchasing power, with impact on the real sectors of the economy.

Although, the economic effects of a lower cedi take time to happen, there are time lags between a change in the exchange rate and changes in commodity prices.

Factors that determine the value of a currency include the current state of the overall economy, inflation, trade balance (the difference between the value of export and import), level of political stability, etc.

Occasionally, external factors like currency speculations on the foreign exchange market can also contribute to depreciation of the local currency. Such being the case, a government can intervene into the foreign exchange market to support its national currency and suppress the process of depreciation.

Currency depreciation can positively impact the overall economic development, though. It boosts competitiveness through lower export costs and secures more income from exported goods in a similar way devaluation does.

On the contrary, depreciation makes imports more expensive and discourages purchases of imported goods stimulating demand for domestically manufactured goods.

Globally, governments intentionally influence the value of their currency utilising the powerful tool of the base interest rates, which are usually set by the country's central bank and this tool is often used to intentionally depreciate the currency rates to encourage exports. Factors that can cause a currency to depreciate are:

Supply and Demand

• Just as with goods and services, the principles of supply and demand apply to the appreciation and depreciation of currency values. If a country injects new currency into its economy, it increases the money supply. When there is more money circulating in an economy, there is less demand. This depreciates the value of the currency. On the other hand, when there is a high domestic or foreign demand for a country's currency, the currency appreciates in value.

Inflation

• Inflation occurs when the general prices of goods and services in a country increase. Inflation causes the value of the cedi to depreciate, reducing purchasing power. If there is rampant inflation, then a currency will depreciate in value.
What causes inflation?

• Printing Money. Note printing money does not always cause inflation. It will occur when the money supply is increased faster than the growth of real output.

• Note: the link between printing money and causing inflation is not straightforward. The money supply does not just depend on the amount the government prints.

• Large National Debt. To finance large national debts, governments often print money and this can cause inflation.
Economic Outlook

If a country's economy is in a slow growth or recessionary phase, the value of their currency depreciates. The value of a country's currency also depreciates if its major economic indicators like retail sales and Gross Domestic Product, or GDP, are declining. A high and/or rising unemployment rate can also depreciate currency value because it indicates an economic slowdown. If a country's economy is in a strong growth period, the value of their currency appreciates.

Trade Deficits

A trade deficit occurs when the value of goods a country imports is more than the value of goods it exports. When the trade deficit of a country increases, the value of the domestic currency depreciates against the value of the currency of its trading partners.

The demand for imports should fall as imports become more expensive. However, some imports are essential for production or cannot be made in the country and have an inelastic demand—we end up spending more on these when the exchange rate falls in value. This can cause the balance of payments to worsen in the short run (a process known as the J curve effect)

Collapse of Confidence

If there is a collapse of confidence in an economy or financial sector, this will lead to an outflow of currency as people do not want to risk losing their currency. Therefore, this causes an outflow of capital and depreciation in the exchange rate. Collapse in confidence can be due to political or economic factors.

Price of Commodities

If an economy depends on exports of raw materials, a fall in the price of this raw material can cause a fall in export revenue and depreciation in the exchange rate. For example, in 2011, a ton of cocoa sold for US4,000 per ton. Currently, it is going for US$2,300 per ton, translating into fewer inflows of dollars.

Interest rate Differential

I will use the International Fischer Effect to explain the relationship between the expected change in the current exchange rate between the cedi and the dollar, which is approximately equivalent to the difference between Ghana and US’ nominal interest rates for that time.

For example, if the average interest rate in Ghana for 2011 was 24 per cent and for US was three per cent, then the dollar should appreciate roughly 21 per cent or the cedi must depreciate 21 per cent compared to the dollar to restore parity.

The rationale for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower
interest rates.

Market Speculations

Market speculations can contribute to a process of spiraling depreciation after smaller market players decide to follow the example of the leading dealers, the so-called market makers, and after they lost confidence in a particular currency start to sell it in bulk amounts. Then only a quick reaction of the country's central bank can restore the confidence of investors and stop the currency rates of the nation's currency from continuous decline.

When the currency depreciation is based on market speculations, in other words, not backed by fundamental economic factors, then the central bank comes to the rescue- intervene.

A sterilised intervention against depreciation can only be effective in the medium term if the underlying cause behind the currency's loss of value can be addressed. If the cause was a speculative attack based on political uncertainty this can potentially be resolved.

Because after a sterilised intervention the money supply remains unchanged at its high level, the locally available interest rates can still be relatively low, so the carry trade continues and if it still wants to prevent depreciation the central bank has to intervene again. This can only go on so long before the bank runs out of foreign currency reserves.

In conclusion, currency depreciation is the result of fundamental deficiencies with the domestic economy which must be corrected over a period of time to restore balance. However, where the depreciation is out of speculative attacks on the currency, then the central bank can intervene to correct the temporary anomalies, which, often is short term in nature.

Lastly, intervention in the foreign exchange market by the central bank to correct fundamental weaknesses, just like the Ghanaian situation will not work, because, very soon, the central bank will run out of international reserves; hence, the cedi must therefore seek its equilibrium level.

The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University. Montgomery, Alabama.


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