Depreciation of Currency Vs Devaluation of Currency
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Background to Depreciation Vs Devaluation of Currency :
August 2015 : The depreciation of various Asian currencies and devaluation of Yuan has been hitting headlines these days in almost all economic newspaper across the world. However, layman finds it difficult to understand the difference between these two terms. Here we will try to explain the same.
In one of our articles under the heading What is Rupee Appreciation or Rupee Depreciation? we have explained the difference between these Rupee Appreciation and Rupee Depreciation terms. The same has been liked by large number of visitors. If you are totally new to the subject, it will be good idea that you first read that article also by clicking on the link above.
Coming back to today’s topic. Interestingly, both the terms i.e. Depreciation and Devaluation deal with the value of a particular currency in the international market. In both cases, the value of the currency actually drops vs other currencies of the world. Thus, to that extent both are same. However, both these (Depreciation and Devaluation) have two different causes and long-term effects on country's economy.
What is Fixed Exchange Rate vs Floating Exchange Rate Systems:
Before we go ahead with the topic, it will be necessary to understand the exchange rate system that prevails among different currencies.
A fixed exchange rate, (also called as pegged exchange rate,) is a type of exchange rate regime where a currency's value is fixed against either the value of another single currency, or to a basket of other currencies, or to another measure of value, such as gold. In a fixed exchange-rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged.
A floating exchange rate or fluctuating exchange rate is a type of exchange-rate regime in which a currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms. A currency that uses a floating exchange rate is popularly known as a floating currency.
By the beginning of the 21st century, most of the developed countries and large economics have shifted to floating exchange rate system. Only few small countries have fixed exchange rate. The last big economy to use a fixed exchange rate system was the People's Republic of China which, in July 2005, adopted a slightly more flexible exchange rate system called a managed exchange rate (Thus, we can say it is not fixed but floating within a band only). China allows its currency to fluctuate only within a fixed band (set at 1% as of January 2014) on either side of the reference rate.
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Depreciation of Currency: Let us start with the meaning of the term depreciation of the currency. Depreciation of currency happens in those currencies which are linked to floating exchange rate and it is likely to change / vary on day to day basis (in actual practice popular currency rates change almost every few minutes / seconds). A floating exchange rate means that the global investment market determines the value of a country's currency. These countries allow supply and demand to determine the value of their currency relative to the currencies of other countries. Depreciation occurs when the forces of supply and demand cause the value of their currency to drop. To check the high volatility, as a prudent measure, almost all central banks of the respective countries try to influence the exchange rates through various means so as to curb such volatility, yet in the end it is the free market that determines the exchange rate of all the currencies linked to floating exchange rate. These days all major economies use a floating exchange rate. Thus, Appreciation / Depreciation (only marginal change) of all such currencies regularly occurs number of time during the period market remains open.. It is only in rare cases, that currency depreciates or appreciates by a wide margin. Such changes happen if something major happens on economic / political front of such country or in the global markets. If a country’s currency has depreciated it will mean that this country's money has less purchasing power in other countries because of the depreciation.
Devaluation of Currency : Devaluation of a currency happens in countries with a fixed exchange rate (or also where it is managed floating rate). In a fixed-rate economy, it is the government that decides what its currency should be worth compared with that of other countries. In this case, usually the government pledges to buy and sell as much of its currency as needed to keep its exchange rate the same. The exchange rate can change only when the government decides to change it. If a government decides to make its currency less valuable, the change is called devaluation.
In cases where a country’s economy is NOT performing good, and its government does not allow free rate mechanism, the country’s currency will look strong only on paper and its economy will suffer more as it will not be able to export at inflated price of the currency. Slowly a day comes when the government is forced to devalue its currency so as to make it more tuned to the realities of the FEX rates.
What is the impact of depreciation or devaluation of the currency on economy of the country:
Broadly speaking both have similar impact in the short term. Both of these (i.e. depreciation or devaluation) help the companies which are exporting goods as a drop in the value of the home currency allows the other countries to import goods at a cheaper price from the country whose value has depreciated / devalued. Thus, exports from country whose currency has devalued / depreciated are likely to increase. On the other hand, the citizens will find it costly to buy goods which are imported from other countries as such goods will become costly. Thus, this is likely to benefit the economy to remain competitive in the international market. These events are good for companies that sell the goods produced from domestic raw material, and also to companies that export to other countries.
A drop in home currency exchange rate makes it more expensive for local people to buy goods from other countries, as import of such goods becomes costlier after depreciation / devaluation. Thus, they will either buy more goods manufactured by domestic companies or reduce their consumption of goods from abroad.
Long Term Impact of Depreciation or Devaluation of the Currency :
Depreciation of the currency is a slow process and value of the currency automatically gets adjusted by the market forces. Thus, once the currency of a country has depreciated, the investors from other countries will see an opportunity and are likely to shift from other economies. This will help in boosting the economy which may in the long run even push back the value of the currency.
On the other hand in case of devaluation, there is less trust in the economy and once currency is devalued, Government finds it very difficult to revalue the same by government dictate as there will be fear that such revaluation can backfire and put the economy in risk mode.
Devaluation of Yuan (China’s currency) in August 2015:
Now let us try to understand the difference in these two terms on the basis of recent happenings in the FEX market :-
It was in the mid August 2015, that China in a surprise move devalued Yuan by about 3.5% over a period of three days. This sent jitters across world stock markets and FEX markets. It sent signals to the global markets about the continued weakening of the China’s market, and its desperate move to remain competitive in export market as exports have started declining since last few quarters. We know China is the world's largest exporter and its exports formed 13.7% of the global exports and close to one-and-a-half times United States' exports last year. Thus this move to devalue is currency (Yuan) is a move to boost its exports and continue its share in export market. Thus, here the value of the currency of China dropped on account of measures of Government. This is called devaluation.
However, soon after the announcement of devaluation of Yuan, FEX markets across the world started readjusting the prices of currencies which are linked to floating exchange rates. Indian Rupee two depreciated by about 3% immediately. Thus there was depreciation of INR. Although there was no direct devaluation by Indian Government, but INR depreciated due to market forces which have changed after the announcement of devaluation of Yuan by China.