Understanding Currency Depreciation: Causes and Effects

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Currency depreciation is a fall in a currency’s exchange rate against other currencies in a floating market. After a depreciation, one unit of the currency buys fewer units of foreign currency. Foreign goods, assets and debts therefore cost more when measured in the weaker money. The term always describes a relationship. A currency depreciates against something, such as another currency, a basket of currencies or an index like the U.S. dollar index (USDX).

How Depreciation Shows Up in an Exchange Rate

Every currency pair is quoted as units of the quote currency per one unit of the base currency. In EUR/USD at 1.20, one euro costs 1.20 dollars.

• If the base currency depreciates, the quoted number falls. EUR/USD dropping from 1.20 to 1.08 means the euro lost value.
• If the quote currency depreciates, the quoted number rises. USD/TRY climbing means each dollar buys more lira, so the lira lost value.

Either way, the depreciating currency buys less foreign money.

The formula

Measure the currency’s value in units of the other currency, then take the percentage change:

Depreciation (%) = (old value − new value) ÷ old value × 100

When the currency sits on the quote side, its value per unit is 1 ÷ rate. The formula then simplifies to:

Depreciation (%) = (1 − old rate ÷ new rate) × 100

A “dollar depreciation rate” is this calculation applied to the U.S. dollar. It is measured against one currency or against a trade-weighted basket such as the USDX, and often annualized when comparing periods.

Worked Example (Hypothetical)

Assume EUR/USD moves from 1.20 to 1.08. There are no transaction costs.

• Euro depreciation against the dollar: (1.20 − 1.08) ÷ 1.20 = 10%.
• Dollar appreciation against the euro: one dollar bought 1 ÷ 1.20 = €0.8333 before and 1 ÷ 1.08 = €0.9259 after. That is a gain of about 11.1%.

The two figures are not mirror images. A 10% fall in one currency equals an 11.1% rise in the other, because each percentage uses a different starting base. Quoting a move without saying which currency it refers to can therefore misstate its size.

In trade terms, a European product priced at €100 cost an American buyer $120 at 1.20 and $108 at 1.08, so it became cheaper abroad without any price cut. A $100 American product rose from about €83.33 to about €92.59 for a European buyer. Exporters in the weakening currency gain price competitiveness, and importers pay more.

What Causes a Currency to Depreciate

Inflation. A currency that loses domestic purchasing power quickly tends to lose external value as well. Higher inflation also raises input costs for exporters, which makes their goods less competitive abroad and can widen the trade deficit. That adds more pressure on the currency.

Interest rate differentials. Large pools of capital move toward higher yields. When a central bank keeps rates low or cuts them while other countries hold or raise theirs, investors can sell the currency to buy higher-yielding assets elsewhere. Expected differentials, not only current ones, can trigger the move. A country that cuts rates to support growth usually has to accept some depreciation, and central banks raise rates to support a falling currency.

Weak external balances. Countries with chronic current account deficits rely on foreign capital to fund the gap. When that funding becomes less willing, the currency has to fall.

Quantitative easing. After the 2007 to 2008 financial crisis, the Federal Reserve ran three rounds of bond purchases that pushed yields to record lows. Following the announcement of QE1 on November 25, 2008, the USDX fell more than 7% over the next three weeks. During QE2 in 2010 to 2011, the dollar reached record lows against the Japanese yen, Canadian dollar and Australian dollar.

Political action and rhetoric. Official statements and trade policy also move currencies. In August 2015 the People’s Bank of China lowered the yuan by roughly 2% against the dollar, citing the need to support exports. U.S.-China tensions shifted toward tariffs in 2018, and in 2019 the U.S. Treasury designated China a currency manipulator.

Risk aversion and contagion. When investors fear further losses, they sell, and their selling deepens the fall. Emerging-market currencies are especially exposed to contagion, where trouble in one country spreads to others seen as similar.

Effects: Who Gains and Who Loses

An orderly, gradual depreciation makes exports cheaper for foreign buyers and imports dearer at home, which can narrow a trade deficit over time. Exporting firms and businesses that compete with imports tend to benefit. So do foreign tourists and investors who buy local assets.

The negative consequences grow with speed and size:

• Imported inflation. Fuel, food and components priced in foreign currency cost more, which feeds into consumer prices and reduces real incomes.
• Foreign-currency debt. Companies and governments that borrowed in dollars or euros need more local currency to service the same debt. Default fears can then deepen the selloff.
• Capital flight. Foreign portfolio investors who expect further declines pull money out, which pushes the currency lower still.
• Policy pressure. Central banks may be forced into sharp rate hikes or reserve sales at a time when the economy is already weak.

Notable Episodes

• Asian financial crisis, 1997: the collapse of the Thai baht was followed by sharp declines across most Southeast Asian currencies.
• Taper tantrum, 2013: the Indian rupee and Indonesian rupiah fell steeply that summer as markets anticipated the Fed scaling back its bond purchases.
• Brexit, 2016: after the June 23 referendum, the British pound fell more than 10% against the dollar.
• Turkish lira, 2018 to 2020: in August 2018 the lira dropped more than 20% against the dollar as several pressures hit at once: fears that Turkish companies could not repay dollar and euro loans, doubled U.S. steel and aluminum tariffs, and a central bank kept from raising rates while holding too few dollars to defend the currency. In September 2018 the central bank raised its policy rate from 17.75% to 24%. Geopolitical risk pushed the lira beyond 8.05 per dollar in October 2020. It lost 26% that year and more than 50% from the end of 2017.

What Depreciation Is Not

• Devaluation: an official decision to lower a pegged or managed rate. Depreciation results from market trading. China’s 2015 move is usually described as a devaluation because authorities set the change.
• Inflation: a loss of purchasing power over domestic goods. Inflation can cause depreciation, but a currency can depreciate against another even when domestic prices are stable.
• Appreciation: the opposite move. Every depreciation in a pair is an appreciation of the other currency, by a different percentage.
• Accounting depreciation: the write-down of an asset’s book value over its useful life. It has no connection to exchange rates.

Limitations of the Concept

A depreciation figure depends on the benchmark. A currency can fall against the dollar while rising against the yen, so “the currency fell” says little until the counter-currency or index is named. A nominal decline also leaves out price levels. If domestic inflation runs well above inflation abroad, a depreciation may only offset it and leave competitiveness unchanged. Finally, the benefit to exporters is not automatic. Exports priced in foreign currency, imported inputs and contracts that are already hedged can all reduce the gain, while the costs of imported inflation and foreign-currency debt arrive anyway.

The Bottom Line

Exporters, importers, travelers and borrowers with foreign-currency debt all feel depreciation, though in different directions. A gradual decline can help exporters and narrow a trade deficit, while a fast or large one brings imported inflation, heavier debt costs and capital flight. Any depreciation figure means little until the benchmark currency or index is named and domestic inflation is taken into account.