Understanding currency depreciation

By Amos Kinuthia

I will discuss this under four subheadings: Why the US dollar; Understanding the forex connection; what has been happening in developing nations and abating to a halt.

Why the US dollar?

I will start with the obvious of facts; that the dollar is at the heart of the global monetary system. I will not go into the itsy-bitsy on how, when and who but will use this information to help you understand what is happening to many economies world over.

Up to the 1920’s, the England Sterling Pound was the reserve currency of the world and the use of the Pound was to say the least, the heart and soul of the world of finance.

A reserve currency (sometimes referred to as anchor currency) is an important piece in a system that is ‘fractional reserve banking’. Before the pound, we had the Dutch guilder, the Venetian ducato, the Islamic dinar, the Roman dinari and the Greek drachma occupying the rather important reserve currency seat.

The sterling-centric system began its collapse in the 1920’s and peaked in the 1930’s. The world financial markets had grown dependent on the pound, and its collapse created a vacuum or more specifically, the question on which currency would bear the mantle of being the ‘reserve currency’ of the world. This vacuum arguably ignited the longest and the most severe worldwide economic depression that would soon graduate into a world war.

To cut the long story short, it was the United states that emerged victorious and the dollar the consequent victor. This was the birth of the dollar-centric monetary system that we have till today.

Understanding the forex connection

The International Monetary Fund (IMF) is the organization that assesses and determines whose currency to include in its basket of reserve currencies with the American greenback, the Pound, the Yen and the Euro making the cut. The Yuan is also a possible addition in the coming years.

As we have already inferred above, an interconnected world swings in tandem and pressures in the reserve currencies (the four mentioned) reverberates across other world currencies in more ways than one. It is therefore in any government best interest to hold significant quantities of anchor currencies as without which, it is impossible to participate in international financial transactions and or regulate their domestic currencies.

Case in point, Russia annexation of Crimea resulted in economic sanctions which coupled with a plunge in international oil prices (Russia main export) saw the rumble slid 40 percent (a slump though significant pales in comparison to what happened in Zimbabwe). As fate would have it, Russia holds huge foreign currency reserves and would embark on a prop-up expending more than 80 billion dollars to support the ruble. Had this not been done, the outcome would have been far much worse.

What has been happening in developing nations

For as long as a nation is importing more than it is exporting, forex depreciation is the expected outcome, a situation that has plagued developing economies for decades.

Developing nations have been economic victims to perpetual current account deficits and un-containable inflationary pressures which have been amplified by the effects of a sharper-than-expected global markets tightening.

Consider Zambia for instance, a country with over US$9,000 million debt and copper as the main export. The price of copper, the country’s largest export has seen sudden and sustained price dips and Kwacha exchange rate have been hit with considerable depreciation. Zambia foreign lenders and creditors alike still expects their dollar debt repayment honored, but the country gets considerably less in export dollar revenue. The mismatch between payment obligations and revenue received forces the country to either renegotiate a longer repayment period, use their forex reserves or purchase dollars to repay the loan.

If the creditor is unwilling to relax the repayment conditions as is with many international lenders, the country embarks in dollar purchase spree. This painful scenario is worsened by the fact that, the dollar crunch has hit many of the resource-rich debt ridden nations and their combined dollar appetite has seen exchange rates depreciate further.

The loss of value for the home currencies as a consequent forces foreign investors to sell off their asset holdings in their efforts to cut on forex losses further putting a pressure in the forex markets. This process plays out until commodity prices recuperate in a condition known as ‘market correction’ and force a market readjustment.

Abating to a halt

At this juncture, I want to mention that the US dollar has in 2014 and 2015 made significant gains against all world currencies as a result of better-than-expected growth in the US economy.

Central banks can sell off their forex reserves and therefore abating (not being affected by) the effects of capital outflows. This however requires an economy to have enough reserves to counter the effects of an out of control global market.

Depreciated currencies also makes exports more competitive and can to a negligible extent push up exports revenue.

The easier way as we have seen is push the interest rates up and hence the Return on Investments (ROI). Though this will result in the crowding-out effect (a concept that requires an independent write-up), may act to attract foreign investors and halt the currency depreciation.


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