What’s it: Currency appreciation is when the exchange rate of one currency against another currency increases. One unit of currency can buy more of another currency.
Appreciation makes foreign products cheaper for domestic buyers, thus encouraging import shipments. Conversely, it makes domestic products more expensive for foreign buyers, weakening exports.
The opposite of appreciation is depreciation, in which the exchange rate of one currency against another currency weakens. You have to spend more money to get foreign currency. In international trade, depreciation makes imported products more expensive. On the other hand, the price of domestic products is lower for foreigners.
Many factors influence currency appreciation, including the trade balance, interest rates, the business cycle, economic policies, and even speculative activity.
How currency appreciation works
Let’s take a simple example. Assumes the rupiah exchange rate against the U.S. dollar moved from IDR12,200/USD to IDR13,000/USD.
For Indonesians, the rupiah depreciates because the purchasing power of the rupiah against the U.S. dollar decreases. They have to spend more rupiah to get one U.S. dollar (from IDR12,200 to IDR13,000).
In contrast, Americans see their currency strengthening because one U.S. dollar can buy more rupiah than before. If previously, they got IDR12,200 when exchanging one dollar, they now get IDR13,000.
IDR12,200/USD to IDR13,000/USD -> Americans say “Appreciation” = Indonesians say “Depreciation”
Next, let’s say the exchange rate moved from IDR13,000/USD to IDR11,000/USD. Indonesians see the rupiah appreciates, and they can get one dollar for only IDR11,000, less than before (IDR13,000).
But, for Americans, the U.S. dollar depreciates. When exchanging 1 U.S. dollar, they get less rupiah than before.
IDR13,000/USD to IDR11,000/USD -> Americans say “Depreciation” = Indonesians say “Appreciation”.
Causes of currency appreciation
Under the free-floating exchange rate regime, exchange rates fluctuate depending on supply and demand on the forex market. If a currency’s demand increases, it increases its value (purchasing power).
There are many factors to explain why exchange rates appreciate. They include the trade balance, interest rates, capital flows, inflation, monetary and fiscal policy, speculation, and political stability.
International trade involves currency as payment. Exports increase demand for domestic currency. Conversely, imports cause an increase in demand for the partner country’s currency.
Let’s take the case of exports and imports between Indonesia and the United States. Suppose you are Indonesian.
When exporting to the United States, the demand for rupiah increases. Americans must convert their dollars into rupiah to pay. Therefore, the increase in exports leads to an increase in demand for the rupiah. This makes the rupiah more valuable relative to the U.S. dollar (the rupiah appreciates), assuming imports and other factors remain constant.
Conversely, when importing, the demand for rupiah does not change. On the other hand, U.S. dollars’ demand increases because Indonesian importers have to exchange their rupiah for paying for the product. Hence, higher imports to domestic currency depreciation.
So, when Indonesia recorded a trade surplus against the United States, the demand for rupiah is higher than the demand for dollars. As a result, the rupiah’s purchasing power against the U.S. dollar strengthens (appreciation).
Conversely, suppose Indonesia reports a trade deficit against the United States. In that case, the rupiah will depreciate because rupiah demand is lower than the demand for U.S. dollars.
Increase in domestic interest rates
Interest rates affect exchange rates through their impact on capital flows. In this case, you should focus on the spread between domestic interest rates against international interest rates.
Assume that international interest rates are constant. Suppose the domestic central bank adopts an expansionary monetary policy by raising interest rates. In that case, it makes domestic assets more attractive to foreigners. An increase in interest rates offers higher returns for foreign creditors. Therefore, it triggers an inflow of capital and causes the currency to appreciate.
Conversely, a cut in interest rates causes the spread of domestic interest rates against international interest rates to fall. It is less attractive to foreign creditors. They shift their capital outward to countries with higher returns. The outflow leads to the depreciation of the domestic currency.
Interest rate spreads are the reason why some foreign investors move their money to the emerging markets. When interest rates approach zero in the U.S., developing countries offer higher interest rates.
Currency appreciation effects
The appreciation of the currency makes imported products cheaper for domestic buyers, both for households and businesses. That encourages them to buy more, leading to increased imports.
Furthermore, because the domestic economy gets lower prices, it will reduce the pressure on imported inflation. For businesses, they get cheaper raw materials and capital goods. Lower operating costs improve profitability. Hence, it is unlikely that they will increase the selling price.
On the other hand, appreciation makes domestic products more expensive for foreign buyers. Domestic products are becoming less competitive, reducing their demand and weakening exports. Since imports are increasing simultaneously, the trade balance tends to decline (or even deficit).
The magnitude of the impact of appreciation on the trade balance depends on the elasticity of product demand. When demand is elastic, the impact of appreciation will be more significant because buyers are relatively sensitive to price changes. Conversely, if demand is inelastic, the impact of appreciation is relatively small.
Apart from affecting the trade balance and imported inflation, appreciation also has several other impacts.
Increased competition from imported products. Due to lower prices, the increase in imported products heightens competition in domestic markets. Some consumers switch from local products. To remain competitive, domestic firms must cut costs and increase productivity to lower selling prices.
Decrease in economic growth. Suppose we assume the other GDP components (consumption, investment, and government spending) are unchanged. In that case, appreciation encourages an increase in imports and weakens exports. As a result, it reduces gross domestic product (GDP).
Decrease in foreign loan payments. For example, Indonesian companies issue global debt securities denominated in U.S. dollars. Say, coupon payments are in U.S. dollars. The rupiah appreciation against the U.S. dollar makes companies need less rupiah to pay for coupons.
Exchange rate translation gains. Say, the U.S., investors realize and convert rupiah capital gains into their functional currency (U.S. dollars). In that case, appreciation makes them earn more U.S. dollars from the translation.
For example, investors get a capital gain of Rp120,000. When they firstly invested, the rupiah exchange rate was IDR14,000/USD. And, when realizing capital gains, the exchange rate is at IDR 12,000 / USD. If the rupiah is constant, investors will only get USD8.57 (120,000/14,000). However, because the rupiah appreciates, investors get USD10 (120,000/12,000).