Currency appreciation is when the value of one currency rises with respect to another. It occurs for many reasons, with the most influential including business activity, monetary policy, international trade, and interest rates.
Learn how currency appreciation works, its pros and cons, and its overall impact on individual investors
Definition and Examples of Currency Appreciation
As currencies are traded in pairs, currency appreciation is when the value of one currency increases when compared to a different currency.
Unlike bonds, crypto or stocks, where investors transact a currency for an asset, in the currency market, an investor transacts a currency for another currency. This means the measurement of currency value is not absolute but rather a comparative measure of value.
For example, at the start of 2011, 1 US dollar would purchase approximately 6.56 South African Rands (USDZAR = 6.56), and since then the dollar has steadily appreciated versus the rand to exchange rate heights of 19.24 rands in April 2020, a currency appreciation of just over 193%.
How Currency Appreciation Works
Currency appreciation for floating exchange rate regimes is the outcome of forex market supply and demand. As with most markets, when the demand for a currency increases, its value tends to rise. This is because, when there are more buyers than sellers for a currency, at a certain price point, it will force the exchange rate to appreciate until another seller is found to satisfy the order.
It can be calculated by determining the percentage change of a currency exchange rate between two periods of time, as follows:
- CA (%) = [(Xc - Xp) / Xp ] * 100
- CA (%) = Currency appreciation as a percentage
- Xc = Current currency exchange rate
- Xp = Previous currency exchange rate
When currency appreciation occurs, there are numerous implications on an economy.
Imports Become Cheaper
When a currency becomes more valuable relative to another, it means its purchasing power rises. Its ability to acquire goods and services is heightened, and a currency can extend further than it previously could.
For example, if the exchange rate of U.S. Dollar-South African Rand pair (USD/ZAR) increases from 13.44 to 14.44, one dollar that previously bought 13.44 South African rands, can now buy 14.44 South African rands.
The dollar extended its ability to purchase more rands. If a business in the U.S. is importing goods from South Africa, their dollars will now stretch further, making it cheaper to import those items. This is then passed on to consumers with lower pricing and helps curb inflation.
Exports Become More Costly
The caveat of an appreciating U.S. dollar and imports becoming cheaper is that foreign countries who wish to purchase goods and services from the U.S. need deeper pockets. The U.S. dollar becomes increasingly more expensive for businesses in countries, like South Africa in our example, to import those goods and services.
This then ends up deterring foreign countries from buying from the U.S. and may take their business to another country. That causes a decline in the amount of money the U.S. makes from international sales.
What Causes a Currency to Appreciate?
The contributing factors to whether or not a currency appreciates includes a vast array of economic variables, and more importantly, the market’s opinion on those variables.
If businesses, governments, and investors globally have high expectations of returns from a particular country, like the United States, its currency value tends to rise. As a byproduct, foreign countries will invest more money into the U.S. economy, causing a higher demand for the U.S. dollar, pushing its value higher. However, if those expectations are not met, international investors may seek returns elsewhere, and convert their U.S. dollars into another currency, causing the dollar value to fall.
There is a constant ebb and flow between expectations, and outcomes of economic performance, that drive currency appreciation or depreciation.
Currency Appreciation vs. Stock Appreciation
Currencies represent the performance of a whole economic region. Thus, the value of a currency is derived from factors such as changes in trade tariffs, interest rates and many more economic variables.
When a currency appreciates, it can be assumed this is due to its economy strengthening relative to another country’s currency (as currencies are quoted in pairs) and vice versa. On the other hand, stocks represent a percentage of a company, whereby their appreciation depends on the company’s overall performance, profitability and earnings.
|Currency Appreciation||Stock Appreciation|
|A relative increase in value between two currencies||The absolute increase in value of a company|
|Reflects overall economic health||Reflects health of an individual company|
Pros and Cons of Currency Appreciation
Currency appreciation can be effective for countries that run a deficit, but a growth resistor for countries that run a surplus. Before diving in, it’s important to understand the pros and cons.
Increased purchasing power
Imports are cheaper
Decrease in exports
A fall in international demand
- Increased purchasing power: As a currency appreciates, it becomes relatively stronger versus other currencies. This means an appreciating currency can purchase more of another currency, due to its increase in strength.
- Imports are cheaper: When a country imports goods and services, they must exchange their local currency for the foreign currency to make the transaction. As the local currency appreciates, local businesses can now buy more foreign currency, with the same amount of their local currency, hence making it relatively cheaper to import goods and services.
- Decrease in exports: Businesses looking to purchase goods and services from other countries seek currencies that have a lower value so that they get better value for money. This means that countries experiencing a currency appreciation become less attractive to international shoppers, causing international sales in that country to decline. That drop in international sales (exports) increases a country's deficit, as the number of imports starts to heavily exceed the amount of export activity.
- A fall in international demand: When a currency appreciates, it becomes more expensive globally than other currencies. This causes domestic businesses to struggle when selling their products to international shoppers, causing a fall in aggregate demand.
What Currency Appreciation Means for Individual Investors
If investors can accurately gauge the health of an economy by using leading business cycle indicators like ISM PMI, they may be able to identify which currencies are more likely to appreciate than others and place better-informed investments.
Traders buy or “go long” on a currency pair on the belief that a currency will appreciate more than another currency in a pair, and will sell or “go short” on the belief that the currency will depreciate compared to the other currency in the pair.
For example, if a trader expected the British pound to appreciate versus the U.S. dollars, they would seek to long GBP/USD. However, if the trader changed their mind, and expected the U.S. dollar to appreciate versus the British pound, they would seek to short GBP/USD.
Investors in stocks, bonds, and index funds can also use currency appreciation as a bullish sign for heavy importers of international goods and services, as it helps increase their purchasing power.
- Currency appreciation is when the value of a currency increases relative to another.
- The value of a currency is determined by the supply and demand in the market. A currency appreciates if it has a higher demand, and depreciates on lower demand.
- Countries and businesses that import more than they export generally prefer currency appreciation, whereas those that export more than they import do not.
- Central authorities with floating currency regimes use monetary and fiscal policies to influence currency appreciation or depreciation to stimulate economic growth.