Readers Question: What will happen to the value of a currency during times of deep recession and high inflation?
There is no hard and fast rule about what will happen to the value of a currency during a recession. Though if a country has a deeper recession than other countries, then a currency is likely to fall because the economy becomes a less attractive place to invest and interest rates likely to fall.
The Pound Sterling fell by over 25% from 2007Â to July 2009. Therefore, this is an example of a recession causing a fall in value of a currency.
This was actually a global recession. But the UK economy suffered a relatively bigger recession because the global credit crunch particularly affected the UK economy, because of its reliance on finance. The Credit crunch adversely affected exports and UK GDP. UK interest rates fell to 0.5% and demand for the Pound fell.
The Credit crunch recession 2008/09 did cause fall in value of Sterling. But the Covid recession didn’t.
US Dollar and Recessions
In 2006-2008 the dollar fell as the US cut interest rates, but during the worst of the 2008/09 recession, the Dollar actually appreciated because investors saw the US dollar as a relatively safe haven during the great financial crisis.
The dollar soared in early 1980s, because of high interest rates. In the boom of late 1980s, the dollar actually fell.
It was a similar experience in the UK in the 1980s. In 1980, there was a rapid appreciation in Sterling due to high interest rates and production of North Sea Oil. In this case, the appreciation in Sterling contributed to the recession of 1980/81. The rise in Sterling made UK exports less competitive, leading to a fall in demand, which particularly hurt exporting manufacturing industries.
As the economy recovered from recession and interest rates fell, the Pound depreciated quite sharply.
2020/21 Recession
During the Covid recession of 2020 to 2021, the Pound didn’t fall because the UK was not particularly affected by Covid more than other countries.
Economic theory behind the value of a currency in recession
Suppose one country, e.g. the UK, enters a deeper recession than all its other competitors. How might we expect the currency to behave?
Recession and interest rates. If the UK enters a recession, then we would expect UK interest rates to fall compared to those in other countries. This would make the UK less attractive for investors to save money. Hot money flows are likely to leave the UK and move to countries with higher interest rates. If people move money out of the UK, they will sell Pounds and buy other currencies, causing a fall in the value of Sterling. Therefore, in theory, we might expect a recession to cause a fall in the value of the currency.
Evaluation
1. In a recession, inflation is likely to fall. Lower inflation will help the country become more competitive, and this may increase demand for the currency causing it to rise.
2. Many factors affect the value of a currency. For example, if the UK had a large current account deficit, then we might expect this trade deficit to put downward pressure on the currency. The fall in the value of Sterling in 2008 was partly related to the UK’s trade deficit and lack of competitiveness. However, if a country like Germany entered a recession, there may be less downward pressure on their currency (the Euro) because Germany has a large current account surplus.
3. It depends on what is happening in other countries. During the great recession, US interest rates fell to 0%, they created money (part of Q.E.), and there were concerns about the size of the US public sector debt. Usually, all these factors (zero interest rates, printing money, high debt) would put downward pressure on the value of the dollar. However, in the Great Recession, most major economies also had low-interest rates and high government debt. Therefore, many investors still felt that the US was relatively a safe haven compared to other countries. Therefore, the dollar has maintained its value because it is still ‘relatively’ good. If the US had entered a recession on its own, the dollar would have fallen by much more.
4. Confidence. If a country goes into recession, investors may lose confidence. For example, a recession will mean higher debt to GDP ratios, and this may cause concern over the reliability of bonds (especially in case of Euro). But, investors can also retain confidence in a currency, even if the economy is in recession. It depends on prospects for the balance of payments and underlying competitiveness.
What happens to the value of currency due to inflation?
If inflation in the UK is relatively higher than other countries, you would expect a fall in the value of the Pound because the Pound is becoming relatively uncompetitive and fewer people will buy British goods.
See also: devaluation, competitiveness and inflation
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