How Does Currency Crisis Occur

Many a time forex investors have been caught off guard since the early 1990s because of currency instability. The aim of this article is to help traders understand what currency instability is and what causes it.

Currency Crisis – Definition

A decline in the value of the currency of a country is what brings about the currency crisis. If the value of a currency falls, the country’s economy will be negatively affected. This causes the exchange rate of the currency to remain unstable. This means that one unit of this currency will no longer be able to buy the same amounts of other currencies that it used to buy. In simple terms, investor expectations will not be met.

Central Banks, Government Policy and Role of Investors

forex market outlookIn a country that is likely to face a currency crisis, central bankers, especially those in fixed exchange rate economies, try their best not to change the existing exchange rate. In order to maintain the exchange rate, countries have to sacrifice a part of their foreign reserves. If they do not allow that to happen, the currency’s exchange rate would fluctuate.

When the country expects a devaluation of its currency, the interest rate has to be raised in order to offset the downward pressure experienced by its currency. If the interest rate has to be increased, the country’s central bank will have to reduce the money supply. This helps to increase demand for the country’s currency. The central bank achieves this by selling off a part of the foreign reserves and creating a capital outflow. As the central bank sells its foreign reserves, it receives domestic currency. The central bank holds the currency as an asset and keeps it out of circulation.

Maintaining the exchange rate by reducing foreign reserves is not a long-term solution, when faced with the threat of currency devaluation, as it can quickly lead to an erosion of foreign reserves and increase unemployment rate. On the other hand, devaluation of the country’s currency results in domestic goods becoming cheaper. This leads to an increase in output and demand for workers. Further, currency devaluation causes interest rates to rise in the short-term. The central bank of the country will have to offset the rate hike with an increase in money supply and foreign reserves.

Investors know how to deal with their country’s devaluation strategy and they often factor in such moves on the part of their governments into their expectations. If a country’s central bank devalues the domestic currency, it would lead to an increase of the exchange rate and the possibility of enhancing foreign reserves by creating aggregate demand will be lost. Therefore, the central bank must make use of its reserves for shrinking the money supply. This will automatically lead to an increase in the domestic interest rate.

Anatomy of a Currency Crisis

If investors do not have confidence in their country’s economic stability, then they would want to move their money out of their own country. Movement of money out of the country is termed as capital flight. Investors sell their domestic-currency denominated holdings and convert them into foreign currency, worsening the exchange rate. This causes a run on the currency and the country would find the prospect of financing its capital spending to be a tough task.

A diverse set of complex variables needs to be analyzed in order to predict when a country would face a currency crisis. Some of the key factors are:

A country’s level of borrowing (current account deficits)
Rapid increase in currency values
Uncertainty associated with the actions of the government in a country; they make investors jittery

The concept is best explained with a couple of examples:

Mexican Currency Crisis 1994

Mexico’s peso was devalued on December 20, 1994. The factors that contributed to the crisis that followed were as follows:

– Economic reforms carried out in the late 1980s were meant to limit inflation cracked and the economy became weak.

– In March 1994, assassination of the Mexican presidential candidate sparked a currency sell off.

– The central bank had foreign reserves of approximately $28 billion. The reserve disappeared in less than 12 months.

– The Mexican central bank started converting short-term peso-denominated debt into dollar-denominated bonds. This resulted in the depletion of the foreign reserves and higher debt.

– A self-fulfilling currency crisis resulted as investors feared that the government would default on debt.

– Finally, when the government devalued the peso they made major mistakes. The currency was not devalued enough and this resulted in the foreign investors pushing the exchange rate of peso drastically lower. The government was forced to increase the interest rates by nearly 80 percent. The country’s GDP fell.

An emergency loan extended by the United States finally averted the crisis.

Asian Currency Crisis 1997

Foreign investment started pouring into Southeast Asia many years prior to 1997. The underdeveloped countries in the region were experiencing rapid growth and exporting a great deal of goods. Capital investment projects were driving growth, but the overall productivity failed to meet expectations. Though the real cause of the crisis continues to be a matter of dispute, Thailand was the first country to bear the brunt.

This is because Thailand relied on foreign debt just like Mexico. Further, the country mismanaged real estate-dominated investment. Further, the private sector maintained huge current account deficits. This exposed Thailand to a great deal of foreign exchange risk. The situation worsened when the US hiked the domestic interest rates as the action restricted the flow of foreign investment into Southeast Asian countries. The current account deficits posed huge problems and a financial crisis ensued.

As a result of the inability to maintain the fixed exchange rates, currencies of many Southeast Asian countries dropped in value. Privately held debt increased rapidly and the situation was further aggravated because of overinflated asset values. Defaults increased and foreign capital inflows waned off.

Final Thoughts

Economic growth in developing countries has a positive impact on the global economy. However, rapid growth can create instability. Further, the chances of capital flight and runs on the domestic currency will be higher. Central banks have a key role to play in managing the situation. However, it is not an easy task to predict the route of an economy and how things will map out later on.

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