What is a currency crisis?

Since the early 1990s, there have been several currency crises. This is due to the sudden and sharp depreciation of the national currency due to market fluctuations and lack of confidence in the national economy. Currency crises are sometimes predictable and often sudden. It may be facilitated by the government, investors, central bank, or any combination of participants. But the result is always the same: negative prospects can lead to large-scale economic losses and capital losses. In this article, we will explore the historical drivers of currency crises and reveal their reasons.

Key points

  • A currency crisis involves a sudden and sharp drop in the value of a country’s currency, which will have a negative chain reaction to the entire economy.
  • Unlike currency devaluation as part of a trade war, currency crises are not a purposeful event and should be avoided.
  • Central banks and governments can intervene to help stabilize currencies by selling foreign currency or gold reserves or intervening in the foreign exchange market.

What is a currency crisis?

The currency crisis is caused by a sharp drop in the value of a country’s currency. In turn, this decline in value will cause exchange rate instability, which will have a negative impact on the economy, which means that a certain unit of a certain currency will no longer buy another currency as before. In simple terms, we can say that from a historical perspective, a crisis occurs when investors’ expectations result in a major change in the value of a currency.

But currency crises—such as hyperinflation—are usually the result of a poor-quality real economy that serves as the country’s monetary base. In other words, currency crises are often a symptom of more severe economic malaise, not disease.

Some places are more susceptible to currency crises than others. For example, although the dollar may collapse in theory, its status as a reserve currency makes it unlikely.

Responding to the currency crisis

The central bank is the first line of defense to maintain currency stability. Under the fixed exchange rate system, the central bank can maintain the current fixed exchange rate system by using its own foreign exchange reserves or intervening in the foreign exchange market when the floating exchange rate system faces the prospect of a currency crisis. .

When the market is expected to depreciate, raising interest rates can partially offset the downward pressure on the currency. In order to raise interest rates, the central bank can reduce the money supply, thereby increasing the demand for money. Banks can do this by selling foreign exchange reserves to create capital outflows. When a bank sells part of its foreign exchange reserves, it will receive payments in the form of domestic currency and circulate the domestic currency as an asset.

Due to political and economic factors such as reduced foreign exchange reserves and rising unemployment, the central bank cannot support the exchange rate in the long term. Devaluing the currency by raising the fixed exchange rate will also make domestic goods cheaper than foreign goods, thereby stimulating demand for workers and increasing output. In the short term, depreciation will also raise interest rates, which must be offset by the central bank by increasing the money supply and increasing foreign exchange reserves. As mentioned earlier, supporting a fixed exchange rate can quickly deplete a country’s reserves, and a currency devaluation can increase reserves.

Investors know very well that depreciation strategies can be used and they can be incorporated into their expectations-which annoys the central bank very much. If the market expected that the central bank would devalue the currency—and thereby raise the exchange rate—the possibility of increasing foreign exchange reserves by increasing aggregate demand would not be realized. On the contrary, the central bank must use its reserves to shrink the money supply, thereby raising domestic interest rates.

What is the cause of the currency crisis?

Anatomy of a currency crisis

If confidence in economic stability is generally weakened, investors will usually try to withdraw large amounts of money. This is called capital flight. Once investors sell investments denominated in their own currency, they will convert those investments into foreign currencies. This will cause the exchange rate to get worse, leading to currency runs, making it almost impossible for the country to finance its capital expenditures.

Currency crisis forecasting involves the analysis of a diverse and complex set of variables. The recent crisis has several common factors:

  • Large country borrowing (current account deficit)
  • The value of money rises rapidly
  • Uncertainty of government actions disturbs investors

Currency crisis example

Let’s take a look at some crises and see how they affect investors.

The Latin American Crisis of 1994

On December 20, 1994, the Mexican peso depreciated. Since the last turmoil in 1982, Mexico’s economy has improved a lot, and interest rates on Mexican securities are at a positive level.

Several factors contributed to the subsequent crisis:

  • The economic reforms of the late 1980s — designed to limit the country’s often rampant inflation — began to burst as the economy weakened.
  • The assassination of Mexico’s presidential candidate in March 1994 raised concerns about currency sell-offs.
  • The central bank sits on about 28 billion U.S. dollars in foreign exchange reserves, which is expected to keep the peso stable. In less than a year, the reserves were gone.
  • The central bank began to convert short-term debt denominated in pesos into bonds denominated in U.S. dollars. The conversion resulted in a decrease in foreign exchange reserves and an increase in debt.
  • When investors worry about government debt defaults, a crisis of self-realization arises.

When the government finally decided to devalue the currency in December 1994, it made some major mistakes. It did not let the currency depreciate sufficiently, which shows that it is unwilling to take the necessary painful steps while following the pegging policy. This caused foreign investors to push down the peso exchange rate substantially, which eventually forced the government to raise domestic interest rates to nearly 80%. This has caused significant losses to the country’s gross domestic product (GDP), which has also declined.U.S. emergency loans finally eased the crisis

1997 Asian Crisis

Southeast Asia is the birthplace of tiger economies (including Singapore, Malaysia, China, and South Korea) and Southeast Asian crises. Over the years, foreign investment has continued to flow in. Underdeveloped economies are experiencing rapid growth and high levels of exports. The rapid growth was attributed to capital investment projects, but overall productivity did not meet expectations. Although the exact cause of the crisis is still controversial, Thailand was the first to run into trouble.

Much like Mexico, Thailand is heavily dependent on foreign debt, which makes it faltering on the verge of insufficient liquidity. Real estate dominates investment, but management efficiency is low. The private sector maintains a large current account deficit and is increasingly dependent on foreign investment for its livelihoods. This exposes the country to a lot of foreign exchange risks.

This risk peaked when the United States raised domestic interest rates, ultimately reducing the amount of foreign investment entering Southeast Asian economies. Suddenly, the current account deficit became a huge problem, and financial contagion spread rapidly. The Southeast Asian crisis originated from several key points:

  • As fixed exchange rates have become extremely difficult to maintain, many Southeast Asian currencies have depreciated.
  • Privately held debt in Southeast Asian economies has rapidly increased, which is supported by excessive asset value inflation in some countries. As foreign capital inflows decrease, defaults increase.
  • Foreign investment may be at least partly speculative, and investors may not pay enough attention to the risks involved.

Lessons learned from the currency crisis

Here are some things that can be eliminated from these currency crises, including:

  • An economy may be solvent at first, but it will still fall into crisis. Low debt is not enough to maintain policy operations or quell negative investor sentiment.
  • Trade surplus and low inflation can reduce the impact of the crisis on the economy, but in the case of financial contagion, speculation limits options in the short term.
  • Governments are often forced to provide liquidity to private banks, which can invest in short-term debt that needs to be paid in the near future. If the government also invests in short-term debt, it can quickly deplete foreign exchange reserves.
  • Maintaining a fixed exchange rate does not make the central bank’s policies work solely on face value. Although announcing the intention to retain the pegged exchange rate may help, investors will ultimately focus on the ability of the central bank to maintain policy. The central bank will have to depreciate in sufficient ways to maintain credibility.

Bottom line

Currency crises can take many forms, but they are mainly formed when investor sentiments and expectations do not match a country’s economic prospects. Although growth in developing countries is generally beneficial to the global economy, history tells us that excessive growth will cause instability and increase the possibility of capital flight and the operation of national currencies. Although effective central bank management can help, it is difficult to predict the course the economy will ultimately take, leading to a continuing currency crisis.

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