Since the early 1990s, a plethora of investors has been hit by many instances of currency crises.
Several countries have seen currencies fluctuate unexpectedly for various reasons, and had a great impact on the general market every time.
So, what’s a currency crisis?
It’s essential a situation whereby the speculators drive down the value of a country’s currency that results in a sudden as well as drastic depreciation.
With such a scenario, the overall economy of that particular country feels the effects of the sudden change. Sometimes, it can result in significant financial issues.
Currency crises are caused by various elements such as currency pegs or merely monetary policy decisions.
They can as well be solved by implementing the floating exchange rates or simply avoiding monetary policies that fight a market rather than embracing it.
When a speculative attack occurs in the foreign exchange value of a currency, it results in a sudden sharp depreciation, which is known as a currency crisis. These crises can have large measurable costs on an economy, as we saw during the global financial crisis in 2008-09, which forced sharp depreciation in several advanced and developing economies.
A currency crisis can arise due to many factors, such as particular decisions in monetary policy or currency pegs. Central banks can remedy a crisis by selling off foreign reserves, including gold and silver, or implementing floating exchange rates.
With that in mind, let’s take a look at how a currency crisis develops, and how to prevent them from occurring.
Causes of Currency Crisis
Basically, the currency crisis is as a result of underlying factors that range from the central bank policies to just pure speculation.
What makes it even more interesting is the fact that they are usually hard to predict in advance.
In the past, the primary cause has always been the failure of the central banks in maintaining a fixed rate peg to the floating rate foreign exchange.
However, the cause of a currency crisis typically comes down to a particular political situation, a misstep by the central bank of the nation, or an economic disaster. Besides, war can also be a cause of a currency crisis.
Nevertheless, once a currency crisis has occurred, the results are always the same; the currency loses value instantly, creating instability in an exchange rate as well as inflation.
In other words, a similar amount of currency will buy less than it did previously.
The Role of Central Banks, Government Policy and Investors
Currency crises are sometimes unexpected; however, when a crisis is expected, some parties have to do something.
For instance, when a country expects a crisis, the central bankers, in most cases, the ones with fixed exchange rate economies, try not to change the current exchange rate.
A country can also offset its currency’s’ downward pressure by raising the interest rate. When that happens, the nation’s central bank will have to reduce the money supply to increase the demand for the country’s currency.
This is achieved by the central bank selling off the foreign reserves and hence creates a capital outflow.
On their part, investors have learned to deal with such devaluation strategy of a country as they usually facto in the moves on the government part into their expectations.
However, if they don’t have confidence in the economic stability of their nation, they may consider moving the money out of the country (capital flight).
How to Know a Country is expecting a Currency Crisis
A currency crisis usually happens unexpectedly; however, it can be predicted by analyzing some variables such as:
- The level of a country’s borrowing (a country’s current account deficits)
- A quick increase in the currency values
- Uncertainty as a result of the government actions in a country
The Bottom Line
In reality, the most appropriate way of avoiding any currency crisis is via comprehensive central banking policies to keep intervention as well as money printing to the minimum.
Therefore, it’s wise to keep ab bay a floating exchange rate, instead of a fixed one.
Nevertheless, predicting the route an economy will take or even mapping out how things will be going forward is not an easy task.
But one thing for sure, a currency crisis result when investor sentiments, as well as expectations, don’t match with the economic outlooks of a given country.