What causes a currency crisis?

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Since the early 1990s, there have been many cases of currency crises percepitated by investors whose outlooks cause wide-scale retreats and the loss of capital. In this article, we’ll explore the historical drivers of currency crises and uncover their causes.


What Is a Currency Crisis?

A currency crisis is brought on by a decline in the value of a country’s currency. This decline in value negatively affects an economy by creating instabilities in exchange rates, meaning that one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies.


The Role of Governments, Central Banks and Investors in a Currency Crisis

First, let’s explain why tapping into foreign reserves is a potential solution. When the market expects devaluation, downward pressure placed on the currency can really only be offset by an increase in the interest rate. In order to increase the rate, the central bank has to lower the money supply, which in turn increases demand for the currency. The bank can do this by selling off foreign reserves to create a capital outflow. When the bank sells a portion of its foreign reserves, it receives payment in the form of the domestic currency, which it holds out of circulation as an asset.

Central banks cannot prop up the exchange rate for long periods due to the resulting decline in foreign reserves as well as political and economic factors, such as rising unemployment. Devaluing the currency by increasing the fixed exchange rate also results in domestic goods being cheaper than foreign goods, which boosts demand for workers and increases output. In the short run, devaluation also increases interest rates, which must be offset by the central bank through an increase in the money supply and an increase in foreign reserves. As mentioned earlier, propping up a fixed exchange rate can eat through a country’s reserves quickly, and devaluing the currency can add back reserves.

Investors are well aware that a devaluation strategy can be used and can build this into their expectations, to the chagrin of central banks. If the market expects the central bank to devalue the currency (and thus increase the exchange rate), the possibility of boosting foreign reserves through an increase in aggregate demand is not realized. Instead, the central bank must use its reserves to shrink the money supply, which increases the domestic interest rate.

What Causes a Currency Crisis?


Anatomy of a Currency Crisis

Investors will often attempt to withdraw their money en mass if there is an overall erosion in confidence of an economy’s stability. This is referred to as capital flight. Once investors have sold their domestic-currency denominated investments, they convert those investments into foreign currency. This causes the exchange rate to get even worse, resulting in a run on the currency, which can then make it nearly impossible for the country to finance its capital spending.

Currency crisis predictions involve the analysis of a diverse and complex set of variables. There are a couple of common factors linking recent crises: 

  • The countries borrowed heavily (current account deficits)
  • Currency values increased rapidly
  • Uncertainty over the government’s actions unsettled investors

Let’s take a look at a few crises to see how they played out for investors:

Example 1: Latin American Crisis of 1994

On December 20, 1994, the Mexican peso was devalued. The Mexican economy had improved greatly since 1982, when it last experienced upheaval, and interest rates on Mexican securities were at positive levels. 

Several factors contributed to the subsequent crisis: 

  • Economic reforms from the late 1980s, which were designed to limit the country’s oft-rampant inflation, began to crack as the economy weakened.
  • The assassination of a Mexican presidential candidate in March of 1994 sparked fears of a currency sell off.
  • The central bank was sitting on an estimated $28 billion in foreign reserves, which were expected to keep the peso stable. In less than a year, the reserves were gone.
  • The central bank began converting short-term debt, denominated in pesos, into dollar-denominated bonds. The conversion resulted in a decrease in foreign reserves and an increase in debt.
  • A self-fulfilling crisis resulted when investors feared a default on debt by the government.

When the government finally decided to devalue the currency in December 1994, it made major mistakes. It did not devalue the currency by a large enough amount, which showed that while still following the pegging policy, it was unwilling to take the necessary painful steps. This led foreign investors to push the peso exchange rate drastically lower, which ultimately forced the government to increase domestic interest rates to nearly 80%. This took a major toll on the country’s GDP, which also fell. The crisis was finally alleviated by an emergency loan from the U.S.

Example 2: Asian Crisis of 1997

Much like Mexico, Thailand relied heavily on foreign debt, causing it to teeter on the brink of illiquidity. Primarily, real estate dominated investment was inefficiently managed. Huge current account deficits were maintained by the private sector, which increasingly relied on foreign investment to stay afloat. This exposed the country to a significant amount of foreign exchange risk.

This risk came to a head when the U.S. increased domestic interest rates, which ultimately lowered the amount of foreign investment going into Southeast Asian economies. Suddenly, the current account deficits became a huge problem, and a financial contagion quickly developed. The Southeast Asian crisis stemmed from several key points:

  • As fixed exchange rates became exceedingly difficult to maintain, many Southeast Asian currencies dropped in value.
  • Southeast Asian economies saw a rapid increase in privately-held debt, which was bolstered in several countries by overinflated asset values. Defaults increased as foreign capital inflows dropped off.
  • Foreign investment may have been at least partially speculative, and investors may not have been paying close enough attention to the risks involved.


Lessons Learned from Currency Crises


There several key lessons from these crises:

  • An economy can be initially solvent and still succumb to a crisis. Having a low amount of debt is not enough to keep policies functioning or quell negative investor sentiment.
  • Trade surpluses and low inflation rates can diminish the extent at which a crisis impacts an economy, but in case of financial contagion, speculation limits options in the short run.
  • Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require near-term payments. If the government also invests in short-term debt, it can run through foreign reserves very quickly.
  • Maintaining the fixed exchange rate does not make a central bank’s policy work simply on face value. While announcing intentions to retain the peg can help, investors will ultimately look at the central bank’s ability to maintain the policy. The central bank will have to devalue in a sufficient manner in order to be credible.


The Bottom Line

Currency crises can come in multiple forms but are largely formed when investor sentiment and expectations do not match the economic outlooks of a country. While growth in developing countries is generally positive for the global economy, history has shown us that growth rates that are too rapid can create instability and a higher chance of capital flight and runs on the domestic currency. Although efficient central bank management can help, predicting the route an economy will ultimately take is difficult to anticipate, thus contributing to a sustained currency crisis.



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