What Is a Currency Crisis?

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DEFINITION

A currency crisis is when a currency experiences extreme volatility, causing a negative impact on a country's financial markets and economy.

Definition and Example of a Currency Crisis

A currency crisis can be caused by many factors. Sometimes a crisis can occur when a currency suddenly experiences volatility that results in speculation in the foreign exchange (forex) market. Currency pegs to other currencies can break down, leading to a crisis. Also, a central bank's monetary policy decisions, such as rapidly hiking or lowering interest rates, can impact capital flows in and out of a country, causing a currency exchange rate to fluctuate wildly and lead to a currency crisis.

A currency crisis can evolve from a central bank's desire to prop up its currency's value to keep investment capital within its borders. Emerging markets went through capital outflows in early 2014, which led their currencies to depreciate. Central banks responded by raising interest rates to attract investors.

China has maintained a peg with the U.S. dollar for decades. The government has never had trouble defending the peg thanks to its large foreign reserves. But this has caused an imbalance in other areas of the market.

A country "pegs" its currency to those of one or more other countries.

For example, the Asian financial crisis of 1997 became a currency crisis. Some Asian economies relied heavily on foreign debt to finance their growth after seeing rapid growth throughout the 1990s. They struggled to meet their debt payments when the taps were turned. Fixed exchange rates became very hard to maintain as investors grew concerned about default risks. Currency valuations fell sharply lower.

How a Currency Crisis Works

Currency crises have occurred more often since the Latin American debt crisis of the 1980s. Investors feared that Mexico would default on its debt when its economy began to slow, and foreign reserves dwindled. These concerns became a sort of self-fulfilling prophecy when the country was forced to devalue its currency in 1994. It then had to raise interest rates to nearly 80%. This ended up taking a toll on its gross domestic product (GDP).

The Latin American currency crisis of 1994 is one of the most well-known.

Many international investors have experienced a currency crisis at some point. Mexico, Argentina, China, and many other countries have seen their currencies move up and down without warning for a number of reasons.

For example, George Soros once bet that the British government wouldn't be able to defend the British pound's shadow peg with Germany's Deutsche mark when Britain had three times the inflation rate of Germany. Soros was correct. The pound fell sharply, netting him an estimated $1 billion in profit.

Currency Crisis Solutions

Some measures can be taken to prevent a crisis from occurring.

Floating exchange rates tend to avoid currency crises by making sure that the market is always setting the price. This is the opposite of fixed exchange rates, where central banks must fight the market. Britain's fight against George Soros required that the central bank spend billions to defend its currency against speculators. It could not maintain this plan.

Central banks should also avoid policies that involve trading against the market unless they must do so to prevent a broader crisis. Emerging market economies could have accepted the inevitability of currency outflows. They could have reformed policies to attract foreign direct investment instead of trying to raise interest rates.

The approach of raising rates can end up costing central banks millions to maintain.

How to Adjust for Currency Crises

You should always be aware of currency dynamics when you're making decisions. It's often possible to predict major problems before they arise, at least to some extent. But market timing can still be very hard.

Currency imbalances can present a good way to hedge a portfolio against risk, rather than be a time to make a major bet against the currency or country.

Key Takeaways

  • A currency crisis can result when a country’s currency experiences rapid ups and downs, causing investors to balk.
  • A crisis often occurs when a country’s central bank acts to support its currency’s value to maintain investment capital.
  • Latin America experienced a well-known crisis in 1994. Asia followed a few years later.
  • Currency crises can provide you with a chance to hedge their portfolios against risk.

Article Sources

  1. The Federal Reserve of St. Louis. "A Case Study of a Currency Crisis: The Russian Default of 1998," Page One.

  2. International Money Fund. "Classification of Exchange Rate Arrangements and Monetary Policy Frameworks."

  3. Federal Reserve History. "Asian Financial Crisis."

  4. Federal Reserve History. "Latin American Debt Crisis of the 1980s."

  5. Federal Reserve Bank of St. Louis. "The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM," Pages 41-45.

  6. EconomicsHelp.org. "Floating Exchange Rates Definition."