What Is a Currency Crisis?

Definition and Examples of a Currency Crisis

Frustrated investor on telephone, head in hands

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A currency crisis can unfold when a currency suddenly experiences volatility that results in speculation in the foreign exchange (forex) market. These crises can be caused by several elements, including currency pegs or monetary policy decisions. They can be solved by implementing floating exchange rates or avoiding monetary policies that fight the market rather than embracing it.

Most international investors have experienced a currency crisis at some point in their careers. Mexico, Argentina, China, and many other countries have seen their currencies unexpectedly fluctuate for a variety of reasons, and the event had an impact on the wider market each time.

What Is 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 experienced capital outflows in early 2014 that led their currencies to depreciate across the board. Central banks responded by increasing interest rates to attract investors, but these higher interest rates led to slower economic growth and real value.

In other cases, countries might want to keep their currencies artificially low to stimulate demand for their exports. The most famous example of this approach was China, which 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.

Currency crises can also be caused by underlying factors ranging from central bank policies to pure speculation, and they're often difficult to predict. The primary cause of currency crises in the past has been a central bank's failure to maintain a fixed rate peg to a floating rate foreign currency.

George Soros once famously 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. Ultimately, Soros was correct and the pound fell sharply, netting him an estimated $1 billion in profit.

Examples of How a Currency Crisis Works

Currency crises have occurred with greater frequency 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 and 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.

Another well-known example is the Asian financial crisis of 1997. Economies relied heavily on foreign debt to finance their growth after experiencing rapid growth throughout the 1990s, so they struggled to meet their debt payments when the taps were turned. Fixed exchange rates became very difficult to maintain as investors grew concerned about default risks and currency valuations fell sharply lower.

Currency Crisis Solutions

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

Floating exchange rates tend to avoid currency crises by ensuring that the market is always setting the price, as opposed to 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, and this strategy proved to be impossible to maintain.

Central banks should also avoid monetary policies that involve trading against the market unless it's necessary to prevent a broader crisis. For example, emerging market economies could have accepted the inevitability of currency outflows and reformed investment 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

Investors should always be cognizant of currency dynamics when they're making investment decisions. It's often possible to predict major problems before they arise, at least to some extent, although market timing can be exceptionally difficult.

Currency imbalances can present a good opportunity to hedge a portfolio against risk, rather than 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 volatility, 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 currency crisis in 1994, and Asia followed a few years later.
  • Currency crises can afford investors with an opportunity to hedge their portfolios against risk.