What is a Currency Crisis?

How Central Banks & Governments Get It Wrong

Euro sign and lifebuoy, symbolic image, rescue of the Euro
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Currency crises are sudden devaluations of a currency that ends up causing speculation in the foreign exchange ("forex") market. These crises can be caused by a number of elements, including currency pegs or monetary policy decisions, and can be solved by implementing floating exchange rates or avoiding monetary policies that fight the market instead of embracing it.

In this article, we'll take a look at the causes and solutions to currency crisis and some examples from the past.

Currency Crisis Causes

Currency crises are caused by a number of underlying factors ranging from central bank policies to pure speculation. The primary cause of a currency crisis is a central bank's failure to maintain a fixed rate peg to an often floating rate foreign currency. For example, George Soros famously bet that the British government wouldn't be able to defend the British Pound's shadow peg with Germany's Deutsche Mark since Britain had three-times the inflation rate of Germany. Ultimately, Soros was correct and the pound fell sharply, netting him billions.

Even when there isn't a peg, currency crises can evolve from a central bank's desire to prop up its currency's value in order to keep investment capital within its borders. For example, emerging markets experienced capital outflows in early 2014 that led their currencies to depreciate. Central banks responded by increasing interest rates to attract investors, but these higher interest rates led to slower economic growth and real value.

Currency Crisis Solutions

There are many possible solutions to a currency crisis, including many preventative measures that can be taken. The best solution to a currency crisis is avoiding them in the first place with preventative measures. 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.

For example, Britain's fight against George Soros required the central bank to spend billions to defend its currency against speculators.

Central banks should also avoid monetary policies that involve trading against the market unless its absolutely 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 which ended up costing central banks millions to maintain.

Examples of Currency Crises

Currency crises have been occurring more and more often since the Latin American debt crisis of the 1980s. The Latin American currency crisis of 1994 is perhaps one of the most well known currency crises. After Mexico's economy began to slow and foreign reserves dwindled, investors began to fear that the country would default on its debt. 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% which ended up taking a toll on its gross domestic product.

The Asian financial crisis of 1997 is another well known example of a currency crisis.

After experiencing rapid growth throughout the 1990s, the "tiger" economies relied heavily on foreign debt to finance their growth, so when the taps were turned off they struggled to meet the debt payments. Fixed exchange rates became very difficult to maintain as investor grew concerned about default risks and currency valuations fell sharply lower.

Key Takeaway Points

  • Currency crises often stem from fixed exchange rates and/or monetary policy that involves central banks fighting the market.
  • Currency crises can often be solved by floating the exchange rate and adopting monetary policies that aren't fighting the market.
  • There are many different examples of currency crises over the years but the two most well known ones were the Latin American financial crisis and the Asian financial crisis.