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Measure content performance. Develop and improve products. List of Partners vendors. Since the early s, there have been several instances of currency crises. These are a sudden and drastic devaluation in a nation's currency matched by volatile markets and a lack of faith in the nation's economy.
A currency crisis is sometimes predictable and is often sudden. It may be precipitated by governments, investors, central banks, or any combination of actors.
But the result is always the same: The negative outlook causes wide-scale economic damage and a loss of capital. In this article, we explore the historical drivers of currency crises and uncover their causes. A currency crisis is brought on by a sharp decline in the value of a country's currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates , meaning 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.
But a currency crisis—such as hyperinflation—is often the result of a shoddy real economy underlying the nation's currency. In other words, a currency crisis is often the symptom and not the disease of greater economic malaise. Some places are more vulnerable to currency crises than others. For instance, although it's theoretically possible the U. Central banks are the first line of defense in maintaining the stability of a currency. In a fixed exchange rate regime, central banks can try to maintain the current fixed exchange rate peg by dipping into the country's foreign reserves, or intervening in the foreign exchange markets when faced with the prospect of a currency crisis for a floating-rate currency regime.
When the market expects devaluation , downward pressure placed on the currency can be offset in part by an increase in interest rates. In order to increase the rate, the central bank can 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 prolonged 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—much 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. Investors often attempt to withdraw their money en masse if there is an overall erosion in confidence of an economy's stability. This is referred to as capital flight. Once investors sell 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:. Let's take a look at a few crises to see how they played out for investors. On Dec. The Mexican economy had improved greatly since when it last experienced upheaval, and interest rates on Mexican securities were at positive levels. Several factors contributed to the subsequent crisis:.
When the government finally decided to devalue the currency in December , it made some 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 took a major toll on the country's gross domestic product GDP , which also fell. The crisis was finally alleviated by an emergency loan from the U. Foreign investments poured in for years.
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. University of California Santa Cruz. Accessed Oct. International Money Fund. Federal Reserve History. Actively scan device characteristics for identification. Use precise geolocation data.
Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.
Measure content performance. Develop and improve products. List of Partners vendors. Trading Forex Trading. Table of Contents Expand. Table of Contents. What Is a Currency Crisis? How a Currency Crisis Works. Currency Crisis Solutions. How to Adjust for Currency Crises. By Justin Kuepper Full Bio LinkedIn Twitter Justin Kuepper is a financial analyst, journalist, and private investor with over 15 years of experience in the domestic and international markets.
Learn about our editorial policies. Reviewed by Gordon Scott. Article Reviewed July 27, Learn about our Financial Review Board. The Latin American currency crisis of is one of the most well-known. The approach of raising rates can end up costing central banks millions to maintain.
Latin America experienced a well-known crisis in Asia followed a few years later. Currency crises can provide you with a chance to hedge their portfolios against risk. Article Sources. Your Privacy Rights. To change or withdraw your consent choices for TheBalance. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.
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