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What’s it: A currency crisis is a situation in which the exchange rate of a currency falls, causing a sharp decline in foreign reserves. The fall was possible due to a brief bout of speculation on the foreign exchange market. Simultaneously, the economic fundamentals were weak and were unable to prevent the exchange rate from falling.
In some cases, currency crises are not isolated events. It usually follows a financial or socio-political crisis. Or vice versa, a currency crisis triggers a financial crisis.
When the fixed exchange rate system was adopted, speculative attacks forced the government to intervene. The central bank used foreign reserves to fight back. If that was ineffective, the government may have devalued the domestic currency. However, if the fall continues, an economic crisis will usually follow, as happened in Indonesia in 1997-1999.
Difference between currency crisis from hyperinflation
A currency crisis is different from hyperinflation, although the two are related. Both reflect a fall in the purchasing power of a country’s currency.
Specifically, hyperinflation is a phenomenon in which the purchasing power of currency for goods and services falls. That is acute inflation. During hyperinflation, the rate of inflation soared by more than 1,000% on an annual basis. In fact, in Venezuela, the percentage rate of inflation exceeded 1,000,000% in 2018.
Hyperinflation causes distrust of the domestic currency. During this period, your money immediately evaporates, and you get much less stuff for the same amount.
Falling confidence in the domestic currency encourages people to switch to a more stable currency, such as the US dollar. The high demand for the US dollar caused the domestic currency to depreciate severely.
Meanwhile, a currency crisis occurs when the domestic currency’s purchasing power against foreign currencies falls (sharp depreciation). It usually happens because of speculation in the foreign exchange market.
The central bank may fight speculation about using international reserves. Such intervention can be successful or fail.
Failure to fight back usually occurs because of the weak credibility of the central bank. Foreign exchange reserves are insufficient to cope with speculative attacks. As a result, international reserves fell, but the exchange rate was still depreciating, leading to a currency crisis.
Thus, a currency crisis refers more precisely to the purchasing power of domestic currencies against foreign currencies. Meanwhile, hyperinflation is due to a sharp decline in the domestic currency’s purchasing power for goods and services.
Even so, the two may be related. The cause of the currency crisis was not only a speculative activity.
As I previously discussed, hyperinflation increases the demand for a more stable foreign currency. And, it can lead to a sharp depreciation of the domestic currency exchange rate. Many people sell domestic currency and exchange it for foreign currency. This situation could lead to a currency crisis.
Causes of a currency crisis
Understanding what triggers a currency crisis is crucial for students of economics, investors, and anyone curious about global economic trends. Here’s a breakdown of the key culprits:
Speculative attack: a self-fulfilling prophecy
Imagine investors betting against a currency, believing it’s about to weaken. This can snowball into a crisis. Countries with weak economic fundamentals are prime targets. This could include low foreign exchange reserves (the country’s war chest of foreign currencies) or a history of running twin deficits (both government budget deficits and trade deficits). Think of a country with limited savings and high spending that also imports more than it exports.
A fixed exchange rate system, where the government pegs the currency to another currency, makes it vulnerable. Speculators can bet heavily on the peg breaking, forcing the government to devalue (weaken) the currency. Imagine a fixed exchange rate like a taut rope. If enough people pull on it (sell the currency), it could snap.
As more investors pile on, selling the targeted currency, its value actually starts to decline. This confirms the initial speculation and triggers panic selling, causing a sharper depreciation. It’s like a domino effect, with each sale pushing the currency down further.
Rising inflation expectations: the looming hyperinflation shadow
When a country experiences high and rising inflation, expectations of hyperinflation (extremely rapid price increases) can trigger a currency crisis:
- Losing faith: As inflation soars, people lose confidence in the domestic currency’s ability to hold its value. Imagine prices constantly rising, making your money less valuable every day. People might start wanting to hold onto a more stable currency.
- Currency flight: To protect themselves, people might start exchanging their domestic currency for foreign currencies perceived as more stable. This increased demand for foreign currencies weakens the domestic currency further. Think of everyone trying to sell their local currency at once, driving down its value.
For example, between 2010 and the first quarter of 2018, the Turkish economy grew steadily. At the same time, the inflation rate continued to rise sharply, ultimately plunging Turkey into a currency crisis.
Banking crisis or default: the broken trust factor
Financial institution failures can also be a trigger for a currency crisis:
- Loss of confidence: If banks or other financial institutions default on their debts, it creates a ripple effect of distrust. People might worry other institutions are also shaky, leading them to withdraw their money. This can put a strain on the entire financial system. Imagine a major bank collapsing. People might fear other banks are next, causing them to rush to withdraw their savings.
- Devaluation risk: When trust in the financial system weakens, investors might fear a government devaluation (intentional weakening) of the currency to stimulate the economy. This anticipation can lead to a sell-off of the domestic currency, accelerating the decline.
Impacts of a currency crisis
A currency crisis, marked by a sharp decline in a country’s exchange rate, isn’t just a number on a chart. It can wreak havoc on an economy, impacting businesses, consumers, and the financial system as a whole. Let’s delve deeper into the far-reaching consequences of a currency crisis:
Triggering a domino effect of defaults and banking crisis
When a currency weakens, foreign-denominated debt becomes much heavier. Imagine a company owing $1 million at an exchange rate of 1 USD to 10 local currency units. A sudden depreciation of 1 USD to 20 local currency units instantly doubles the debt burden to 2 million local currency units! This can cripple businesses and strain their ability to repay loans.
As companies struggle with debt, defaults can become more common. This creates a ripple effect, shaking confidence in the entire financial system. Banks, worried about bad loans, may tighten lending or even collapse if they suffer heavy losses. This lack of access to credit further cripples businesses and hinders economic growth.
In a desperate attempt to protect their savings, people might rush to buy foreign currencies perceived as more stable. This surge in demand further weakens the domestic currency, creating a vicious cycle. We saw this play out in Indonesia during the 1997-1999 crisis.
Depleting the country’s war chest: foreign exchange reserves
Central banks hold foreign exchange reserves as a war chest to defend their currency during times of crisis. They can sell foreign currency to buy domestic currency, aiming to stabilize the exchange rate. However, a severe currency crisis can quickly deplete these reserves.
The effectiveness of central bank intervention depends on the intensity of speculation and the size of their reserves. If reserves are insufficient, the central bank might be left powerless to stop the currency’s decline.
The chilling effect on international trade: a double-edged sword
A weaker domestic currency can make a country’s exports cheaper on the global market, potentially boosting export volumes. Imagine your country’s furniture becoming more attractive to foreign buyers due to a depreciation. However, this benefit depends on the price elasticity of exported goods. If price changes don’t significantly impact demand (inelastic goods), the export boost might be limited.
On the flip side, due to the weakened currency, imports become significantly more expensive. This can hurt consumers and businesses that rely on imported goods. Imagine essential raw materials for production suddenly becoming much more expensive. Companies might have to delay purchases or even shut down if they can’t absorb the cost increase. This disrupts supply chains and weakens domestic production.
Imported inflation skyrocket
As the cost of imported goods rises due to the currency depreciation, domestic inflation picks up steam. Imagine everyday items like electronics or clothing becoming more expensive due to a weaker currency. This reduces purchasing power and hurts consumer spending.
Due to the depreciation, businesses that rely on imported raw materials face higher production costs. To maintain profits, they might be forced to raise prices for their own goods and services, further fueling inflation. This creates a vicious cycle in which a weaker currency leads to higher import prices, inflation, and potentially even slower economic growth.
Real-world examples of currency crises
Understanding how currency crises play out in real life can solidify our grasp of the concept. Let’s explore three historical cases that illustrate different triggers and consequences:
Currency crisis in Turkey in 2018
In 2018, the Turkish lira fell by nearly 45% against the US dollar. Between 2010 and 2018, Turkey experienced average GDP growth of around 6.5%.
During this period, Turkish businesses and banks borrowed large sums of money from international investors. Most of the debts are denominated in US dollars, which means that Turkey is particularly vulnerable to US monetary policy.
The crisis started when the US Federal Reserve raised interest rates in the first half of 2018. The policy change increased the total debt owed by Turkish companies and banks.
Global investors are also starting to lose faith in Turkish President Recep Erdogan’s government’s ability to sustain robust economic growth. Combining these factors led to a drastic drop in demand for the Turkish lira on the foreign exchange market.
A decrease in the US dollar demand increases depreciation pressure. It causes a further decline in the exchange rate of the Lira against the US dollar. The decrease further increased the face value of the USD-denominated debt held by Turkish banks and companies. Thus, forming a kind of vicious circle and creating a currency crisis.
Currency crisis in Indonesia 1998-1999
The Asian financial crisis started in Thailand in May 1997. The government found it more difficult to peg the Thai baht at THB25 per US dollar. On July 2, 1997, Thailand allowed the baht to float freely and was unpegged.
Indonesia, which has large foreign reserves and is seen as having a strong economy, responded on July 11, 1997, by widening the target exchange rate limit from 8% to 12%. Indonesia took similar action in the years leading up to the crisis, in December 1995, from 2% to 3%, in response to the Mexican financial crisis, and in June and September 1996, from 3 to 5% and then 5% to 8%.
However, this widening strategy failed. Before the crisis hit Indonesia, the rupiah exchange rate against the US dollar was still relatively stable at IDR2,380 per US dollar in June 2017. Suddenly, in January 1998, the rupiah weakened considerably, reaching a level of IDR11,000 per US dollar. Then in July 1998, the rupiah continued to depreciate to IDR14,150 per US dollar.
Currency crisis in Germany in 1929
After the First World War, German banks borrowed large sums of money from international lenders to help finance post-war reconstruction.
Due to the 1929 stock market crash and the ensuing financial crisis, international lenders refunded their loans to German banks. Nevertheless, German financial institutions were unable to make debt payments. As a result, Germany experienced severe hyperinflation and a currency crisis, which caused the government to collapse.
Key predictors of the currency crisis
Quoting from the IMF working paper, several indicators are useful for providing signals and anticipating currency crises, including:
International reserves—The credibility of the central bank’s intervention in the foreign exchange market depends on the position of foreign reserves. High foreign exchange reserves make the central bank more credible.
Real exchange rate – Exchange rate overvaluation plays a vital role in sharp exchange rate depreciation. Overvaluation often occurs in a fixed exchange rate system when the real exchange rate does not reflect supply and demand. That, in turn, encourages speculators to sell the domestic currency, causing acute depreciation.
Domestic inflation – High inflation, as in hyperinflation, reduces confidence in the domestic currency. Many people switch to foreign currency and sell domestic currency. Such panic can lead to a currency crisis.
Trade balance – Chronic trade deficits leave a country vulnerable to bouts of minor speculation on the forex market.
Export performance—Exports are a major source of entry for foreign currencies. High exports increase the supply of foreign currency and foreign reserves, which is useful not only for covering import payments but also for intervention in the forex market.
Money growth – Growth in the money supply, especially M2, helps predict episodes of sharp depreciation. When the money supply grows faster than real GDP growth, it creates high inflation pressure. It shows you more money chasing less stuff.
Real GDP growth – Currency crises tend to occur when real GDP growth is low.
Fiscal deficit – A high deficit increases government debt. To pay off debt, the government finances it through seigniorage (printing money). That will likely lead to uncontrolled inflation and increasing distrust of the domestic currency.
The possible solutions to the currency crisis
There are several possible solutions to avoid a currency crisis, including:
Adopt a floating exchange rate. One of the keys to Thailand’s success in avoiding the 1997 crisis was allowing its exchange rate to float freely when speculators began to launch their attacks. Fixed exchange rates require a credible policy against the market. And often, a country doesn’t have the large reserves to do so. If the government still maintains a fixed exchange rate, devaluation is an alternative policy.
Raise interest rates. The increase keeps the spread between domestic and international interest rates attractive. The aim is to encourage investment inflows, thereby increasing the demand for domestic currency. Or, at least, it prevents foreign investment from exiting the domestic market. Apart from interest rates, central banks may also adopt other tight monetary policies in response to currency crisis risks.
Fiscal policy tightening. Governments often borrow abroad to finance deficits. Therefore, when the government lowers the deficit, it reduces the debt from the international market.
Control of capital outflows. The government restricted domestic currency exchange and imposed greater controls on capital flight. Such controls avoid the exodus of funds and the massive sale of the domestic currency. However, often, the market does not like it.
IMF bailout funds. This option is usually less popular in some countries. Such bailouts are likely to have undesirable byproducts, such as higher taxes and lower government spending.
