Currency Crisis: Causes, Signs, Impacts and Possible Solutions

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, the speculative attacks forced the government to intervene. The central bank uses foreign reserves to fight back. And, if that is ineffective, the government may devalue the domestic currency.

However, if the fall continues, an economic crisis will usually follow, as happened in Indonesia in 1997-1999.

Currency crisis and 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. For the same amount, you get much less stuff.

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 it can 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.

What happened during the currency crisis

Depreciation severely hurts the economy. Many economic and business decisions depend on exchange rates. A fall in the exchange rate will create instability and mistrust of the domestic currency.

Let’s take a simple example. Suppose you are Indonesian.

Before the crisis, the rupiah exchange rate against the US dollar was IDR2,000/USD. Let’s say you buy an imported item for USD1 per unit.

Then, the crisis hit and depreciated the exchange rate to IDR20,000/USD. To get the same item, you have to spend more rupiah. Depreciation makes you have to pay Rp 20,000 or 10 times more expensive than before the crisis.

Impacts of the currency crisis

The effect of the currency crisis on the economy can take several routes.

First, a currency crisis can trigger a default and banking crisis.

The risk of default on foreign debt soars. Depreciation causes debts denominated in foreign currencies to increase dramatically, reducing the ability to repay debtors, be they governments or companies.

For example, suppose a company owes 1 US dollar at the exchange rate of IDR1,000 per USD. The crisis hit, and the exchange rate depreciated to IDR14,000 per USD.

If we convert it into rupiah, the depreciation causes the debt to swell from IDR1,000 (1 US dollar) to IDR14,000 or a 14-fold increase.

Such a nominal increase in debt can make a company bankrupt. It can creep into the financial system, as companies may also take out loans from domestic banks.

Trying to secure business, some people may buy up US dollars in anticipation of further depreciation.

Of course, buying US dollars will only make matters worse. The sale of domestic currency causes the exchange rate to fall even further. This kind of situation occurred during the crisis in Indonesia in 1997-1999.

Second, the crisis depleted foreign exchange reserves.

Currency crises can be very damaging to an economy. The central bank took on the role of fending off speculative attacks using foreign reserves. Its purpose is to prevent the depreciation from deepening.

As a result, foreign exchange reserves fell sharply.

How strong foreign exchange reserves can last depends on the intensity of speculation, the severity of exchange rate depreciation, and the size of foreign reserves held.

Third, the crisis brings uncertainty to international trade.

The sharp depreciation made domestic goods very cheap for foreigners. That should increase exports.

How significant the effect is on the demand for domestic goods depends on the price elasticity of the exported goods—the more elastic the demand, the greater the export.

On the other hand, a severe depreciation caused foreign goods’ price to skyrocket for domestic consumers. Imports are shrinking. Again, how much imports will shrink depends on the price elasticity of imported goods.

Fourth, severe depreciation increases imported inflation. 

The price of imported goods soared due to the depreciation of the exchange rate. Consumers may stop buying imported goods.

However, companies cannot just stop imports. Indeed, they may delay the purchase of imported capital goods. But, for raw materials, they will still buy (otherwise, they will stop operating altogether).

The increase in raw material prices raises production costs. To maintain profits, producers pass on the increase in costs to the selling price. As a result, domestic inflation has risen sharply.

Sources of the currency crisis

A fall in domestic currency exchange rates occurs for several reasons, including:

• Speculative attack. Speculators make immediate profits by attacking the currencies of certain countries. The main targets are countries that adopt a fixed exchange rate and have weak economic fundamentals. For example, targets are countries with little foreign exchange reserves or running twin deficits for years. Note: twin deficits are when a country runs both a fiscal deficit and a current account deficit.
• Increase in inflation expectations leading to hyperinflation. Currency crises are typically preceded by periods of rising inflation and high inflation expectations. For example, between 2010 and the first quarter of 2018, the Turkish economy grew steadily. At the same time, the inflation rate continues to rise sharply. That ultimately plunged Turkey into a currency crisis.
• Banking crisis or default. Currency crises usually start with the failure of financial institutions to pay off their debts.

Three examples of currency crises

Currency crisis in Turkey in 2018

In 2018, the Turkish currency, the 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 in that country 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 has taken 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 stock market crash of 1929 and the ensuing financial crisis, international lenders refunded their loans to German banks. Nevertheless, German financial institutions are 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 foreign reserves’ position. 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. It 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, 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 of domestic interest rates 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.