what causes currency crisis

8/9/2019 what causes currency crisis

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WHAT CAUSES A

CURRENCY CRISIS?

Ali Jumani 14424


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BACK GROUND

Since the early 1990s, there have been manycases of currency investors who have been caughtoff guard, which lead to runs on currencies andcapital flight. What makes currency investors

and international financiers respond and act likethis? Do they evaluate the minutia of an economy,or do they go by gut instinct? In this article, we'lllook at currency instability and uncover what

really causes it.


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FIXED EXCHANGE RATE

A fixed exchange rate, sometimes called a pegged exchange rate,is also referred to as the Tag of particular Rate, which is a typeof exchange rate regime where a currency's value is fixed againstthe value of another single currency, to a basket of othercurrencies, or to another measure of value, such as gold.

A fixed exchange rate is usually used to stabilize the value of acurrency against the currency it is pegged to. This makes tradeand investments between the two countries easier and morepredictable and is especially useful for small economies in which

external trade forms a large part of their GDP.

It can also be used as a means to control inflation. However, asthe reference value rises and falls, so does the currency peggedto it.


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MAINTENANCE

Typically, a government wanting to maintain a fixedexchange rate does so by either buying or selling itsown currencyin the open market. This is one reasongovernments maintain reserves of foreign currencies.

If the exchange rate drifts too far below the desiredrate, the government buys its own currency in themarket using its reserves. This places greater demandon the market and pushes up the price of the currency.

If the exchange rate drifts too far above the desiredrate, the government sells its own currency, thusincreasing its foreign reserves.


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FLOATING EXCHANGE RATE

afloating exchange rateis determined by the private

market through supply and demand.

A floating rate is often termed "self-correcting," as any

differences in supply and demand will automatically becorrected in the market.

If demand for a currency is low, its value will decrease,thus making imported goods more expensive and

stimulating demand for local goods and services. This inturn will generate more jobs, causing an auto-correction inthe market.

A floating exchange rate is constantly changing.
http://www.investopedia.com/terms/f/floatingexchangerate.asphttp://www.investopedia.com/terms/f/floatingexchangerate.asp


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THE BOTTOM LINE

Although the peg has worked in creating globaltrade and monetary stability, it was used only ata time when all the major economies were a partof it. While a floating regime is not without its

flaws, it has proven to be a more efficient meansof determining the long-term value of a currencyand creating equilibrium in the internationalmarket.


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WHAT IS A CURRENCY CRISIS?

A currency crisis is brought on by a decline in thevalue of a country's currency. This decline invalue negatively affects an economy by creatinginstabilities in exchange rates, meaning that one

unit of the currency no longer buys as much as itused to in another. To simplify the matter, we cansay that crises develop as an interaction betweeninvestor expectations and what those

expectations cause to happen.


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GOVERNMENT POLICY, CENTRAL

BANKS AND THE ROLE OF

INVESTORS

When faced with the prospect of a currency crisis,central bankers in afixed exchange rateeconomycan try to maintain the current fixedexchange rate by eating into the country's

foreign reserves, or letting the exchange rate

fluctuate.
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INVESTORS

Why is tapping into foreign reserves a

solution?When the market expects devaluation, downwardpressure placed on the currency can really only be

offset by an increase in the interest rate. In order toincrease the rate, the central bank has to shrink themoney supply, which in turn increases demand forthe currency. The bank can do this byselling off foreign reservesto create a capital outflow.

When the bank sells a portion of its foreign reserves,it receives payment in the form of the domesticcurrency, which it holds out of circulation as an asset.
http://www.investopedia.com/ask/answers/06/reserverequirements.asphttp://www.investopedia.com/ask/answers/06/reserverequirements.asp


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INVESTORS

Propping up the exchange rate cannot last forever, both interms of a decline in foreign reserves as well as politicaland economic factors, such as rising unemployment.

Devaluing the currency by increasing the fixed exchange

rate results in domestic goods being cheaper than foreigngoods, which boosts demand for workers and increasesoutput.

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 foreignreserves. As mentioned earlier, propping up a fixedexchange rate can eat through a country's reserves quickly,and devaluing the currency can add back reserves.


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INVESTORS

Unfortunately for banks, but fortunately for you,investors are well aware that a devaluation strategycan be used, and can build this into theirexpectations. If the market expects the central bank

to devalue the currency, which would increase theexchange rate, the possibility of boosting foreignreserves through an increase in aggregate demand isnot realized. Instead, the central bank must use its

reserves to shrink the money supply, which increasesthe domestic interest rate.


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ANATOMY OF A CRISIS

If investors' confidence in the stability of an economy iseroded, then they will try to get their money out of thecountry. This is referred to ascapital flight. Once investors

have sold their domestic-currency denominated investments,

they convert those investments into foreign currency. Thiscauses the exchange rate to get even worse, resulting in arun on the currency, which can then make it nearlyimpossible for the country to finance its capital spending.

There are a couple of common factors linking the morerecent crises:The countries borrowed heavily (current account deficits)

Currency values increased rapidlyUncertainty over the government's actions made investors jittery
http://www.investopedia.com/terms/c/capitalflight.asphttp://www.investopedia.com/terms/c/currentaccountdeficit.asphttp://www.investopedia.com/terms/c/currentaccountdeficit.asphttp://www.investopedia.com/terms/c/capitalflight.asp


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LATIN AMERICAN CRISIS OF 1994

On December 20, 1994, the Mexican peso was devalued. The Mexican economy hadimproved greatly since 1982, when it last experienced uplift, and interest rates on Mexicansecurities were at positive levels.

Several factors contributed to the subsequent crisis:Economic reforms from the late 1980s, which were designed to limit the countrys oft-rampantinflation, began to crack as the economy weakened.

The assassination of a Mexican presidential candidate in March of 1994 sparked fears of a currencysell off.

The central bank was sitting on an estimated $28 billion in foreign reserves, which were expected tokeep the peso stable. In less than a year, the reserves were gone.

The central bank began converting short-term debt, denominated in pesos, into dollar-denominatedbonds. The conversion resulted in a decrease in foreign reserves and an increase in debt.

A self-fulfilling crisis resulted when investors feared a default on debt by the government.

When the government finally decided to devalue the currency in December of 1994, it mademajor mistakes. It did not devalue the currency by a large enough amount, which showedthat while still following thepeggingpolicy, it was unwilling to take the necessary painful

steps. This led foreign investors to push the peso exchange rate drastically lower, whichultimately forced the government to increase domestic interest rates to nearly 80%. Thistook a major toll on the country'sGDP,which also fell. The crisis was finally eased by an

emergency loan from the United States.
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LESSONS LEARNED

There several key lessons from these crises:An economy can be initially solvent and still succumb to a crisis.Having a low amount of debt is not enough to keep policiesfunctioning.

Trade surpluses and low inflation rates can diminish the extent

at which a crisis impacts an economy, but in case of financialcontagion, speculation limits options in the short run.

Governments will often be forced to provide liquidity to privatebanks, which can invest in short-term debt that will require near-term payments. If the government also invests in short-termdebt, it can run through foreign reserves very quickly.

Maintaining the fixed exchange rate does not make a centralbank's policy work simply on face value. While announcingintentions to retain the peg can help, investors will ultimatelylook at the central bank's ability to maintain the policy. Thecentral bank will have to devalue in a sufficient manner in orderto be credible.


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PAKISTAN CURRENCY CRISIS

Causes:Various natural disasters vast areas of cultivated land has beendestroyed, and Pakistan being an agro based country has to suffer dueto this loss and damage.

Due to immense inflation the State Bank of Pakistan has felt theurgency of issuing more currency and notes in the local public andcommercial sectors to meet up the high inflation, but the national bankof any state cant issue notes and currency unless they have an equalamount of reserves of precious metals which include gold and silver.Pakistan does not have such high reserves of precious metals so theycant issue worthy and high value currency. Due to this reason, the only

possible solution for this query is that they have reduced the worth ofthe currency and can dispatch high quantity notes and currency whichinternational value is not that much high.

High values of loans and debt has also played its role in the devaluationof the national currency


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PAKISTAN CURRENCY CRISIS

Causes:Instead of selling goods in Pakistani rupees, whichwould create a demand for the rupee on theinternational exchange market, the State Bank of

Pakistan settles the export payments in US dollars.


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what causes currency crisis