Currency Crisis

Currency Crisis

What is a Currency Crisis?

Many economists define a currency crisis as a situation when there is a swift decline of not less than 20 percent in the local currency of a nation with respect to the United States dollar. Anytime the value of a country’s local currency declines then a currency crisis is said to have occurred. In most cases, the country’s economy is negatively affected by such an occurrence resulting to unstable exchange rates.

Currency crises have hit most of the emerging markets in the past few decades and have often times resulted in regional recessions such as the 1997-1998 Asian financial crisis. The devaluation of a local currency culminates especially when balance of payment crisis occurs. A currency crisis raises the value of foreign dominated debt and financial institution as well as the government finds itself in a struggle to fulfill debt obligations.

How does a Currency Crisis ensue?

There are always various factors that contribute to the decline of a local currency including economic, political, and market forces. These factors may work together or individually towards pressurizing the exchange rate. A country in a currency crisis tends to have more imports than exports, running persistent current account deficits, or borrowing a lot of money from foreign lending institutions, often with a short period of maturity.

As soon as the economy shows signs of instability, foreign investors start losing confidence and try to remove their money from that country. This is usually known as capital flight. They often begin by selling their domestic-currency dominated investments, converting them into foreign currency. This drives down exchange rates and the country may find it almost impossible to finance its spending. It may also deplete reserves, raise domestic interest rates, and end up triggering a recession.

Predicting a Currency Crisis

Despite the fact that it will take several years for an economy to destabilize, currency...