What Is The Currency Crisis?

Key Takeaways

  • A currency crisis is when the country’s domestic currency falls significantly due to overinflation, banks default, financial market fluctuations, the balance of payment deficit, war situations, etc.Currency crises immensely affect the economy and are regulated by the government through selling foreign reserves or other essential measures. Heavy fluctuations in the stock and foreign exchange market, increase in inflation and unemployment, a downturn of the economy, adverse changes in monetary policy, heavy reliance on foreign investment, and clashes between the two countries causing war are the causes of the currency crises.One can prevent it through investment-friendly policies, early problem detention, prevention, multiple countries’ investments, and suitable trade relations.

Explanation

It is the situation where the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more faces a downfall and inflation rises. Such a situation creates doubt in citizens’ minds about the working and management of the government and banking system. During this time, many fluctuations are noticed in the foreign exchange marketForeign Exchange MarketThe foreign exchange market is the world’s largest financial market that decides the exchange rate of currencies.read more. However, it does not occur suddenly; there are many symptoms before it appears, such as the decline in purchasing power of the people due to inflation, high unemployment, heavy fluctuations in the stock market, failure of the banking system, etc.

Such a crisis can be controlled by the country’s apex bank or government by increasing the money supply in the market by increasing currency issuance, increasing the interest rates, selling the foreign reserves, etc. The government takes measures to make the home currency stable. The currency crisis also affects foreign investors.

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History

The concept of currency crisis began in the 1990s, the instances like downfall in the economy, unemployment, high volatility in the market, etc. results in loss of capital by the countries, which results in the devaluationDevaluationCurrency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies. This mechanism is used by economies with a semi-fixed or fixed exchange rate, and it should not be confused with depreciation.read more of the home currency and loss of interest by investors and investments start to decline. Also, the global crisis of 1994 increased the currency crisis worldwide. Again, the unfriendly investors’ policy by the Asian government devised the currency crisis in 1997.

Such circumstances originate from the balance of paymentBalance Of PaymentThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more situation as a deficit in the balance of payment leads to a fiscal crisis. The fiscal turmoil slows down the economy, which results in the liquidation Liquidation Liquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read moreof balance of paymentBalance Of PaymentThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more situation as a deficit in the balance of payment leads to a fiscal crisis. The fiscal crisis slows down the economy, which results in the liquidation of foreign investments Foreign InvestmentsForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more and downfall in the stock and forex market.

Currency Crisis Examples

After 2008 the global financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, every country tried to attract foreign investors through their investment policies. Subsequently, in 2008, Turkey faced a decrease in foreign investment. Therefore, it brought several reforms by making the banking sector strong and supplying money in the market to attract investors. But, during that period, the Turkish banks and business entities borrowed a huge amount, mostly dollar-based. In 2018, due to the increase in the interest rate by the US federal reserve, the borrowers were scared as they had to repay more, resulting in a loss of faith by Turkey investors. All the conditions resulted in the Turkish currency’s devaluation, which led to a currency crisis.

Models

The indicators of currency crisis are explained in the stage-wise name. The first-generation currency crisis reflects the symptoms at an initial stage. The second-generation currency crisis reflects the situations of fluctuation in a middle and third-generation currency crisis, i.e., the final stage explains the main factors due to which the currency devalued and the currency crisis occurred. Therefore, each model is described under –

#1 – First Generation Currency Crisis

During the first generation, the rate of gold starts fluctuating due to the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more fluctuation. It resulted in changes in the forex marketForex MarketFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more. Investors get skeptical but maintain the investment after the government’s assurance about conserving fixed exchange rates.

#2 – Second Generation Currency Crisis

In the second stage, investors’ doubt increases due to constant fluctuations in the exchange rate as the government might not maintain the fixed exchange rateFixed Exchange RateA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity.read more. The second stage symptoms are inflation, slow economy, economic and monetary policy changes, increasing unemployment, etc. In such a case, the government is forced to look deliberately into the fluctuations and maintain the fixed and continuous rate to prevent a recession. Therefore, in the second stage, the government may also sell foreign reserves to maintain a fixed rate.

#3 – Third Generation Currency Crisis

The third generation is the bubble blasts due to continuous fluctuations. The deficit in the balance of payment situation arises, and the banking industry starts collapsing due to heavy volatility and dependence on foreign investments. The value of the loans Loans A loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read moretaken by the country’s government in foreign currency denominations also increases because of the devaluation of the home currency. As a result, the country’s government was forced to devalue its currency, and the currency crisis began.

Causes

  • Heavy fluctuations in the stock market and foreign exchange market.Rise in inflation and unemployment.The adverse affecting changes in monetary policy.The downturn of the economy.Heavy reliance on foreign investment.Clashes between the two countries can cause war situations.

How To Prevent From Currency Crisis?

  • The government should maintain a low inflation rate by providing employment and a favorable monetary policy.Through investors’ friendly policies, the country can prevent a currency crisis.Maintaining fair monetary policies Monetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more.Maintaining good trade relations with the other countries.

Conclusion

The currency crisis is the situation where the country’s home currency starts devaluating. Many problems led to high inflation, increased unemployment, heavy reliance on foreign funds or investors, and bad relations with some countries that led to war.

It can be prevented by investment-friendly policies, early problem detection, prevention, investment in multiple countries, favorable trade relations, etc.

This article has been a guide to Currency Crisis and its definition. We discussed the currency crisis, model history, prevention, examples, causes, and anatomy. You can learn more about it from the following articles: –

Many countries utilize the same currencies – the dollar or euro. Therefore, when the currency loses its value in one country, it also loses in many other countries. Moreover, the World Bank also provides loans to ease the currency crisis. In addition, international investors also search for countries with similar currency crises and withdraw money from other countries. Domestic investors look to reciprocate against the countries due to which the currency crises occur by withdrawing money from that country. 

A financial crisis is when the asset values decrease very quickly and is frequently caused due to panic or a bank run. A currency crisis includes an immediate and abrupt national currency value downturn.

International reserves, credit growth, real exchange rate, credit to the public sector, export performance, money growth, fiscal deficit, and real GDP growth are the leading indicators of currency cris

The Weimar Republic financial crisis in Germany following World War I; the Mexican peso crisis in 1994; the Asian Crisis in 1997; the Russian financial crisis in 1998, the Argentine crisis in the late 1990s, the Venezuelan economic crisis in 2016; and Turkey’s crisis in 2016 are the financial crises that gave rise to the recession cycle.

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