Since the early 1990s, there have been many cases of currency investors who have been caught off guard, which lead to runs on currencies and capital flight. What makes currency investors and international financiers respond and act like this? Do they evaluate the minutia of an economy, or do they go by gut instinct? In this article, we'll look at currency instability and uncover what really causes it.

What Is a Currency Crisis?
A currency crisis is brought on by a decline in the value of a country's currency. This decline in value negatively affects an economy by creating instabilities in exchange rates, meaning that one unit of the currency no longer buys as much as it used to in another. To simplify the matter, we can say that crises develop as an interaction between investor expectations and what those expectations cause to happen.

Government Policy, Central Banks and the Role of Investors
When faced with the prospect of a currency crisis, central bankers in a fixed exchange rate economy can try to maintain the current fixed exchange rate by eating into the country's foreign reserves, or letting the exchange rate fluctuate.

Why is tapping into foreign reserves a solution? When the market expects devaluation, downward pressure placed on the currency can really only be offset by an increase in the interest rate. In order to increase the rate, the central bank has to shrink the money supply, which in turn increases demand for the currency. The bank can do this by selling off foreign reserves to create a capital outflow. When the bank sells a portion of its foreign reserves, it receives payment in the form of the domestic currency, which it holds out of circulation as an asset.

Propping up the exchange rate cannot last forever, both in terms of a decline in foreign reserves as well as political and economic factors, such as rising unemployment. Devaluing the currency by increasing the fixed exchange rate results in domestic goods being cheaper than foreign goods, which boosts demand for workers and increases output. 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 foreign reserves. As mentioned earlier, propping up a fixed exchange rate can eat through a country's reserves quickly, and devaluing the currency can add back reserves.

Unfortunately for banks, but fortunately for you, investors are well aware that a devaluation strategy can be used, and can build this into their expectations. If the market expects the central bank to devalue the currency, which would increase the exchange rate, the possibility of boosting foreign reserves through an increase in aggregate demand is not realized. Instead, the central bank must use its reserves to shrink the money supply, which increases the domestic interest rate.

Anatomy of a Crisis
If investors' confidence in the stability of an economy is eroded, then they will try to get their money out of the country. This is referred to as capital flight. Once investors have sold their domestic-currency denominated investments, they convert those investments into foreign currency. This causes the exchange rate to get even worse, resulting in a run on the currency, which can then make it nearly impossible for the country to finance its capital spending.

Predicting when a country will run into a currency crisis involves the analysis of a diverse and complex set of variables. There are a couple of common factors linking the more recent crises:

  • The countries borrowed heavily (current account deficits)
  • Currency values increased rapidly
  • Uncertainty over the government's actions made investors jittery

Let's take a look at a few crises to see how they played out for investors:

Example 1: Latin American Crisis of 1994

On December 20, 1994, the Mexican peso was devalued. The Mexican economy had improved greatly since 1982, when it last experienced upheaval, and interest rates on Mexican securities were at positive levels.
Several factors contributed to the subsequent crisis:

  • Economic reforms from the late 1980s, which were designed to limit the country\'s oft-rampant inflation, began to crack as the economy weakened.
  • The assassination of a Mexican presidential candidate in March of 1994 sparked fears of a currency sell off.
  • The central bank was sitting on an estimated $28 billion in foreign reserves, which were expected to keep 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-denominated bonds. 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 made major mistakes. It did not devalue the currency by a large enough amount, which showed that while still following the pegging policy, it was unwilling to take the necessary painful steps. This led foreign investors to push the peso exchange rate drastically lower, which ultimately forced the government to increase domestic interest rates to nearly 80%. This took a major toll on the country\'s GDP, which also fell. The crisis was finally alleviated by an emergency loan from the United States.

Example 2: Asian Crisis of 1997
Southeast Asia was home to the "tiger" economies, and the Southeast Asian crisis. Foreign investment had poured in for years. Underdeveloped economies experience rapid rates of growth and high levels of exports. The rapid growth was attributed to capital investment projects, but the overall productivity did not meet expectations. While the exact cause of the crisis is disputed, Thailand was the first to run into trouble.

Much like Mexico, Thailand relied heavily on foreign debt, causing it to teeter on the brink of illiquidity. Primarily, real estate dominated investment was inefficiently managed. Huge current account deficits were maintained by the private sector, which increasingly relied on foreign investment to stay afloat. This exposed the country to a significant amount of foreign exchange risk. This risk came to a head when the United States increased domestic interest rates, which ultimately lowered the amount of foreign investment going into Southeast Asian economies. Suddenly, the current account deficits became a huge problem, and a financial contagion quickly developed. The Southeast Asian crisis stemmed from several key points:

  • As fixed exchange rates became exceedingly difficult to maintain, many Southeast Asian currencies dropped in value.
  • Southeast Asian economies saw a rapid increase in privately-held debt, which was bolstered in several countries by overinflated asset values. Defaults increased as foreign capital inflows dropped off.
  • Foreign investment may have been at least partially speculative, and investors may not have been paying close enough attention to the risks involved.

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 policies functioning.
  • Trade surpluses and low inflation rates can diminish the extent at which a crisis impacts an economy, but in case of financial contagion, speculation limits options in the short run.
  • Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require near-term payments. If the government also invests in short-term debt, it can run through foreign reserves very quickly.
  • Maintaining the fixed exchange rate does not make a central bank's policy work simply on face value. While announcing intentions to retain the peg can help, investors will ultimately look at the central bank's ability to maintain the policy. The central bank will have to devalue in a sufficient manner in order to be credible.

The Bottom Line
Growth in developing countries is generally positive for the global economy, but growth rates that are too rapid can create instability, and a higher chance of capital flight and runs on the domestic currency. Efficient central bank management can help, but predicting the route an economy will ultimately take is a tough journey to map out.

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