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A currency crisis comes from a decline in the value of a country’s currency. When one unit of currency can no longer buy as much of another currency, an unstable exchange rate results.

Investors remove their money from any economy in which they lose confidence. That’s capital flight. Investors sell their domestic investments and convert them into foreign currency. This makes the exchange rate deteriorate. A run on the currency results, which makes it nearly impossible for the country to finance its capital spending.

Central bankers in a fixed exchange rate economy often combat a currency crisis by eating into their foreign reserves to maintain the current rate. When the devaluation of a currency is expected, increasing the interest rate is the only way to offset downward pressure.

To increase the rate, the central bank shrinks the money supply by selling off foreign reserves to create a capital outflow, and withholds payment it receives in domestic currency to increase demand for the domestic currency.

Currency investors should remember that growth in developing nations is generally good, but not when growth rates are so fast it creates instability. That leads to capital flight and runs on the domestic currency.

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