What Is Currency Crisis And How Can It Occur?
Posted by William Byrnes on August 4, 2014
Author Bio: Luke Peters is an avid reader of finance and economics related books, novels and other literature and likes to keep up with the latest news and developments in the market. He has written several blogs and articles related to law, finance and economics across the internet.
In simple words, a currency crisis is a situation which is a result of decline in the value of the currency in a particular country. Currency crisis is one of the major causes for economic depression and economic downfall of a country. It affects the economy by disturbing the foreign exchange rates and decreases the purchasing power of a country. During the currency crisis, an economy’s central bank is unable to meet the demands that the banknotes promise through its exchange reserves and leads to the devaluation of the currency in foreign market. Listed below are the several factors that can trigger the currency crisis in an economy. (Image Credits @ epSos)
- Excessive Credit Creation
While the foreign exchange pegs are intended to increase the inflow of foreign exchange in the reserves to allow the creation of more money, the developing nations are plagued by higher credit creation from the foreign exchange reserves. The monetary policies of most developing nations are aimed at the protection from inflation that keeps their domestic interest rates higher than the foreign ones. This creates more demand for foreign currency.
- Excessive Liberalization
Most East Asian countries introduced liberalization policies during their early stages of developments and led to the decline of the domestic market and increase in the demand for imports. Globalization of the financial market during the early stages did not allow the market to fully develop to match the growing competition while the domestic interest rates remain high. Also the lack of risk assessment standards put the economy in further debt.
- Speculative Attacks
One of the major factors that have caused currency crisis across the world is the investor’s disbelief in the government’s ability to back up the promised made through their currency. Emerging economies often need large amount of financial credits to develop their economic and industrial sector and several times the debt surpasses the amount of reserves in the country’s central reserve. Pegging the domestic currency against a reserve currency can certainly stabilize a country’s economy but also makes the government susceptible to such speculative attacks from investors.
- Real Estate and Bad Debts
While the expansion of credit gave rise to the real estate business, poor risk assessment standards and the excessive amount of bad and unpaid debts led to the collapse of several banking institutions. Unpaid debts cause the depositors to lose faith in the bank’s ability to safe guard their money, leading to withdrawal of depositor funds that in turn leads to the bank’s collapse. The closed down bank put an additional stress on the government’s reserves and also causes a bad impression in the investors’ minds.
- Loose Monetary Policies
One of the major causes of currency crisis is the poor fiscal and foreign exchange policy of the government. Less emphasis on the domestic market and loose risk assessment policies often leads to excess credit creation, effectively creating a moral hazard for a country’s reserves. Abundance of liquid assets allow unrestricted outflow of money without the guarantee of equivalent returns. The IMF policies have further led to the decline of several economies as easy credit increased the probabilities of adverse selection and losses.
The abovementioned factors are the major reasons that can trigger currency crisis in an economy. The controlled use of foreign exchange reserves and enforcement of monetary policies is one probable solution to the problem of currency crisis. One can refer to several foreign exchange websites to shire the services of forex brokers in Switzerland and other places in the world. Foreign exchange brokers facilitate an easy and stress free solution to all your foreign exchange needs.