What is a Currency Crisis?

Since the early 1990s, there have been several instances of currency crises. These are a sudden and drastic devaluation in a nation’s currency matched by volatile markets and a lack of faith in the nation’s economy. A currency crisis is sometimes predictable and is often sudden. It may be precipitated by governments, investors, central banks, or any combination of actors. But the result is always the same: The negative outlook causes wide-scale economic damage and a loss of capital. In this article, we explore the historical drivers of currency crises and uncover their causes.

A currency crisis is brought on by a sharp decline in the value of a country’s currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates, meaning one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that, from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies. But a currency crisis—such as hyperinflation—is often the result of a shoddy real economy underlying the nation’s currency. In other words, a currency crisis is often the symptom and not the disease of greater economic malaise.

Some places are more vulnerable to currency crises than others. For instance, although it’s theoretically possible the US dollar to collapse, its status as a reserve currency makes it unlikely. Central banks are the first line of defense in maintaining the stability of a currency. In a fixed exchange rate regime, central banks can try to maintain the current fixed exchange rate peg by dipping into the country’s foreign reserves, or intervening in the foreign exchange markets when faced with the prospect of a currency crisis for a floating-rate currency regime.

When the market expects devaluation, downward pressure placed on the currency can be offset in part by an increase in interest rates. In order to increase the rate, the central bank can lower 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.

Central banks cannot prop up the exchange rate for prolonged periods due to the resulting decline in foreign reserves as well as political and economic factors such as rising unemployment.

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