Currency crisis

Currency crisis is the situation when financial market investors lose confidence in a given currency. This is manifested by the sudden and mass sale of currency (the so-called speculative attack), which causes a sharp fall in the exchange rate and foreign exchange reserves. The result is currency devaluation. Usually, currency crises lead to further deterioration of the crisis situation in the economy.

Symptoms of the upcoming currency crisis

• high level of interest rate, whose task is to maintain the exchange rate, which in turn leads to stunted economic growth

political situation in the country or external factors (e.g. crisis in neighboring countries), causing imbalance of the balance of payments in the country.

• All signals predicting the onset of the currency crisis make the country less attractive to investors who, due to the high investment risk, often decide to invest their capital in countries with a stable economic situation.

Causes of the currency crisis

• monetary crisis (a radical increase in interest rates, a reduction in the circulation of money),
• banking crisis (not bank withdrawals),
• stock market crisis (stock price collapse).

Each currency crisis, regardless of its causes, is always accompanied by:

• strong devaluation of the national currency, that is, the monetary authorities decide to lower the national currency rate,
• lowering foreign currency reserves,
• soaring interest rates,

There are three models of currency crises

• first generation (canonical) models,
• second-generation models,
• third generation models (eclectic).

First-generation models - Latin America's currency crises are categorized: Mexico 1973-82, Argentina 1978-81, Chile 1983, Uruguay 1980-82 and the Russian crisis of 1998. The creator of the first generation models was Paul Krugman (1979) who, assuming (including an open economy in terms of a fixed exchange rate, excellent capital mobility, lack of uncertainty, rationality of expectations) argued that the main reason for currency crises is the lack of coherence between the excessively expansive policy fiscal and monetary policy, and the fixed exchange rate policy. The resulting budget deficit contributes to inflation, an increase in the trade deficit, deterioration in the current account and the balance of payments of the country. Foreign currency reserves are declining until the devaluation of the currency is inevitable. If investors come to the conclusion that the reserves are too small, there is a massive sale of the currency and the unintentional devaluation of money becomes a fact. A speculative attack follows, which speeds up the collapse of the currency.

Models of the second generation - the creator is Maurice Obstfeld. They concern countries in which prudent macroeconomic policy is conducted, in accordance with the fixed exchange rate regime. The currency crisis is the result of a conflict of economic policy goals, between maintaining exchange rate stability and, for example, increasing employment. The reason for the crisis, no matter how favorable the macroeconomic indicators are, is the speculative attack that comes after previous observations of the state's economic goals (when investors come to the conclusion that the authorities will soon stop defending the exchange rate due to high costs). The crisis in Mexico and the European Monetary System in the early 1990s is an example of currency crises of the second type. of he twentieth century.

Third generation models - this model is characteristic of the Asian crisis, which in 1997 affected, among others, including Thailand, Indonesia, Philippines, South Korea and Malaysia. One of the most important reasons for the crisis is the weakening of the competitiveness of the economies of the above-mentioned countries (the saturation of industrial goods exported from these areas to the world market). The Asian crisis also resulted from the exaggerated concentration of investments in the real estate market, which were financed by bank loans and the liberalization of the banking sector. Financial institutions have largely become dependent on risky and uncertain economic investments. The situation was not improved by the economic policy pursued by these countries, focusing primarily on maintaining fixed exchange rates and preventing inflation. The depreciation of the yen in relation to the dollar also contributed to the crisis. Its immediate effect was the decline of Japanese investors' interest in the Asian market and the weakening of the attractiveness of the goods of countries struggling with the crisis compared to goods produced in Japan. However, financial liberalization is considered the main external cause. It involves the abolition of control in granting loans, privatization and independence of banks, the absence of systems regulating the exchange rate and the freedom to undertake activity in the financial sector. All manifestations of the crisis in these countries led to a reduction in economic activity, inflation and unemployment, as well as to a fall in exchange rates.

The role of the International Monetary Fund

The International Monetary Fund, operating within the framework of the United Nations, was created in 1944 during a conference in Bretton Woods. Its main task is to control inter-national settlements and help in maintaining financial stability. At a time when exchange rates are changing, it provides support to Member States in a difficult economic situation.

Currency crisis — recommended articles

Foreign exchange reserves — European monetary system — Money emission — Emerging market economy — Interventionism — Expansionary monetary policy — Inflation target — Price stability — Hyman Minsky

References

• Burnside, C., Eichenbaum, M., & Rebelo, S. (2001). Prospective deficits and the Asian currency crisis. Journal of political Economy, 109(6), 1155-1197.
• Flood, R., & Marion, N. (1999). Perspectives on the recent currency crisis literature. International Journal of Finance & Economics, 4(1), 1-26.
• Brown, S. J., Goetzmann, W. N., & Park, J. M. (2000). Hedge funds and the Asian currency crisis. The Journal of Portfolio Management, 26(4), 95-101.