WHAT CAUSES A

CURRENCY CRISIS?

Ali Jumani 14424

BACK GROUND

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.

FIXED EXCHANGE RATE

A fixed exchange rate, sometimes called a pegged exchange rate,

is also referred to as the Tag of particular Rate, which is a type
of exchange rate regime where a currency's value is fixed against
the value of another single currency, to a basket of other
currencies, or to another measure of value, such as gold.
A fixed exchange rate is usually used to stabilize the value of a
currency against the currency it is pegged to. This makes trade
and investments between the two countries easier and more
predictable and is especially useful for small economies in which
external trade forms a large part of their GDP.
It can also be used as a means to control inflation. However, as
the reference value rises and falls, so does the currency pegged
to it.

MAINTENANCE

Typically, a government wanting to maintain a fixed

exchange rate does so by either buying or selling its
own currency in the open market. This is one reason
governments maintain reserves of foreign currencies.
If the exchange rate drifts too far below the desired
rate, the government buys its own currency in the
market using its reserves. This places greater demand
on the market and pushes up the price of the currency.
If the exchange rate drifts too far above the desired
rate, the government sells its own currency, thus
increasing its foreign reserves.

FLOATING EXCHANGE RATE

a floating exchange rate is determined by the private

market through supply and demand.
A floating rate is often termed "self-correcting," as any
differences in supply and demand will automatically be
corrected in the market.
If demand for a currency is low, its value will decrease,
thus making imported goods more expensive and
stimulating demand for local goods and services. This in
turn will generate more jobs, causing an auto-correction in
the market.
A floating exchange rate is constantly changing.

THE BOTTOM LINE

Although the peg has worked in creating global

trade and monetary stability, it was used only at
a time when all the major economies were a part
of it. While a floating regime is not without its
flaws, it has proven to be a more efficient means
of determining the long-term value of a currency
and creating equilibrium in the international
market.

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.

GOVERNMENT POLICY, CENTRAL

BANKS AND THE ROLE OF
INVESTORS

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.

GOVERNMENT POLICY, CENTRAL

BANKS AND THE ROLE OF
INVESTORS
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.

GOVERNMENT POLICY, CENTRAL

BANKS AND THE ROLE OF
INVESTORS

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.
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

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 uplift, 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 countrys 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 eased by an
emergency loan from the United States.

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 nearterm 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 instabili
ty
, 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.

PAKISTAN CURRENCY CRISIS

Causes:

Various natural disasters vast areas of cultivated land has been

destroyed, and Pakistan being an agro based country has to suffer due
to this loss and damage.

Due to immense inflation the State Bank of Pakistan has felt the
urgency of issuing more currency and notes in the local public and
commercial sectors to meet up the high inflation, but the national bank
of any state cant issue notes and currency unless they have an equal
amount of reserves of precious metals which include gold and silver.
Pakistan does not have such high reserves of precious metals so they
cant issue worthy and high value currency. Due to this reason, the only
possible solution for this query is that they have reduced the worth of
the currency and can dispatch high quantity notes and currency which
international value is not that much high.

High values of loans and debt has also played its role in the devaluation
of the national currency

PAKISTAN CURRENCY CRISIS

Causes:

Instead

of selling goods in Pakistani rupees, which

would create a demand for the rupee on the
international exchange market, the State Bank of
Pakistan settles the export payments in US dollars.