A currency crisis occurs when a country’s currency depreciates rapidly over time. A currency crisis typically does not happen overnight – it builds up over time since it is primarily driven by deteriorating domestic economic conditions or political instability. The culmination of a currency crisis occurs in the forex market, with the domestic currency depreciating against other foreign currencies. Sometimes the problems might spill over to other markets such as USA500.
Due to its nature of a slow build-up, currency crises are sometimes unpredictable. This article will explore the causes of a currency crisis and how it manifests in the forex market.
Note that a currency crisis can result in a rapid appreciation of the currency without any changes in a country’s fundamental economic factors in some rare cases.
Causes of Currency Crisis
A currency crisis is caused by several factors, all of which are traceable back to a country’s economic deterioration and lack of confidence in both financial and political institutions to institute proper reforms.
Keep in mind that demand and supply forces determine a country’s currency’s value in the forex market. Thus, when there is a lack of confidence in a country’s economic, monetary, and political institutions, domestic currency demand will fall. Foreigners holding the domestic currency will dump it, which creates oversupply, thus driving down its value relative to other currencies in the forex market.
Here are the most significant causes of a currency crisis.
Endogenous economic factors play a significant role in determining the value of a country’s currency. When the economy is performing well, there is a rise in domestic expenditure, which leads to higher GDP growth. A flourishing economy tends to have lower unemployment. In this scenario, the domestic currency increases in value.
Now, if over time, a country’s economy deteriorates. The rate of unemployment increases, which in turn reduces the domestic demand in the economy. Consequently, the economy goes into a cyclical risk. That means that unemployment leads to reduced domestic expenditure. The depressed spending forces businesses to cut back on production, which leads to layoffs, hence, a higher unemployment rate. If left unchecked, this cycle continues in perpetuity.
In some cases, economic deterioration can be caused by a systemic financial crisis during the global financial crisis in 2007 – 2008. During such times, currency traders can opt for alternative assets like platinum trading to avoid the extreme volatility in the forex market.
Furthermore, economic deterioration can be a direct result of localized natural disasters. Such disasters might cause irreparable damage to a country’s critical infrastructure that ends up crippling economic activities. This tends to lead to capital flight, especially by foreign investors.
Failure of Monetary and Economic Institutions
Suppose the economy is performing poorly, monetary institutions like the central bank intervene to stimulate growth. Such an intervention involves the implementation of expansionary monetary and fiscal policies. Lowering interest rates and an increase in government expenditure are some of the most common measures.
When not correctly implemented, the expansionary measures result in hyperinflation. Cutting the interest rates at a faster pace floods the market with cheap money. Furthermore, a lower interest rate means that investors will receive lower returns. This results in capital flight, which might cripple the economy, especially if a country is highly dependent on direct foreign investment.
Similarly, expansionary fiscal policies might require that the government employs quantitative easing measures or more debt. When governments take on unsustainable amounts of debt, it may overburden the domestic economy with debt repayment. Consequently, most of the government revenue goes towards debt repayment rather than economic development. The country’s international credit rating may drop, which leads to freezes on further international lending and an increase in the cost of credit.
Deliberate devaluation of a currency
Sometimes, a government might decide to devalue the domestic currency deliberately. Most countries that devalue their currencies often have three goals. Firstly, to boost their earnings from exports by making domestic exports more favorable. Secondly, currency devaluation helps to shrink trade deficits and, thirdly, it lowers the burden of debt repayment. When the domestic currency is weaker, debt repayment becomes less expensive.
Examples of Currency Crises
Turkey’s Currency Crisis of 2018
From January to December 2018, the Turkish Lira depreciated against the USD by up to 47.8%.
The Turkey currency crisis was a result of a series of economic and political failures in Turkey. Economically, Turkey’s trade deficit reached $51.6 billion in 2018, which made it one of the biggest current account deficits globally. During that period, the Turkish economy contracted by 2.6%. More so, there was unprecedented borrowing by Turkish banks and businesses from the international market. Since most of the debt was in USD, the Turkish economy would be positively impacted by any monetary policies in the US.
The Turkish Lira crisis began when the US Federal Reserve Bank started hiking interest rates. In 2018, the US Fed Funds Rate rose from 1.5% to 2.25%, effectively increasing the debt owed by Turkish banks and businesses.
More so, the Turkish government was growing increasingly authoritarian. Politicians interfered with monetary policy decisions, which are supposed to be independently decided upon by the CBRT. Consequently, foreign investors lost trust in Turkish institutions.
2015 Swiss Franc Case
In some rare cases, a currency crisis can lead to an appreciation of the domestic currency. In such instances, the interest rate fluctuation has nothing to do with a country’s economic fundamentals. An example of this is with the 2015 Swiss Franc crisis.
In January 2015, the Swiss National Bank announced that it would de-peg the CHF from the EUR. That meant removing the fixed lower limit in the EUR/CHF exchange rate of 1.2. Consequently, the CHF appreciated against the EUR up to 30%.
Can you Trade Currency Crises?
Well, yes. However, note that it is almost impossible to predict upcoming currency crises. For most forex traders, currency crises only manifest when it is full-blown. Based on historical trends, it might be risky to jump into trades when a currency crisis begins to manifest. You can never be certain for how long the exchange rate will trend. More so, such periods experience extreme volatility, which might end up wiping your trade account.
If you are interested in trading currency crises, be sure to conduct thorough analyses of economic, monetary, and geopolitical factors that may impact a country’s currency.