💾 Archived View for gmi.noulin.net › mobileNews › 3882.gmi captured on 2023-06-14 at 16:12:15. Gemini links have been rewritten to link to archived content
⬅️ Previous capture (2023-01-29)
-=-=-=-=-=-=-
2012-03-14 09:20:08
October 10 2008 | Filed Under Bonds , Economics , Forex , Forex Theory ,
Forex-Beginner , Options
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.
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. (Still learning about currencies?
Check out Common Questions About Currency Trading and our Forex Special
Feature.)
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.
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.
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.
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.
Predicting when a country will run into a currency crisis involves the analysis
of a diverse and complex set of variables. 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
Let's take a look at a few crises to see how they played out for investors:
Example 1: 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 upheaval, 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
country's 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 alleviated
by an emergency loan from the United States.
Example 2: Asian Crisis of 1997
Southeast Asia was home to the "tiger" economies, and the Southeast Asian
crisis. Foreign investment had poured in for years. Underdeveloped economies
experience rapid rates of growth and high levels of exports. The rapid growth
was attributed to capital investment projects, but the overall productivity did
not meet expectations. While the exact cause of the crisis is disputed,
Thailand was the first to run into trouble. (Keep reading about these economies
in Dragons, Samurai Warriors And Sushi On Wall Street and What Is An Emerging
Market Economy?)
Much like Mexico, Thailand relied heavily on foreign debt, causing it to teeter
on the brink of illiquidity. Primarily, real estate dominated investment was
inefficiently managed. Huge current account deficits were maintained by the
private sector, which increasingly relied on foreign investment to stay afloat.
This exposed the country to a significant amount of foreign exchange risk. This
risk came to a head when the United States increased domestic interest rates,
which ultimately lowered the amount of foreign investment going into Southeast
Asian economies. Suddenly, the current account deficits became a huge problem,
and a financial contagion quickly developed. (For more insight, read Current
Account Deficits.)
The Southeast Asian crisis stemmed from several key points:
As fixed exchange rates became exceedingly difficult to maintain, many
Southeast Asian currencies dropped in value.
Southeast Asian economies saw a rapid increase in privately-held debt, which
was bolstered in several countries by overinflated asset values. Defaults
increased as foreign capital inflows dropped off.
Foreign investment may have been at least partially speculative, and investors
may not have been paying close enough attention to the risks involved.
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 near-term 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.
(To keep reading about this, see Forces Behind Exchange Rates.)
Conclusion
Growth in developing countries is generally positive for the global economy,
but growth rates that are too rapid can create instability 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.
by Brent Radcliffe
Brent Radcliffe is an analyst with a publishing company based in Washington,
DC. He is a graduate of the University of Florida with a degree in
International Economics, with minors in both French and International
Relations. Radcliffe is a freelance writer covering topics related to
economics, trade and investing.