An Overview of the Currency Crisis
The decline in the value of a country's currency is referred to as a currency crisis. It negatively affects the economy of a country as it creates instability in the currency exchange rate. A currency crisis raises the probability of a banking crisis, rise in debt, less growth, and an economic crisis. A currency crisis is normally considered a part of a financial crisis. Let us read further about the currency crisis, forex crisis, forex reserve, banking crisis in India, etc.
Basket of Currency which Determines the Exchange Rate and Influences Currency Crisis
What is the Currency Crisis?
A currency crisis is a situation in which the currency unexpectedly loses its substantial value relating to other currencies in the foreign exchange market. Use of one currency crisis or money crisis is followed by a financial and a socio-political crisis.
Causes of Currency Crisis
A single reason cannot cause such a big crisis. It is also called the money crisis. There are a lot of reasons for a currency crisis.
When the value of a currency depreciates it leads to the value crisis. The features of value crisis are as follows:
Central bank policies that slowed down the economy.
Collapse in the banking structure when there is a default in debt payments and over-reliance on foreign investment and foreign debt.
In the case of sanctions placed by a nation.
Over-reliance by the country on one source of income for the economy.
Political disturbance, for example, the assassination of the country leader or military situations such as wars.
Economic situations like inflation and high fiscal deficit.
What is Forex Crisis and What are Forex Reserves?
External assets in the form of gold, foreign currency assets, special drawing rights of the IMF, and foreign direct investment accumulated by your country and controlled by the central bank. Such accumulation by the central bank of any country is called forex reserves.
Forex reserves are held by the country for supporting and maintaining the confidence of a country’s currency in terms of monetary policy and exchange rate management. It helps to overcome any external vulnerability in the case of fluctuation in the foreign exchange market and helps to absorb any shock in times of crisis.
To overcome the money crisis and value crisis, the central bank of a country keeps forex reserves. If there are not enough foreign exchange reserves left with a country, then it leads to a forex crisis.
What is The Financial Crisis?
A situation where the financial assets of the country lose their nominal value is known as a financial crisis. It includes stock market crashes, currency crises, banking panics, and sovereign defaults. If the financial crisis is ignored, then it can cause an economy to go towards recession or depression. During a financial crisis, businesses have trouble meeting their financial obligations and they lack sufficient cash to meet their immediate needs. In this case, the investors tend to lose their confidence in the asset value which further leads to compromises and difficulties in paying a debt.
The Banking Crisis in India
The amount of non-performing assets in the banking sector of India has been increasing in the last five years. This has been accompanied by a slowdown in investment growth. The banking sector of India has been facing many hurdles. There are many factors that have been attributed to the crisis in the banking sector, the main being the government-owned banks.
Around 70% of the bank loans have been in the account of public sector banks and account for 90% of the total non-performing asset. This has resulted in the erosion of their capital because of the bad loans. To overcome this crisis, the government had to recapitalize the bank and form a bad bank to overcome the crisis of non-performing assets. The reason for the poor performance of the public sector bank lies in the poor governance, the influence of politicians and bureaucrats, and corruption.
The Reserve Bank of India being the sole regulator of the banking sector in India needs to have tight supervision of the public sector bank and help overcome the financial crisis that the banking sector of India is going through. A well-defined framework for resolving the situation of non-performing assets is needed.
Example of a Currency Crisis
In the 2008 global financial crisis, the world faced a major setback. Subsequently, Turkey faced the condition of a decrease in foreign investment. This led to changes in reforms by the country and making a strong banking sector by supplying the money in the market for attracting investors. Due to the heavy flow of money, the business entities borrowed a huge amount of money. Further, in 2018, the US Federal Reserve increased the interest rate which feared the borrowers as they had to repay more which resulted in the loss of faith. These conditions resulted in the devaluation of the Turkish currency and led to a currency crisis.
The features of the value crisis if ignored can cause more economic slowdown leading to recession.
Conclusion
A currency crisis is a situation when the home currency of a country starts devaluating. This crisis led to many problems such as inflation, an increase in unemployment, relying on foreign funds, and bad relations with the global world. The economic policies of the nation must be formulated in such a manner that it is in line with the world, overcome any loopholes, and focus on the economic development of the country. The financial stability of the country lies in the hands of the central bank which should frame proper monetary policy and keep a check on the financial system of the country.
FAQs on Currency Crises: Causes and Effects
1. What is a currency crisis in simple terms?
A currency crisis, also known as a balance of payments crisis, occurs when there is a sudden and steep decline in the value of a country's currency. This event causes a negative shift in the exchange rate, making it difficult for the country to pay its foreign debts and leading to widespread economic instability. It is often triggered by speculative attacks on the currency in the foreign exchange market.
2. What are the main causes of a currency crisis?
The primary causes of a currency crisis are rooted in macroeconomic imbalances. Key factors include:
- Persistent Current Account Deficits: When a country imports significantly more than it exports, it creates a high demand for foreign currency, putting downward pressure on its own currency.
- Large Government Budget Deficits: If a government finances its spending by printing more money, it leads to inflation and erodes the currency's value.
- Sudden Capital Outflows: When foreign investors lose confidence and rapidly withdraw their investments, it floods the market with the local currency, causing its value to plummet.
- Speculative Attacks: If speculators believe a currency is overvalued under a fixed exchange rate system, they may sell off large amounts of it, forcing the central bank to devalue.
3. What are the common effects of a currency crisis on an economy?
A currency crisis has severe negative effects on a country's economy and its citizens. The most common consequences include:
- Hyperinflation: The cost of imported goods soars, leading to a rapid increase in the overall price level.
- Decreased Real Wages: As inflation rises faster than wages, the purchasing power of the population decreases significantly.
- Increased Unemployment: Businesses, especially those reliant on imports or with foreign debt, may fail, leading to job losses.
- Higher Foreign Debt Burden: The value of debt denominated in foreign currencies (like the US Dollar) increases dramatically in local currency terms, making repayment extremely difficult.
4. What is the difference between a fixed and a floating exchange rate in the context of a currency crisis?
A fixed exchange rate is where the government or central bank ties the official exchange rate to another country's currency. A crisis can occur when the market believes the fixed rate is unsustainable, leading to a speculative attack that depletes the country's foreign reserves and forces a sudden, sharp devaluation. In contrast, a floating exchange rate is determined by supply and demand. While it can still experience sharp declines (depreciation), the adjustments are often more gradual, reducing the risk of a sudden collapse from a speculative attack designed to break a fixed peg.
5. How can a country manage or prevent a currency crisis?
Governments and central banks can take several measures to prevent or mitigate a currency crisis. These include maintaining sound macroeconomic policies such as controlling inflation and managing government debt. Building up substantial foreign exchange reserves is crucial as it allows the central bank to intervene in the market to support the currency. Adopting investor-friendly policies to attract stable, long-term foreign investment and implementing a flexible or floating exchange rate regime can also reduce vulnerability.
6. Can you provide some real-world examples of currency crises?
History provides several prominent examples of currency crises.
- The 1997 Asian Financial Crisis: This crisis started in Thailand and spread to other East Asian economies like Indonesia and South Korea. These countries had pegged their currencies to the US dollar, but large deficits and investor panic led to massive speculative attacks, forcing them to devalue their currencies.
- The 1994 Mexican Peso Crisis: Also known as the Tequila Crisis, it was triggered by a sudden devaluation of the peso against the US dollar, which caught investors by surprise and led to a rapid capital flight.
- Recent Crises: More recently, countries like Turkey and Sri Lanka have faced severe currency crises due to high foreign debt, dwindling forex reserves, and poor economic policies.
7. How is a currency crisis related to a broader financial crisis?
A currency crisis is often a trigger for or a component of a larger financial crisis. When a currency collapses, it can set off a domino effect. For instance, banks and companies with large foreign currency debts may suddenly find themselves insolvent. This can lead to a banking crisis, as banks fail due to bad loans. The resulting credit crunch and loss of confidence can freeze economic activity, turning a currency problem into a full-blown financial and economic crisis that affects the entire system.
8. Why is a large stock of foreign exchange reserves considered a buffer against a currency crisis?
Large foreign exchange reserves act as a critical defence mechanism. When speculators start selling a country's currency, the central bank can use its reserves (e.g., US dollars) to buy back its own currency from the market. This counteracts the selling pressure and helps stabilise the exchange rate. A substantial reserve signals to the market that the central bank has the firepower to defend its currency, which can deter speculators and maintain investor confidence, thereby preventing a crisis from escalating.
