What Causes a Currency Crisis
The phrase “currency crisis” is thrown around a lot, and unfortunately not always in the correct manner. However, there is such thing as a currency crisis, and in this article I will give you an idea as to what it actually is.
A currency crisis is essentially a situation where speculators are driving down the value of a currency, resulting in a sudden and drastic depreciation. When this happens, the overall economy feels the effects of this type of sudden change, and it can cause major financial issues. A currency crisis can occur for many reasons, such as decisions made in monetary policy. They can also have a political backdrop. One example of politics causing a currency crisis would be the recent case of the Turkish lira crisis, which has lost over one third of its value in recent months due to political changes and loss of confidence in the Turkish central bank. This obviously has far-reaching consequences for the general population. Though this type of situation is extreme, it does happen from time to time.
The anatomy of a currency crisis
A currency crisis can develop due to several different factors. Typically, it comes down to some type of political situation, economic disaster, or perhaps even a misstep by the local central bank. Beyond that, war can also come into play. Regardless of the reason, the end result is always the same: it’s the currency losing massive amounts of value in a very short amount of time. This creates extreme instability in the exchange rate, and inflation for the local populace. This means that the same amount of currency buys less that it previously did. As that’s the case, and if the negativity surrounding the currency doesn’t change, it becomes a self-feeding cycle.
As this happens, it makes it incredibly difficult for the host economy to finance its capital spending. In order to fight this, central banks will raise interest rates to counterbalance the downward pressure that speculators have placed upon the currency. The theory goes that if interest rates are higher, that rewards traders for holding onto that currency, driving the value higher. To raise interest rates, the central bank will sell its foreign reserves, which will shrink the money supply of their own country and create a capital outflow. It will also withhold payments received in domestic currency to increase the demand for that currency. Unfortunately, many small central banks around the world have learned that propping up its own currency is almost impossible in the long term because of the limited foreign reserves that they hold. Beyond that, you also have various economic issues that can come in that scenario.
Devaluation can also be caused by a central bank. Recently, Venezuela has done this by simply erasing some zeros off of the bolivar. The central bank has essentially increased the fixed exchange rate, which eventually should make domestic goods relatively cheaper than foreign goods. However, Venezuela finds itself in an untenable situation, with inflation possibly running as high as 1,000,000%! In theory, driving up local demand for local products is what people hope will happen when this method is employed.
Large financial deficits can create currency crises as well, although ironically the United States doesn’t seem to have this problem. Maybe it’s because the greenback is the world’s reserve currency. Still, there are plenty of small countries around the world that have been hammered in these situations. Typically, excessive money printing is the biggest culprit. However, more than once political turmoil has been the culprit. If a country looks like it is ready to fall, the currency can go into a bit of a death spiral.
A country needs sound money to avoid a potential currency crisis, and this is typically managed with intelligent central bank policies that keep money printing to a minimum. However, there are some notable exceptions - the United States being the prime example. Even though in theory it would seem that having a fixed exchange rate would prevent a currency crisis, floating rates quite often work out better for currencies, because it allows the market to set the rate. Several central banks around the world have tried to defend a currency peg against speculators, only to fail in the end after spending billions.
Currency meltdowns are devastating for any local economy. However, Forex traders have the advantage of being able to profit from these types of moves, often quite faster than they anticipated. I remember being short of the USD/JPY pair in 2007 when the first part of the housing crisis in the United States started. As money flowed into the relative safety of the Japanese yen, I was up by hundreds of pips before I knew what was going on.
Obviously, it works in both directions. Speculators will often line up ahead of time to anticipate a potential currency devaluation. For example, the Swiss National Bank had pegged the Swiss franc at €1.20 for a long time. Speculators simply bought the pair every time he got close to that level, because they knew that the SNB was propping it up. However, one day they suddenly stepped away, and the next thing you know the bottom fell out. Several people were wiped out in the process, as the sudden lack of support sent the markets careening. In fact, when this move was made in January 2015, it took three years just to get back to the same general region that we fell from. Currency devaluations and currency crises can be brutal, and very sudden. However, if you are on the right side of a trade like that, it can make your entire year.
At the end of the day, currency crises may be predictable in some situations, and while they can cause serious problems in the real world, they can also create great opportunities for Forex traders. Just be aware of the potential for losses as well, as happened in the SNB crisis, and plan your trades and strategies accordingly.