Currency Crisis

What is the Currency Crisis?

Currency Crisis is the situation in which the domestic currency of the country falls drastically due to several reasons like over inflation, default by banks, financial market fluctuations, the deficit in the balance of payment, war conditions, etc. which affects the economy very badly and can be controlled by the government by selling the foreign reserves or by other necessary measures.

Explanation

This is the situation where the economy faces the downfall and the inflation rises. The situation creates doubt in the mind of citizens about the working and management of the government and banking system. During this, lots of fluctuations are noticed in the foreign exchange market. It does not occur suddenly; there are many symptoms before it occurs, as the decline in purchasing power of the people due to inflation, high unemployment, heavy fluctuations in the stock market, failure of the banking system, etc.

This crisis can be controlled by the country’s apex bank or government by increasing the money supply in the market by increasing currency issuance, increasing the interest rates, selling the foreign reserves, etc. The government takes measures to make the home currency stable. The currency crisis also affects foreign investors.

Currency-Crisis

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History

The concept of currency crisis began in the 1990s, the instances like downfall in the economy, unemployment, high volatility in the market, etc. results in loss of capital by the countries, which results in the devaluationDevaluationCurrency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies. This mechanism is used by economies with a semi-fixed or fixed exchange rate, and it should not be confused with depreciation.read more of the home currency and loss of interest by investors and investments start to decline. Also, the global crisis of 1994 increased the currency crisis world-wide. Again, the unfriendly investors’ policy by the Asian government gave birth to the currency crisis in 1997.

This situation basically originates from the balance of paymentBalance Of PaymentThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more situation as a deficit in the balance of payment leads to a fiscal crisis. The fiscal crisis slows down the economy, which results in the liquidation of foreign investmentsForeign InvestmentsForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more and downfall in the stock and forex market.

Currency Crisis Examples

After 2008 the global financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, every country trying to attract foreign investors from their investment policies. After 2008, turkey faced a decrease in foreign investment. To attract the investors, it bought several reforms by making the banking sector strong, and by supplying money in the market. But during that period, the Turkish banks and business entities borrowed a huge amount, and the borrowing was mostly the dollar-based. And in 2018, due to the increase in the rate of interest by US federal reserve, the borrowers were scared as they had to repay more and resulted in a loss of faith by Turkey investors. All the conditions resulted in the devaluation of the Turkish currency, which lead to a currency crisis.

Models

The indicators of currency crisis are explained stage-wise name first-generation currency crisis reflects the symptoms at an initial stage. The second-generation currency crisis reflects the situations of fluctuation in a middle and third-generation currency crisis, i.e., the final stage explains the main factors due to which the currency devalued and the currency crisis occurred. Each model is explained as under:

#1 – First Generation Currency Crisis

During First Generation is the rate of gold starts fluctuating due to the fluctuation of the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more. This resulted in fluctuations in the forex marketForex MarketFor those wishing to invest in currencies, the currency market is a one-stop solution. In the currency market different currencies are bought and sold by participants operating in various jurisdictions across the world. It is important in international trade and is also known as Forex or Foreign Exchange.read more. Investors start little doubting but maintain the investment after assurance from the government about the maintenance of fixed exchange rates.

#2 – Second Generation Currency Crisis

In the second stage, investors’ doubt increases due to continued fluctuations in the exchange rate as the government might be unable to maintain the fixed exchange rate. The second stage symptoms are inflation, slow of economy, changes in economic and monetary policies, increasing unemployment, etc. which forces the government to look seriously into the fluctuations and try to maintain the fixed and continuous rate to prevent a recession. In the second stage, the government might sell foreign reserves so as to maintain a fixed rate.

#3 – Third Generation Currency Crisis

In the third generation is the bubble blasts due to continuous fluctuations, the deficit in the balance of payment situation arises, the banking industry starts collapsing due to heavy fluctuations and dependence on foreign investments. The value of the loans taken by the country’s government in foreign currency denominations also increases because of the devaluation in the home currency. The government of the country is forced to devalue its currency, and the currency crisis begins.

Causes

  1. Heavy fluctuations in the stock market and foreign exchange market.
  2. Rise in inflation and unemployment.
  3. The adverse affecting changes in monetary policy.
  4. The downturn of the economy.
  5. Heavy reliance on foreign investment.
  6. Due to clashes between the two countries, which cause the situations of war.

How to Prevent from Currency Crisis?

Conclusion

Currency Crisis is the situation where the home currency of the country starts devaluating. Many situations led to this – high inflation, an increase in unemployment, heavy reliance on foreign funds or foreign investors, bad relations with some countries that lead to war, etc.

This can be prevented by investment-friendly policies, early problem detection, and prevention, investment in multiple countries, favorable trade relations, etc.

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