Many investors and international financiers have within the last two decades been caught off-guard by currency crises. Their knee-jerk responses to small economic tremors have always been in the form of capital flight and runs on different currencies. Many people argue that it is such reactions that really cause earth-shaking currency crises.
What analysts are sure about is the fact that many investors don’t take time to understand the market dynamics before making their decisions. They rely on their instincts at the expense of the economyís minutia. A currency crisis is said to have occurred when there is a sharp decline in the value of an economy’s currency. Such a decline creates much instability in areas like exchange rates.
In simpler terms, a currency crisis is the result of an interaction of very many factors. One of these factors is investor expectations. Another factor is the result or outcomes of these expectations. When it comes to matters of expectations among investors, the spotlight turns on central banks, government policies, and the investors themselves.
The central bank plays a very pivotal role in trying to stabilize the countryís currency exchange rates. In times of a currency crisis, the first move by the central bank is to try as much as possible to retain the current exchange rates. This it does by eating into the existing foreign exchange reserves. Alternatively, it may allow the exchange rate to run its course and continue fluctuating.
The reason for tapping into the existing foreign reserves is very simple to explain – when the market expectations are in devaluation, increasing the prevailing interest rates is the only way through which the downward pressure on the currency of a country can be offset.
When there is a need to increase the interest rates of a country’s currency, the level of currency supply has to be shrunk. The obvious result of this is an increase in demand for more and more currency. To do this, the central bank has to sell off some of its foreign currency reserves so as to stimulate a high rate of capital outflow. When the foreign reserves are sold, the money that the central bank gets is usually in the form of domestic currency. This currency is withheld as an asset.
[ad#downcont]A prop-up of exchange rates cannot last forever. The foreign reserves might begin to decline in quantities. Other social-economic factors such as unemployment might press the government to lose grip of the situation. At this level, a currency crisis is said to have occurred.
When a local currency is devalued, goods that are produced locally become cheaper compared to foreign goods. This boosts the outcome of the workersí output, leading to an increase in levels of production. The devaluation of a currency is therefore a good way of dealing with a currency crisis.