What is a Currency Crisis?

How Central Banks & Governments Get It Wrong

Euro sign and lifebuoy, symbolic image, rescue of the Euro
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Most international investors have experienced a currency crisis at some point in their lifetimes. Mexico, Argentina, China, and many other countries have seen their currencies unexpectedly fluctuate for a variety of different reasons and it had an impact on the wider market each time.

Currency crises are sudden volatility in a currency that ends up causing speculation in the foreign exchange (forex) market.

These crises can be caused by a number of elements - including currency pegs or monetary policy decisions - and can be solved by implementing floating exchange rates or avoiding monetary policies that fight the market instead of embracing it.

Currency Crisis Causes

Currency crises are caused by a number of underlying factors ranging from central bank policies to pure speculation - and they're often difficult to predict in advance.

The primary cause of currency crises in the past has been a central bank's failure to maintain a fixed rate peg to a floating rate foreign currency. For example, George Soros famously bet that the British government wouldn't be able to defend the British Pound's shadow peg with Germany's Deutsche Mark when Britain had three-times the inflation rate of Germany. Ultimately, Soros was correct and the pound fell sharply, netting him billions of dollars in profits.

Even when there isn't a peg, currency crises can evolve from a central bank's desire to prop up its currency's value in order to keep investment capital within its borders.

For example, emerging markets experienced capital outflows in early 2014 that led their currencies to depreciate across the board. Central banks responded by increasing interest rates to attract investors, but these higher interest rates led to slower economic growth and real value.

In other cases, countries may want to keep their currency artificially low to stimulate demand for its exports.

The most famous example of this has been China, which maintained a peg with the United States dollar for decades. While the government has never had trouble defending the peg - thanks to its large foreign reserves, it has caused an imbalance in other areas of the market.

Currency Crisis Solutions

There are many possible solutions to a currency crisis, including many preventative measures that can be taken to prevent a crisis from ever occurring.

The best solution to a currency crisis is avoiding them in the first place with preventative measures. Floating exchange rates tend to avoid currency crises by ensuring that the market is always setting the price, as opposed to fixed exchange rates where central banks must fight the market. For example, Britain's fight against George Soros required the central bank to spend billions to defend its currency against speculators, which proved to be impossible to maintain.

Central banks should also avoid monetary policies that involve trading against the market unless its absolutely necessary to prevent a broader crisis. For example, emerging market economies could have accepted the inevitability of currency outflows and reformed investment policies to attract foreign direct investment instead of trying to raise interest rates which ended up costing central banks millions to maintain.

It could have even helped spur exports and improve their domestic economies.

Examples of Currency Crises

Currency crises have been occurring with greater frequency since the Latin American debt crisis of the 1980s and earlier examples throughout history.

The Latin American currency crisis of 1994 is perhaps one of the most well known currency crises. After Mexico's economy began to slow and foreign reserves dwindled, investors began to fear that the country would default on its debt. These concerns became a sort of self-fulfilling prophecy when the country was forced to devalue its currency in 1994 and raise interest rates to nearly 80% which ended up taking a toll on its gross domestic product (GDP).

The Asian financial crisis of 1997 is another well known example of a currency crisis. After experiencing rapid growth throughout the 1990s, the "tiger" economies relied heavily on foreign debt to finance their growth, so when the taps were turned off they struggled to meet the debt payments.

Fixed exchange rates became very difficult to maintain as investor grew concerned about default risks and currency valuations fell sharply lower.

Lessons for Investors

Investors should always be cognizant of currency dynamics when making investment decisions. Often times, it's possible to predict major problems before they arise to some extent, although market timing can be exceptionally difficult. This means that currency imbalances may be a good time to hedge a portfolio against risk rather than a time to make a major bet against the currency or country.