What Causes a Currency Crisis?

The world has been through quite a few currency crises in the past few years. Those faced by the United States, Spain, and Greece particularly stood out, considering just how many news stories focused on the instability of these countries at the time of their crises.

We’ve heard the word ‘crisis’ thrown around millions of times since the first rise in sightings of extreme currency crises in 2009. Since then, it seems to have lost some strength in meaning. When you use a word often enough, it is bound to become commonplace.

However, despite the fact that currency crises have become commonplace according to how often they have been occurring, they are still very serious matters. It is not something to take lightly, and it hopefully never will be. Though we know what a currency crisis involves and how it affects a country as well the lives of its people, it is not often that we hear what exactly occurred to cause such a crisis. The following are the top 4 causes for a currency crisis.

1. Decline in currency value

The decline of value of a country’s currency is actually the first step in what seems to be a steady decline toward a currency crisis. It acts very much like an off-balance domino that makes one false move and leads to the unfortunate demise of all dominos in close relation to it. Once the value of a given currency decreases, exchange rates lose their stability because this lower valued currency is now unable to buy the same amount of currency as it once could.

Now, having an unstable exchange rate has a negative effect on forex traders in that they become afraid of this currency’s value remaining low. So, expectedly, they take action by doing something called ‘capital flight’, taking back their money from that country’s economy. The thing is, when traders begin to remove their money and exchange these domestic investments for foreign currencies, it unfortunately causes the exchange rate to drop even lower. Economies that have experienced this and are therefore not particularly stable include the countries of Brazil, Indonesia, and Turkey. These are called emerging markets.

2. Borrowing money

As a result of having an increasingly low exchange rate and traders removing their money and exchanging it for other types of currency, a country may have no choice but to borrow money in order to raise their exchange rate and hope to bring traders back.

This is not as easy or as predictable as it looks, however. Sometimes borrowing money leads to no substantial change in exchange rate and no traders returning with their funds. When this happens, the country is left not only with a low exchange rate and no trader interest, but on top of this they are now indebted to the country whose money they borrowed from as well.

3. Current Account Deficit

A current account deficit is caused by a country’s inability to export an equal amount of goods, or at least equally valuable goods, as those that are imported from elsewhere. When a country is unable to provide goods that are as valuable to their neighbors as the goods received from these neighbors, a current account deficit is what results.

This means that the country is spending more than it is receiving in terms of the trading of goods. In order to pay for this deficit, the country needs to have a surplus elsewhere, on the Capital account for example.