Currency crisis

A currency crisis is when, serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency.

A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. Currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar, Euro or Pound sterling). Currency crises have large, measurable costs on an economy, but the ability to predict the timing and magnitude of crises is limited by theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations, and government policy.

There is no widely accepted definition of a currency crisis, which is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of a currency of at least 25% but it is also defined at least 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation or appreciation, see Al-Assaf et al. (2013).

Recessions attributed to currency crises include the 1994 economic crisis in Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002).

Theories

The currency crises and sovereign debt crises that have occurred with increasing frequency since the Latin American debt crisis of the 1980s have inspired a huge amount of research. There have been several 'generations' of models of currency crises.

First generation

The 'first generation' of models of currency crises began with Paul Krugman's adaptation of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market. In his article, Krugman argues that a sudden speculative attack on a fixed exchange rate, even though it appears to be an irrational change in expectations, can result from rational behavior by investors. This happens if investors foresee that a government is running an excessive deficit, causing it to run short of liquid assets or "harder" foreign currency which it can sell to support its currency at the fixed rate. Investors are willing to continue holding the currency as long as they expect the exchange rate to remain fixed, but they flee the currency en masse when they anticipate that the peg is about to end.

Second generation

The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986). In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency.

Third generation

'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.

McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks).

Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics.

Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,

Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.

Krugman(1999) suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, the banking system plays no role in his model. His model led to the policy prescription: impose a curfew on capital flight which was implemented by Malaysia during the Asian financial crisis.

Eurozone crisis as a balance-of-payments crisis

According to some economists the ongoing Eurozone crisis is in fact a balance-of-payments crisis or at least can be thought of as at least as much as a fiscal crisis. According to this view, a capital flow bonanza of private funds took place during the boom years preceding this crisis into countries of Southern Europe or of the periphery of the Eurozone, including Spain, Ireland and Greece; this massive flow financed huge excesses of spending over income, i.e. bubbles, in the private sector, the public sector, or both. Then following the global financial crisis of 2007–08, came a sudden stop to these capital inflows that in some cases even led to a total reversal, i.e. a capital flight.

Others, like some of the followers of the Modern Monetary Theory (MMT) school, have argued that a region with its own currency cannot have a Balance of Payments crisis because there exists a mechanism, the TARGET2 system, that ensures that Eurozone member countries can always fund their current account deficits. These authors do not claim that the current account imbalances in the Eurozone are irrelevant but simply that a currency union cannot have a balance of payments crisis proper. Some authors tackling the crisis from an MMT perspective have claimed that those authors who are denoting the crisis as a 'balance of payments crisis' are changing the meaning of the term.

See also

• Alter-globalization
• ATTAC (Association for the Taxation of Financial Transactions for the Aid of Citizens)
• Central banks - which issue currency
• Currency
• Currency transaction tax
• Economic collapse
• Exorbitant privilege
• Financial market
• Financial transaction tax
• Fluctuation in exchange rates
• Foreign exchange controls
• Foreign exchange market
• Global Justice Movement
• Jubilee 2000
• Liquidity crisis
• Money market
• Paul Bernd Spahn
• Spahn tax
• Speculation
• Speculative attack
• Sudden stop (economics)
• Speculation in foreign exchange markets
• Tobin tax

Related economic crises

• 1994 economic crisis in Mexico
• 1997 Asian Financial Crisis
• 1998 Russian financial crisis
• Argentine economic crisis (1999–2002)
• Financial crisis of 2007–2010

External links

• Mindmapping for Economic Crises