Currency crisis

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A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated debt will rise drastically relative to the declining value of the home currency. Generally doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate, if it has any.

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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. Financial institutions and the government will struggle to meet debt obligations and economic crisis may ensue. Causation also runs the other way. The probability of a currency crisis rises when a country is experiencing a banking or default crisis, [1] [2] while this probability is lower when an economy registers strong GDP growth and high levels of foreign exchange reserves. [3] To offset the damage resulting from a banking or default crisis, a central bank will often increase currency issuance, which can decrease reserves to a point where a fixed exchange rate breaks. The linkage between currency, banking, and default crises increases the chance of twin crises or even triple crises, outcomes in which the economic cost of each individual crisis is enlarged. [4]

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. [5] A currency crisis may also have political implications for those in power. Following a currency crisis a change in the head of government and a change in the finance minister and/or central bank governor are more likely to occur. [6]

A currency crisis 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.[ citation needed ]

Recessions attributed to currency crises include the hyperinflation in the Weimar Republic, 1994 economic crisis in Mexico, 1997 Asian financial crisis, 1998 Russian financial crisis, the 1998–2002 Argentine great depression, and the 2016 Venezuela and Turkey currency crises and their corresponding socioeconomic collapse.

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. [7]

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. [8] In his article, [9] 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). [10] 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. Specifically, investors expect a contingent commitment by the government and if things get bad enough, the peg is not maintained. For example, in the 1992 ERM crisis, the UK was experiencing an economic downturn just as Germany was booming due to the reunification. As a result, the German Bundesbank increased interest rates to slow the expansion. To maintain the peg to Germany, it would have been necessary for the Bank of England to slow the UK economy further by increasing its interest rates as well. As the UK was already in a downturn, increasing interest rates would have increased unemployment further and investors anticipated that the UK politicians were not willing to maintain the peg. As a result, investors attacked the currency and the UK left the peg.

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

Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency, [12] 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. [13] [14]

Krugman (1999) [15] 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.[ citation needed ]

Eurozone crisis as a balance-of-payments crisis

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European 10 year bonds, before the Great Recession in Europe bonds floated together in parity
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Ireland bond prices, Inverted yield curve in 2011 15 year bond 10 year bond 5 year bond 3 year bond Ireland bond prices.webp
Ireland bond prices, Inverted yield curve in 2011
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According to some economists the Eurozone crisis was in fact a balance-of-payments crisis or at least can be thought of as at least as much as a fiscal crisis. [17] 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. [18]

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. [19] [20] 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. [21] 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. [20] [22]

See also

Related Research Articles

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<span class="mw-page-title-main">Exchange rate</span> Rate at which one currency will be exchanged for another

In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of the euro.

<span class="mw-page-title-main">Global financial system</span> Global framework for capital flows

The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic action that together facilitate international flows of financial capital for purposes of investment and trade financing. Since emerging in the late 19th century during the first modern wave of economic globalization, its evolution is marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations aimed at improving the transparency, regulation, and effectiveness of international markets. In the late 1800s, world migration and communication technology facilitated unprecedented growth in international trade and investment. At the onset of World War I, trade contracted as foreign exchange markets became paralyzed by money market illiquidity. Countries sought to defend against external shocks with protectionist policies and trade virtually halted by 1933, worsening the effects of the global Great Depression until a series of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the international monetary system after World War II improved exchange rate stability, fostering record growth in global finance.

<span class="mw-page-title-main">Balance of payments</span> Difference between the inflow and outflow of money to a country at a given time

In international economics, the balance of payments of a country is the difference between all money flowing into the country in a particular period of time and the outflow of money to the rest of the world. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services.

<span class="mw-page-title-main">Government debt</span> Total amount of debt owed to lenders by a government/state

A country's gross government debt is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit occurs when a government's expenditures exceed revenues. Government debt may be owed to domestic residents, as well as to foreign residents. If owed to foreign residents, that quantity is included in the country's external debt.

Foreign exchange reserves are cash and other reserve assets such as gold held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more reserve currencies, nowadays mostly the United States dollar and to a lesser extent the euro.

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A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

In economics, a speculative attack is a precipitous selling of untrustworthy assets by previously inactive speculators and the corresponding acquisition of some valuable assets. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board. Paul Krugman, who visited the Board as a graduate student intern, soon adapted their mechanism to explain speculative attacks in the foreign exchange market.

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<span class="mw-page-title-main">Greek government-debt crisis</span> Sovereign debt crisis faced by Greece (2009–2018)

Greece faced a sovereign debt crisis in the aftermath of the financial crisis of 2007–2008. Widely known in the country as The Crisis, it reached the populace as a series of sudden reforms and austerity measures that led to impoverishment and loss of income and property, as well as a small-scale humanitarian crisis. In all, the Greek economy suffered the longest recession of any advanced mixed economy to date. As a result, the Greek political system has been upended, social exclusion increased, and hundreds of thousands of well-educated Greeks have left the country.

Financial fragility is the vulnerability of a financial system to a financial crisis. Franklin Allen and Douglas Gale define financial fragility as the degree to which "...small shocks have disproportionately large effects." Roger Lagunoff and Stacey Schreft write, "In macroeconomics, the term "financial fragility" is used...to refer to a financial system's susceptibility to large-scale financial crises caused by small, routine economic shocks."

Self-fulfilling crisis refers to a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors. In other words, investors' fear of the crisis makes the crisis inevitable, which justified their initial expectations.

<span class="mw-page-title-main">Causes of the European debt crisis</span>

The European debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to repay or re-finance their government debt without the assistance of third parties.

In economics, twin crises are simultaneous crises in banking and currency. The term was introduced in the late 1990s by economists Graciela Kaminsky and Carmen Reinhart, after the occurrence of several episodes with this characteristic around the globe.

References

  1. ↑ Kaminsky, Graciela L.; Reinhart, Carmen M. (1999). "The Twin Crises: The Causes of Banking and Balance-of-Payment Problems". American Economic Review. 89 (3): 473–500. CiteSeerX   10.1.1.321.5821 . doi:10.1257/aer.89.3.473. S2CID   5960798.
  2. ↑ Reinhart, Carmen M. (2002). "Default, Currency Crises, and Sovereign Credit Ratings" (PDF). World Bank Economic Review. 16 (2): 151–170. doi:10.1093/wber/16.2.151.
  3. ↑ Camba-Crespo, Alfonso; García-Solanes, José; Torrejón-Flores, Fernando (7 July 2021). "Current-account breaks and stability spells in a global perspective". Applied Economic Analysis. 30 (88): 1–17. doi: 10.1108/AEA-02-2021-0029 . S2CID   237827555.
  4. ↑ Feenstra, Robert Christopher; Taylor, Alan M. (2014). International Macroeconomics (3rd ed.). Macmillan Learning. p. 352. ISBN   9781429278430.
  5. ↑ Federal Reserve Bank of San Francisco, Currency Crises, September 2011
  6. ↑ Frankel, Jeffrey A. (2005). "Mundell-Fleming Lecture: Contractionary Currency Crashes in Developing Countries". IMF Staff Papers. 52 (2): 149–192. doi:10.2307/30035893. S2CID   154951242.
  7. ↑ Craig Burnside, Martin Eichenbaum, and Sergio Rebelo (2008), 'Currency crisis models', New Palgrave Dictionary of Economics, 2nd ed.
  8. ↑ Salant, Stephen; Henderson, Dale (1978). "Market anticipations of government policies and the price of gold". Journal of Political Economy. 86 (4): 627–48. doi:10.1086/260702. S2CID   677477.
  9. ↑ Krugman, Paul (1979). "A model of balance-of-payments crises". Journal of Money, Credit, and Banking. 11 (3): 311–25. doi:10.2307/1991793. JSTOR   1991793.
  10. ↑ Obstfeld, Maurice (1986). "Rational and self-fulfilling balance-of-payments crises". American Economic Review. 76 (1): 72–81. JSTOR   1804128.
  11. ↑ Chang, R.; Velasco, A. (2001). "A model of currency crises in emerging markets". Quarterly Journal of Economics. 116 (2): 489–517. CiteSeerX   10.1.1.319.6858 . doi:10.1162/00335530151144087.
  12. ↑ Chang, R.; Velasco, A. (2000). "Financial fragility and the exchange rate regime" (PDF). Journal of Economic Theory. 92: 1–34. doi:10.1006/jeth.1999.2621. hdl: 10419/100855 .
  13. ↑ Burnside, C.; Eichenbaum, M.; Rebelo, S. (2001). "Hedging and financial fragility in fixed exchange rate regimes" (PDF). European Economic Review. 45 (7): 1151–93. doi:10.1016/s0014-2921(01)00090-3.
  14. ↑ Burnside, C.; Eichenbaum, M.; Rebelo, S. (2004). "Government guarantees and self-fulfilling speculative attacks". Journal of Economic Theory. 119: 31–63. CiteSeerX   10.1.1.199.7437 . doi:10.1016/j.jet.2003.06.002.
  15. ↑ Balance Sheets, the Transfer Problem, and Financial Crises. International Finance and Financial Crises: Essays in Honor of Robert P. Flood, Jr. Bosten: Kluwer Academic, 31-44.
  16. ↑ Corsetti, Giancarlo; Erce, Aitor; Uy, Timothy (July 2020). "Official sector lending during the euro area crisis". The Review of International Organizations. 15 (3). Figure 3. doi:10.1007/s11558-020-09388-9. S2CID   225624817 . Retrieved 5 April 2023.
  17. ↑ Selected sources on viewing the Eurozone Crisis as a balance-of-payments crisis:
  18. ↑ Pisani-Ferry, Jean; Merler, Silvia (April 2, 2012). "Sudden stops in the Eurozone". Vox.Accominotti, Olivier; Eichengreen, Barry (September 14, 2013). "The mother of all sudden stops: Capital flows and reversals in Europe, 1919-1932". Vox.
  19. ↑ Wray, Randall (July 16, 2012). "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 2". Economonitor.
  20. 1 2 Pilkington, Philip (September 2, 2013). "Playing Humpty Dumpty: More on the Definition of "Balance of Payments Crisis"". Fixing the Economists.
  21. ↑ Wray, Randall (July 12, 2012). "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 1". Economonitor.
  22. ↑ Pilkington, Philip (August 31, 2013). "Can a country without a currency have a currency crisis?". Fixing the Economists.
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