Currency crisis

Short description: When a country's central bank lacks the foreign reserves to maintain a fixed exchange rate

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.

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]

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.

## Contents

* 1 Theories
* 1.1 First generation
* 1.2 Second generation
* 1.3 Third generation
* 2 Eurozone crisis as a balance-of-payments crisis
* 3 See also
* 3.1 Related economic crises
* 4 References

## 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[8] of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market.[9] In his article,[10] 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).[11] 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.[12] 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,[13] 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.[14][15]

Krugman (1999)[16] suggested another two factors, in an attempt to explain the 1997 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.

## Eurozone crisis as a balance-of-payments crisis

European 10 year bonds, before the Great Recession in Europe bonds floated together in parity

Greece 10 year bond

Portugal 10 year bond

Ireland 10 year bond

Spain 10 year bond

Italy 10 year bond

France 10 year bond

Germany 10 year bond

Ireland bond prices, Inverted yield curve in 2011[17]

15 year bond

10 year bond

5 year bond

3 year bond

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.[18] 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. The 2008 financial crisis resulted in a sudden stop to these capital inflows that in some cases even led to a total reversal, i.e. a capital flight.[19]

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 TARGET system, that ensures that Eurozone member countries can always fund their current account deficits.[20][21] 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.[22] 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.[21][23]

## See also

* Finance:Currency intervention - Monetary policy operation
* Finance:Currency war - Competition between nations to gain competitive advantage by manipulating monetary supply
* Finance:Currency transaction tax - Tax on the use of currency
* Finance:Debt crisis - Situation in which a government cannot pay back its debt
* Finance:Exorbitant privilege - Economic gain by reserve currency nation
* Finance:Financial crisis - Situation in which financial assets suddenly lose a large part of their nominal value
* Finance:Financial market - Generic term for all markets in which trading takes place with capital
* Finance:Financial transaction tax - Tax levied on trades of financial instruments such as stocks, bonds, or derivatives
* Finance:Foreign exchange controls - Controls imposed by a government on the purchase/sale of foreign currencies
* Finance:Foreign exchange market - Global decentralized trading of international currencies
* Finance:Liquidity crisis - Acute shortage of liquidity
* Finance:Money market - Type of financial market providing short-term funds
* Finance:Spahn tax - Type of currency transaction tax
* Finance:Speculation
* Finance:Speculative attack - Concept in economics
* Finance:Sudden stop (economics)
* Finance:Tobin tax - Form of tax

### Related economic crises

* Bretton Woods system § U.S. balance of payments crisis (1960s)
* Mexican peso crisis
* 1997 Asian financial crisis
* 1998 Russian financial crisis
* 1998–2002 Argentine great depression
* 2008 financial crisis

## 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. doi:10.1257/aer.89.3.473.
2. ↑ Reinhart, Carmen M. (2002). "Default, Currency Crises, and Sovereign Credit Ratings". World Bank Economic Review 16 (2): 151–170. doi:10.1093/wber/16.2.151. http://www.nber.org/papers/w8738.pdf.
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.
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.
7. ↑ Craig Burnside, Martin Eichenbaum, and Sergio Rebelo (2008), 'Currency crisis models', New Palgrave Dictionary of Economics, 2nd ed.
8. ↑ Krugman, Paul. "Currency Crises". http://web.mit.edu/krugman/www/crises.html.
9. ↑ 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.
10. ↑ Krugman, Paul (1979). "A model of balance-of-payments crises". Journal of Money, Credit, and Banking 11 (3): 311–25. doi:10.2307/1991793.
11. ↑ Obstfeld, Maurice (1986). "Rational and self-fulfilling balance-of-payments crises". American Economic Review 76 (1): 72–81.
12. ↑ Chang, R.; Velasco, A. (2001). "A model of currency crises in emerging markets". Quarterly Journal of Economics 116 (2): 489–517. doi:10.1162/00335530151144087.
13. ↑ Chang, R.; Velasco, A. (2000). "Financial fragility and the exchange rate regime". Journal of Economic Theory 92: 1–34. doi:10.1006/jeth.1999.2621. http://www.nber.org/papers/w6469.pdf.
14. ↑ Burnside, C.; Eichenbaum, M.; Rebelo, S. (2001). "Hedging and financial fragility in fixed exchange rate regimes". European Economic Review 45 (7): 1151–93. doi:10.1016/s0014-2921(01)00090-3. http://www.nber.org/papers/w7143.pdf.
15. ↑ Burnside, C.; Eichenbaum, M.; Rebelo, S. (2004). "Government guarantees and self-fulfilling speculative attacks". Journal of Economic Theory 119: 31–63. doi:10.1016/j.jet.2003.06.002.
16. ↑ 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.
17. ↑ 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. https://www.researchgate.net/figure/a-Irish-yield-curve-dynamics-around-2011-loan-amendments-b-Portuguese-yield-curve_fig2_342609297. Retrieved 5 April 2023.
18. ↑ Selected sources on viewing the Eurozone Crisis as a balance-of-payments crisis:
* "Origins of the Euro Crisis". The New York Times. September 23, 2011. https://krugman.blogs.nytimes.com/2011/09/23/origins-of-the-euro-crisis/.
* "Wishful Thinking And The Road To Eurogeddon". The New York Times. November 7, 2011. https://krugman.blogs.nytimes.com/2011/11/07/wishful-thinking-and-the-road-to-eurogeddon/.
* "European Crisis Realities". The New York Times. February 25, 2012. https://krugman.blogs.nytimes.com/2012/02/25/european-crisis-realities/.
* "But Where's My Phoenix?". The New York Times. September 14, 2013. https://krugman.blogs.nytimes.com/2013/09/14/but-wheres-my-phoenix/.
* Krugman, Paul (August 26, 2014). "Currency Regimes, Capital Flows, and Crises". IMF Economic Review 62 (4): 470–493. doi:10.1057/imfer.2014.9.
* "Why the Bundesbank is wrong". Financial Times. April 10, 2012. http://www.ft.com/intl/cms/s/0/f07a9aa6-8234-11e1-b06d-00144feab49a.html.
* "The eurozone decouples from the world". Financial Times. November 6, 2011. http://blogs.ft.com/gavyndavies/2011/11/06/the-eurozone-decouples-from-the-world/.
* "The eurozone crisis as balance of payment problem". Financial Times (Financial Times Alphaville). November 8, 2011. http://ftalphaville.ft.com/2011/11/08/734241/the-eurozone-crisis-as-balance-of-payment-problem/.
* "Who killed the euro zone?". The Economist. November 28, 2011. https://www.economist.com/blogs/freeexchange/2011/11/euro-crisis-21.
* "Euro's Unity Continues to Defy the Bears". The Wall Street Journal. December 2, 2012. https://www.wsj.com/articles/SB10001424127887323401904578155060105117202.
* "How to rescue the euro: Ten commandments". Vox. October 3, 2011. http://www.voxeu.org/article/how-rescue-euro-ten-commandments.
* "Sudden stops in the Eurozone". Vox. April 2, 2012. http://www.voxeu.org/article/public-capital-flows-replacing-private-flows-eurozone-what-it-means-policy.
* "The Eurozone crisis: Fiscal fragility, external imbalances, or both?". Vox. May 16, 2012. http://www.voxeu.org/article/eurozone-crisis-fiscal-fragility-external-imbalances-or-both.
* "What Really Caused the Eurozone Crisis? Part 1". The Street Light. September 22, 2011. http://streetlightblog.blogspot.gr/2011/09/what-really-caused-eurozone-crisis-part.html.
* "What Really Caused the Eurozone Crisis? Part 2". The Street Light. September 27, 2011. http://streetlightblog.blogspot.gr/2011/09/causes-of-eurozone-crisis-part-2-policy.html.
* Böttcher, Barbara, ed (October 26, 2011). "EU Monitor 88: Euroland's hidden balance-of-payments crisis". Deutsche Bank Research. http://www.dbresearch.de/PROD/DBR_INTERNET_DE-PROD/PROD0000000000279906/Euroland’s+hidden+balanQ-Çof-payments+crisis.pdf. .
* "CESifo Forum Special Issue January 2012". CESifo Group Munich. 2012. http://www.cesifo-group.de/ifoHome/publications/docbase/details.html?docId=17638878. .
19. ↑ "Sudden stops in the Eurozone". Vox. April 2, 2012. http://www.voxeu.org/article/public-capital-flows-replacing-private-flows-eurozone-what-it-means-policy. "The mother of all sudden stops: Capital flows and reversals in Europe, 1919-1932". Vox. September 14, 2013. http://www.voxeu.org/article/mother-all-sudden-stops.
20. ↑ "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 2". Economonitor. July 16, 2012. http://www.economonitor.com/lrwray/2012/07/16/mmt-and-the-euro-current-account-imbalances-and-the-euro-crisis-part-2/.
21. ↑ 21.0 21.1 "Playing Humpty Dumpty: More on the Definition of "Balance of Payments Crisis"". Fixing the Economists. September 2, 2013. http://fixingtheeconomists.wordpress.com/2013/09/02/playing-humpty-dumpty-more-on-the-definition-of-balance-of-payments-crisis/.
22. ↑ "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 1". Economonitor. July 12, 2012. http://www.economonitor.com/lrwray/2012/07/12/mmt-and-the-euro-are-current-account-imbalances-to-blame-for-the-euro-disaster-part-1/.
23. ↑ "Can a country without a currency have a currency crisis?". Fixing the Economists. August 31, 2013. http://fixingtheeconomists.wordpress.com/2013/08/31/can-a-country-without-a-currency-have-a-currency-crisis/.

* v
* t
* e

Financial crises

* Banking panic
* Bear market
* Credit crunch
* Credit cycle
* Currency crisis
* Debt crisis
* Energy crisis
* Flash crash
* Hyperinflation
* Liquidity crisis
* Minsky moment
* Stock market crash

Pre–1000|

* Crisis of the Third Century (CE 235–284)

1000–1760|

* Great Bullion Famine (c. 1400–c. 1500)
* The Great Debasement (1544–1551)
* Kipper und Wipper (1621–1623)
* Tulip mania crash (1637)
* South Sea bubble crash (1720)
* Mississippi bubble crash (1720–1721)

1760–1840|

* Amsterdam banking crisis of 1763
* Bengal bubble crash (1769–1784)
* Crisis of 1772
* Dutch Republic financial collapse (c. 1780–1795)
* Panic of 1785
* Copper Panic of 1789
* Panic of 1792
* Panic of 1796–97
* Danish state bankruptcy of 1813
* Panic of 1819
* Panic of 1825
* Panic of 1837

1840–1870|

* Panic of 1847
* Panic of 1857
* Panic of 1866
* Black Friday (1869)

1870–1914|

* Panic of 1873
* Paris Bourse crash of 1882
* Panic of 1884
* Arendal crash (1886)
* Baring crisis (1890)
* Encilhamento (1890–1893)
* Panic of 1893
* Australian banking crisis of 1893
* Black Monday (1894)
* Panic of 1896
* Panic of 1901
* Panic of 1907
* Shanghai rubber stock market crisis (1910)
* Panic of 1910–11

1918–1939|

* Early Soviet hyperinflation (1917–1924)
* Weimar Republic hyperinflation (1921–1923)
* Shōwa financial crisis (1927)
* Wall Street Crash of 1929
* Panic of 1930

1945–1973|

* Kennedy Slide of 1962

1973–1982|

* 1970s energy crisis (1973–1980)
* 1973 oil crisis
* 1973–74 stock market crash
* Secondary banking crisis of 1973–1975
* Latin American debt crisis (1975–1982)
* 1976 IMF crisis
* 1979 oil crisis
* Brazilian hyperinflation (1980–1982)

1982–2007|

* Brazilian hyperinflation (1982–1994)
* Souk Al-Manakh stock market crash (1982)
* Chilean crisis of 1982
* 1983 Israel bank stock crisis
* Black Saturday (1983)
* Savings and loan crisis (1986–1995)
* Black Monday (1987)
* 1988–1992 Norwegian banking crisis
* Friday the 13th mini-crash (1989)
* Japanese asset price bubble crash (1990–1992)
* 1990 oil price shock
* Rhode Island banking crisis (1990–1992)
* 1991 Indian economic crisis
* 1990s Swedish banking crisis (1991–1992)
* 1990s Finnish banking crisis (1991–1993)
* 1990s Armenian energy crisis (1991–1995)
* Cuban Special Period (1991–2000)
* Black Wednesday (1992)
* 1992 Colombian energy crisis
* 1994 bond market crisis
* Venezuelan banking crisis of 1994
* Mexican peso crisis (1994)
* 1997 Asian financial crisis
* October 27, 1997 mini-crash
* 1998 Russian financial crisis
* 1998–99 Ecuador financial crisis
* Samba effect (1999)
* California electricity crisis (2000–01)
* Dot-com bubble crash (2000–2004)
* 2001 Turkish economic crisis
* 9/11 stock market crash (2001)
* Stock market downturn of 2002
* South American economic crisis of 2002
* 2002 Uruguay banking crisis
* 2003 Myanmar banking crisis
* 2000s energy crisis (2003–2008)
* 2004 Argentine energy crisis
* Nigerian energy supply crisis (2005–)
* 2007 Chinese stock bubble crash
* Zimbabwean hyperinflation (2007–)

2007–08|

* U.S. housing market correction (2006–07)
* 2008 Bulgarian energy crisis
* 2008 Central Asia energy crisis
* 2008 Latvian financial crisis
* 2008–09 Belgian financial crisis
* 2008–09 Russian financial crisis
* 2008–09 Ukrainian financial crisis
* 2008–2011 Icelandic financial crisis
* 2008–2011 Irish banking crisis
* 2008–2014 Spanish financial crisis
* European debt crisis
* Greek government-debt crisis
* Subprime mortgage crisis
* U.S. bear market of 2007–2009

Post–2008|

* 2009 Ecuador electricity crisis
* 2009 Dubai debt standstill
* Venezuelan banking crisis of 2009–10
* 2010 Flash Crash
* 2010–2014 Portuguese financial crisis
* Energy crisis in Venezuela (2010–)
* 2011 Tōhoku earthquake and tsunami stock market crash
* August 2011 stock markets fall
* 2011 Bangladesh share market scam
* 2012–13 Cypriot financial crisis
* 2013 Chinese banking liquidity crisis
* Venezuela economic crisis (2013–)
* Gaza electricity crisis (2013–)
* 2014–2016 Brazilian economic crisis
* Puerto Rican government-debt crisis (2014–)
* 2014–2017 Russian financial crisis
* 2015–16 Chinese stock market turbulence
* 2015–16 stock market selloff
* Zulia energy collapse (2015–)
* Brexit stock market crash (2016)
* 2016 Southeastern U.S. gas shortage
* Venezuelan hyperinflation (2016–)
* 2017 Sri Lankan fuel crisis
* Ghana banking crisis (2017–18)
* 2018 cryptocurrency crash
* 2018 Turkish currency and debt crisis

* List of banking crises
* List of economic crises
* List of sovereign debt crises
* List of stock market crashes and bear markets

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