CURRENCY CRISIS

Main Cause Of Currency Crisis

Main Cause Of Currency Crisis

Introduction

A currency crisis is brought on by a decline in the value of a country's currency. This decline in value negatively affects an economy by creating instabilities in exchange rates, meaning that one unit of the currency no longer buys as much as it used to in another. To simplify the matter, we can say that crises develop as an interaction between investor expectations and what those expectations cause to happen.

Propping up the exchange rate cannot last forever, both in terms of a decline in foreign reserves as well as political and economic factors, such as rising unemployment. Devaluing the currency by increasing the fixed exchange rate results in domestic goods being cheaper than foreign goods, which boosts demand for workers and increases output. In the short run devaluation also increases interest rates, which must be offset by the central bank through an increase in the money supply and an increase in foreign reserves. (Paul, 2006:312)

Discussion

As mentioned, propping up a fixed exchange rate can eat through a country's reserves quickly, and devaluing the currency can add back reserves.

Unfortunately for banks, but fortunately for you, investors are well aware that a devaluation strategy can be used, and can build this into their expectations. If the market expects the central bank to devalue the currency, which would increase the exchange rate, the possibility of boosting foreign reserves through an increase in aggregate demand is not realized. Instead, the central bank must use its reserves to shrink the money supply, which increases the domestic interest rate.

The currency crisis that started in Thailand spread to the neighboring countries of Southeast Asia and eventually triggered serious crisis in the currency and financial markets of South Korea which had just recently joined the ranks of the advanced economies of the world. While there is a tendency to speak of these crises which covered the entire region as a single event and phenomenon, background factors and causes are not necessarily identical among the affected nations. The crises also served to uncover serious structural flaws in these countries, including weaknesses in the financial sector, delays in vital transformations in the industrial structure, and defects in corporate governance. The structural flaws are regarded as a major factor in obstructing the return to stability by the affected currencies.( Maurice, 2004,73)

To summarize, while it is true that failures of financial institutions and speculative pressures did play a role in generating the crisis in Thailand, the principal factor responsible for the collapse of the foreign exchange regime was the unsustainability of the macroeconomic imbalance. On this point, the Thai crisis can be said to resemble the Mexican currency crisis of 1994, with the exception that government liabilities were the problem in the case of Mexico as opposed to private banking liabilities in the case of Thailand.

Even after a floating exchange-rate regime was instituted in July the baht continued to lose ground, forcing the Chavalit Administration which was then in power to ...