Currency Crisis

A currency crisis is when the country’s domestic currency falls drastically due to overinflation, default by banks, financial market fluctuations, a deficit in the balance of payment, war conditions, etc. That affects the economy immensely and can be controlled by the government by selling foreign reserves or other necessary measures. A crisis of this nature can increase a nation’s debt burden, and unemployment, and cause hyperinflation.

A currency crisis is often linked to the devaluation of the country’s currency. However, it can be prevented by investment-friendly policies, early problem detection, prevention, investment in multiple countries, favorable trade relations, etc. Most governments find it difficult to create citizen-centric policies in such situations as the economy might already be in heavy debt and such policies might be costly.

• A currency crisis is when the country's domestic currency falls significantly due to overinflation, banks default, financial market fluctuations, the balance of payment deficit, war situations, etc.
• Currency crises immensely affect the economy and are regulated by the government through selling foreign reserves or other essential measures. 
• Heavy fluctuations in the stock and foreign exchange market, increase in inflation and unemployment, a downturn of the economy, adverse changes in monetary policy, heavy reliance on foreign investment, and clashes between the two countries causing war are the causes of the currency crises.
• One can prevent it through investment-friendly policies, early problem detention, prevention, multiple countries' investments, and suitable trade relations.

The currency crisis is a situation where the country's home currency starts devaluating. Many problems led to high inflation, increased unemployment, heavy reliance on foreign funds or investors, and bad relations with some countries that led to war.

It is the situation where the economy faces a downfall and inflation rises. Such a situation creates doubt in citizens' minds about the working and management of the government and banking system. During this time, many fluctuations are noticed in the foreign exchange market. However, it does not occur suddenly; there are many symptoms before it appears, such as the decline in purchasing power of the people due to inflation, high unemployment, heavy fluctuations in the stock market, failure of the banking system, etc.

The concept of currency crisis began in the 1990s, the instances like downfall in the economy, unemployment, high volatility in the market, etc. results in loss of capital by the countries, which results in the devaluation of the home currency and loss of interest by investors and investments start to decline. Also, the global currency crisis of 1994 increased the currency crisis worldwide. Again, the unfriendly investors' policy by the Asian government devised the currency crisis in 1997.

Such circumstances originate from the balance of payment situation as a deficit in the balance of payment leads to a fiscal crisis. The fiscal turmoil slows down the economy, which results in the liquidation of balance of payment situation as a deficit in the balance of payment leads to a fiscal crisis. The fiscal crisis slows down the economy, which results in the liquidation of foreign investments and downfall in the stock and forex market.

Such a crisis can be controlled by the country's apex bank or government by increasing the money supply in the market by increasing currency issuance, increasing the interest rates, selling foreign reserves, etc. The government takes measures to make the home currency stable. The currency crisis also affects foreign investors.

The indicators of a currency crisis are explained in the stage-wise name. The first-generation currency crisis reflects the symptoms at an initial stage. The second-generation currency crisis reflects the situations of fluctuation in a middle and third-generation currency crisis, i.e., the final stage explains the main factors due to which the currency devalued and the currency crisis occurred. Therefore, each model is described under -

#1 - First Generation

During the first generation, the rate of gold starts fluctuating due to the stock market fluctuation. It resulted in changes in the forex market. Investors get skeptical but maintain the investment after the government's assurance about conserving fixed exchange rates.

#2 - Second Generation

In the second stage, investors' doubt increases due to constant fluctuations in the exchange rate as the government might not maintain the fixed exchange rate. The second stage symptoms are inflation, slow economy, economic and monetary policy changes, increasing unemployment, etc. In such a case, the government is forced to look deliberately into the fluctuations and maintain a fixed and continuous rate to prevent a recession. Therefore, in the second stage, the government may also sell foreign reserves to maintain a fixed rate.

#3 - Third Generation

The third generation is the bubble blasts due to continuous fluctuations. The deficit in the balance of payment situation arises, and the banking industry starts collapsing due to heavy volatility and dependence on foreign investments. The value of the loans taken by the country's government in foreign currency denominations also increases because of the devaluation of the home currency. As a result, the country's government was forced to devalue its currency, and the currency crisis began.

1. Heavy fluctuations in the stock market and foreign exchange market.
2. Rise in inflation and unemployment.
3. The adverse affecting changes in monetary policy.
4. The downturn of the economy.
5. Heavy reliance on foreign investment.
6. Clashes between the two countries can cause war situations.

After 2008 the global financial crisis, every country tried to attract foreign investors through their investment policies. Subsequently, in 2008, Turkey faced a decrease in foreign investment. Therefore, it brought several reforms by making the banking sector strong and supplying money in the market to attract investors. But, during that period, Turkish banks and business entities borrowed a huge amount, mostly dollar-based. In 2018, due to the increase in the interest rate by the US federal reserve, the borrowers were scared as they had to repay more, resulting in a loss of faith by Turkey investors. All the conditions resulted in the Turkish currency's devaluation, which led to a currency crisis.

• The government should maintain a low inflation rate by providing employment and a favorable monetary policy.
• Through investors friendly policies, the country can prevent a currency crisis.
• Maintaining fair monetary policies.
• Maintaining good trade relations with other countries.

This article has been a guide to what is Currency Crisis. Here we explain its examples, causes, and models along with discussing how to prevent it. You can learn more about it from the following articles: -

• Currency Appreciation
• Currency Depreciation
• Investing in Currency
• Currency Peg