Currency Crises

A currency crisis occurs when the value of a currency crashes in foreign exchange markets, when holders of a currency stampede to sell it in foreign exchange markets out of fear that the currency is headed for lower values in the future. Foreign exchange markets determine the rate or price at which one currency can be purchased with another currency. An exchange rate of $1 per 10 Mexican pesos tells how many pesos it takes to purchase a dollar and how many dollars it takes to purchase a peso. While exchange rates are subject to market forces, certain groups have vested interests in exchange rate stability. One such group would be U.S. investors who have purchased Mexican peso bonds issued by the Mexican government. Bondholders who purchased Mexican bonds with dollars when the exchange rate stood at 10 pesos per $1 will experience a windfall loss if the Mexican peso depreciates to 20 pesos per $1. When they sell the Mexican bonds and convert the pesos back into dollars, they will receive roughly half as many dollars as they originally invested. Therefore, if holders of Mexican bonds expect the peso to depreciate in the future, they will try to sell their Mexican bonds for pesos, and convert the pesos back into dollars before the depreciation occurs. If large numbers of investors try to sell pesos for dollars all at once, the value of the peso in the foreign exchange market will crash.

Speculators may trigger a currency crisis if they think a currency is vulnerable to a sudden crash. If speculators think the peso may deprecate in the future, they will borrow pesos and sell them for dollars. If speculators borrow pesos to buy dollars when the exchange rate is 10 pesos per $1, then they can repay their loans and reap a profit if the peso depreciates to 20 pesos per $1. Speculative attacks can turn mere expectations that a currency will depreciate into a self-fulfilling prophecy.

The common denominator behind all currency crises is a current account deficit. A current account deficit most likely indicates that outflows of domestic currency from imports exceed inflows of domestic currency from exports. As long as outflows of domestic currency approximately balance inflows of domestic currency, the foreign exchange rate tends to remain stable. If the outflow of currency outruns the inflow of currency on the current account, then foreign investors must either be willing to hold financial assets denominated in the domestic currency, or the central bank responsible for the domestic currency must buy back the excess outflow with its holdings of other foreign currencies. Central bank holdings of other foreign currencies are called foreign exchange reserves. The more foreign exchange reserves a central bank holds, the less likely a domestic currency will suffer a currency crisis. A current account deficit and the associated excess outflow of currency lead to currency depreciation if the central bank does not buy back the excess currency outflow and if foreign investors do not find financial assets denominated in the domestic currency attractive. If, for instance, Mexico has a currency account deficit and the Banco de Mexico does not hold sufficient reserves of U.S. dollars to buy back the excess outflow of pesos, then excess supply of pesos will build up in foreign exchange markets and one of two possibilities are left. One possibility is that foreign investors will purchase the excess supply of pesos and use the pesos to purchase bonds and other investments in Mexico. If foreign investors are afraid of investing in Mexico, or find Mexican interest rates too low, then there will be pesos in foreign exchange markets that nobody wants, and the Mexican peso will depreciate.

Countries that run persistent current account deficits tend to run out of foreign exchange reserves. Speculators are prone to launch speculative attacks on countries with current account deficits and low foreign exchange reserves. If the attack is successful, the currency crashes.

A current account deficit usually indicates a large government budget deficit, but it can indicate a high level of domestic investment spending relative to domestic savings. Either way, the country is importing foreign capital. A currency crisis usually occurs when a country that has been experiencing a foreign capital inflow suddenly starts experiencing a foreign capital outflow, perhaps because foreign investors have lost confidence.