Causes and Solutions for Currency Crises. Historical Overview and Explanatory Models

Seminar Paper , 2021 , 19 Pages , Grade: 2.3

Economics - Monetary theory and policy

In recent years, several currency crises were recorded. These include the currency crises of Latin America (1995), East Asia (1997), Russia (1998), Zimbabwe (2000), Turkey (2018), and currently Lebanon and Venezuela. Why have some currencies failed or crashed throughout history? And are there models/theories to explain why these crises occur?

This paper, therefore, seeks to primarily discuss the general and some possible reasons behind the occurrence of currency crises. The paper also looks at the possible outcomes and effects of currency crises as well as measures that can be taken to address them. It discusses further some known examples of currency crises and the features they have in common.

The rest of the paper is structured as follows: Section 2: Definition of currency crises; Section 3: The general theories of currency crises; Section 4: Examples of some historic currency crises; Section 5: Possible or potential causes of currency crises; Section 6: The outcomes and costs of currency crises; Section 7: Early warning systems and indicators of a currency crisis; Section 8: Measures to mitigate or prevent a currency crisis; and Section 9: Conclusion.

Table of Contents

ABSTRACT

1. INTRODUCTION

2. DEFINITION OF CURRENCY CRISES

3. THE GENERAL THEORIES OF CURRENCY CRISES
3.1 The First Generation Models
3.2 The Second Generation Models
3.3 The Third Generation Models

4. EXAMPLES OF SOME HISTORIC CURRENCY CRISES
4.1 The Mexican Crisis (1995)
4.2 The East Asian Crisis (1997)
4.3 The Russian Crisis (1998)
4.4 The Brazilian Crisis (1999)
4.5 The Ecuadorian Crisis (2000)
4.6 Conclusion from Historic Examples

5. POSSIBLE OR POTENTIAL CAUSES OF CURRENCY CRISES
5.1 Political Instability, Conflicts, Natural Disasters, and Pandemics
5.2 Bad Economic Policy; Corruption; and Nepotism
5.3 Low Stock of Foreign Exchange Reserves
5.4 Fixed and Pegged Exchange Rates
5.5 Lack of Capital Controls Over The In and Outflow of Foreign Direct Investments
5.6 Hyperinflation

6. THE OUTCOMES AND COSTS OF CURRENCY CRISES

7. EARLY WARNING SYSTEMS AND INDICATORS OF CURRENCY CRISES

8. MEASURES TO MITIGATE OR PREVENT A CURRENCY CRISIS

9. CONCLUSION

Works Cited

ABSTRACT

Many countries have experienced currency crises with varying impacts on their respective economies. Many theories have been developed to explain why these currency crises occur. Notable among them are the theories of Krugman (1979), Obstfeld (1986; 1994; & 1996), and Chang & Velasco (2001). Currency crises can be detrimental to economic growth as it leads to losses in economic output. It is therefore imperative that they are identified early and addressed appropriately to limit their impacts.

1. INTRODUCTION

In recent years several currency crises were recorded. These include the currency crises of Latin America (1995), East Asia (1997), Russia (1998), Zimbabwe (2000), Turkey (2018), and currently Lebanon and Venezuela. Why have some currencies failed or crashed throughout history? And are there models/theories to explain why these crises occur?

This paper, therefore, seeks to primarily discuss the general and some possible reasons behind the occurrence of currency crises. The paper also looks at the possible outcomes and effects of currency crises as well as measures that can be taken to address them. It discusses further some known examples of currency crises and the features they have in common.

The rest of the paper is structured as follows: Section 2: Definition of currency crises; Section 3: The general theories of currency crises; Section 4: Examples of some historic currency crises; Section 5: Possible or potential causes of currency crises; Section 6: The outcomes and costs of currency crises; Section 7: Early warning systems and indicators of a currency crisis; Section 8: Measures to mitigate or prevent a currency crisis; and Section 9: Conclusion.

2. DEFINITION OF CURRENCY CRISES

According to Krugman (2000), there does not exist a universally accepted definition for currency crises. He however admits that they involve the common element of investors fleeing a currency in large numbers (capital flight) due to fear of devaluation, which results in the devaluation the investors so much feared. Saxton (2002) alternatively defines a currency crisis as “a situation in which a currency experiences heavy selling pressure or exchange market pressure or a speculative attack”. Chiodo & Owyang (2002) similarly assert that a currency crisis is a speculative attack on a country’s currency that can result in a debt default.

A more theoretical definition of currency crisis is proposed by Frankel & Rose (1996) who define it as “ a nominal depreciation of a currency by at least 25% that is also at least a 10% increase in the rate of depreciation”.

It is important to note that while currency crises fall under the broad category of financial crises, they can be differentiated from other forms of crises such as debt and bank crises. These different forms of crises are often observed to either occur together in a “Twin Crisis” scenario or precede one another. They often develop into an economic crisis which has even more severe consequences.

3. THE GENERAL THEORIES OF CURRENCY CRISES

There exist several pieces of academic literature that have looked into why there are currency crises (Krugman, 1979; Obstfeld, 1986; 1994; & 1996; Eichengreen et al., 1996; Corsetti et al., 1998a & 1998b; and Chang & Velasco, 2001). These models have been classified into 3 groups, namely: the First Generation Models, the Second Generation Models, and the Third Generation Models.

3.1 The First Generation Models

Empirical research on this class of models is generally attributed to Salant & Henderson (1978); Krugman (1979); and Flood & Garber (1984). The central idea shared by these models, particularly by Krugman (1979), is that a currency crisis occurs when there exist fundamental weaknesses in the economic structure such that the government is unable to defend a fixed or pegged exchange rate and fails to fend off speculative attacks. This results in an abandonment of the exchange rate peg and an eventual devaluation of the currency.

In the mechanism proposed by Krugman (1979), he asserts that when the fundamental economic conditions of a country begin to worsen (for example increasing debt levels as well as current account and balance of payment deficits), pressure is exerted on the country’s foreign exchange reserves to address such worsening economic conditions. The pressure on the foreign exchange reserves causes investors to worry and fear a devaluation of the currency. This investor panic will trigger a capital flight and exert pressure on the exchange rate. This further mounts pressure on the government to defend the exchange rate or face a currency devaluation. But before the foreign exchange reserves decline to a critical level, a speculative attack on the currency is initiated which ultimately depletes the reserves and subsequently causes the exchange rate peg to be abandoned whiles the currency depreciates over time.

From the explanation of Krugman (1979), it can be inferred that a country with weak economic fundamentals coupled with a low stock of foreign exchange reserves and particularly an exchange rate peg is highly vulnerable to speculative attacks. These attacks when unsuccessfully defended then result in a currency crisis and an ensuing devaluation of the currency.

3.2 The Second Generation Models

These models developed most importantly by Obstfeld (1986; 1994; & 1996) demonstrate contrary to Krugman (1979) that currency crises may be due to purely self-fulfilling events rather than as a result of weakened economic fundamentals. The possibility of a currency crisis occurring is dependent on a change in rational expectations which results in a speculative attack and not the economic fundamentals (Saxton, 2002). This implies that speculators can initiate an attack even when the economic fundamentals are strong. The success of such an attack however depends on the robustness of the economic fundamentals and the government or central bank’s ability to defend the currency.

Obstfeld (1986) indicates that investors anticipating a change in the economic fundamentals (particularly economic policy) decide whether or not to issue a speculative attack. He adds that change in the rational expectations about future policy coupled with the government’s ability to fend off such an attack can potentially result in a multiple equilibria situation. According to Eichengreen et al. (1996), the possible equilibria are either the speculators do not issue the attack and economic conditions remain unchanged or the speculators issue the attack which ultimately results in a change in the economic fundamentals and possibly a currency crisis in which the exchange rate peg is abandoned and the currency is devalued.

3.3 The Third Generation Models

This class of models explains the causes of the recent currency crises that do not fit the explanations of the first and second generation models. Claessens & Kose (2013) assert that the motivation for this class of models is from the 1990s Asian Crises where large imbalances in the balance sheets of the corporate and financial sectors facilitated the emergence of currency crises. Important contributions to these models were made by Chang & Velasco (2001) who sort explain how deficiencies in the banking and financial system could result in a crisis.

Corsetti et al. (1998a and 1998b) also sort explain the occurrence of currency crises by focusing on microeconomic weaknesses such as moral hazards and over-borrowing. Contributions to this class of models were also made by Eichengreen et al. (1996) who explained that crises could contagiously spread to other countries, particularly to countries with similar characteristics to the crises-originating country.

4. EXAMPLES OF SOME HISTORIC CURRENCY CRISES

This section discusses briefly some notable currency crises in history. The examples of currency crises discussed in this section are obtained from the narration of Aschinger (2001). Aschinger (2001) narrates how currency crises unfolded in five places, notably Mexico, Asia, Russia, Brazil, and Ecuador. The discussions are as follows:

4.1 The Mexican Crisis (1995)

In the aftermath of the 1982 Mexican debt crisis, policymakers implemented restrictive monetary and fiscal monetary measures. These policy restrictions yielded positive results as there were improvements in most macroeconomic variables by 1994. This positive economic progress attracted an inflow of short-term foreign investments. Mexico used a crawling peg against the US dollar and the peso was revalued in real terms. This resulted in an increase in current account deficits and a decline in competitiveness.

At the beginning of 1994, interest rates rose in the US thus draining portfolio capital out of the Mexican economy and causing the Mexican government to roll over its foreign debt. This development coupled with political instability and other factors resulted in speculative attacks against the peso which later was devalued by approximately 30%.

4.2 The East Asian Crisis (1997)

Before the East Asian currency crisis unfolded in 1997, most East Asian countries experienced high growth rates in real GDP; maintained budget surpluses; and kept inflation rates low. The exchange rate regime mostly in use was a fixed peg to the US dollar. The promising economic performance of these countries attracted huge capital inflows thus resulting in a massive accumulation of credit. Promises of bank rescues resulted in moral hazards which led to a further accumulation of debt. These developments coupled with poor risk management and poor supervision of the banking system resulted in huge credit failures and a banking crisis.

Despite the promising economic performances, issues of corruption and nepotism made these countries highly vulnerable to speculative attacks. Unfortunately in 1997, Thailand devalued the baht and this marked the beginning of the East Asian currency crises. Due to similarities in the structure of the economies of the East Asian countries, the crises quickly spread to the Philippines, Malaysia, Indonesia, and South Korea. As a consequence of the crises, the currencies of these countries lost over 50% of their respective values against the US dollar. As shown in the figure-1 below, the decline started with Indonesian rupia and subsequently spread to other countries.

Figure-1: Currency Depreciation in East Asian Countries and Russia from 1997-98

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4.3 The Russian Crisis (1998)

According to Aschinger (2001), Russia’s transition to a market economy in 1990 posed some challenges to the Russian economy as many industries and their products were obsolete. The Russian rouble was pegged to the US dollar in 1995. New investment opportunities and support from other European governments increased foreign investments. In 1998 however, the weaknesses in the Russian economy led to a capital flight from the economy. The resulting pressure mounted on the Russian rouble contributed to the exchange rate peg being subsequently abolished. The events that followed saw the rouble being devalued by more than 50% which can be confirmed in figure 1 as the Russian Rouble declined sharply after July 1998.

4.4 The Brazilian Crisis (1999)

In 1994, the Brazilian economy exhibited some structural deficiencies as economic indicators showed among other things, persistently high inflation levels. Following the implementation of the Plano Real (a stabilization plan), economic conditions improved and the Brazilian currency (the real) was pegged to the US dollar using a crawling peg. The Brazilian real was revalued in real terms, resulting in huge current account and budget deficits. The events that followed saw a decline in foreign exchange reserves; a transition to a flexible exchange rate regime; and a devaluation of the real by more than 40%.

4.5 The Ecuadorian Crisis (2000)

Similar to the development of the Brazilian real crises, the Ecuadorian economy experienced deterioration in its economic fundamentals. The deterioration of the economic fundamentals piled pressure on the Ecuadorian sucre (the country’s official currency) as the crawling peg to the US dollar was continuously raised. Foreign exchange reserves got depleted which ultimately led the Ecuadorian central bank to adopt a flexible exchange rate. The sucre was subsequently devalued by more than 40% to the US dollar while the economy deteriorated further.

4.6 Conclusion from Historic Examples

From the narration of Aschinger (2001), it can be concluded that the crises of Russia, Ecuador, and Brazil depicts the explanation of the first generation models. This is because currency crises resulted from the deterioration in economic fundamentals in the respective countries. The crises in Mexico and Asia on the other hand fit the description of the second and third generation models respectively. This is because while the crisis in Mexico was due to self-fulfilling events, the crises in East Asia were a result of issues relating to a weakened financial system, moral hazards, and contagion. The table below summarises and compares the currency crises discussed above.

Table-1 Summary and Comparison of Recent Currency Crises

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5. POSSIBLE OR POTENTIAL CAUSES OF CURRENCY CRISES

It can be inferred from the general models that a currency crisis occurs when the actions of economic agents trigger the initiation of a speculative attack on a currency. These attacks when unsuccessfully defended by the government results in exchange market pressures, depletion of foreign exchange reserves, and a devaluation of the currency. The triggers from the general models are either deteriorating economic fundamentals (first generation models); self-fulfilling events that involve a change in the rational expectations of economic agents about future economic policy (second generation models); or moral hazards, contagion, and deterioration of the financial or banking system (third generation models). Below are some specific factors that can potentially cause a currency crisis:

5.1 Political Instability, Conflicts, Natural Disasters, and Pandemics

With the political situation within a country being unstable for the foreseeable future, investors might be prompted to withdraw their investments to avoid losing them. The same situation might occur in conflict-prone regions that are severely threatened by natural disasters and/or pandemics. The massive capital flight resulting from the reasons given above can exert pressure on the exchange rate. Given that the country in question is not well equipped to deal with such a situation, then there is a chance that the local currency is devalued. An example of this situation is the impact of the two-World Wars on world currencies and the international monetary system during that era. Similarly, the ongoing Covid-19 Pandemic could put pressure on the currencies of emerging economies. Without the necessary and adequate intervention, this can spark another series of currency crises.

5.2 Bad Economic Policy; Corruption; and Nepotism

Bad economic policy, corruption, and nepotism can potentially undermine economic efficiency and economic performance. Extreme levels of these practices can result in poor supervision and management of a country’s financial system, misappropriation and misallocation of public funds, hyperinflation, investment losses, and overborrowing. A continuous trend like this can result in huge economic crises with severe consequences. With increasing fears that investments are going to be lost, investors will be moved to withdraw their investments. Pressure is then mounted on the exchange rate and attempts by the government to defend the exchange rate can result in the foreign exchange reserves of the country being depleted and the currency being devalued. An example of this instance will be the East Asian and Mexican Crises where bad economic practices, corruption, and nepotism were part of the causes of the crisis.

5.3 Low Stock of Foreign Exchange Reserves

From the explanation of Krugman (1979) on currency crises, a country’s ability to fend off speculative attacks relies partly upon its possession of enormously large foreign exchange reserves. A couple of pieces of literature cite the importance of the volume of foreign exchange reserves in events preceding the occurrence of a currency crisis (Krugman (1979); Sachs et al. (1996) and Disyatat (2001)). The findings of Sachs et al. (1996) and Disyatat (2001) particularly indicate that countries become vulnerable to speculative attack once their foreign exchange reserves declined beyond a certain threshold. Hence, it can be concluded that a country that is low on foreign exchange reserves risks experiencing a currency crisis as it cannot defend its currency once an attack is initiated.

5.4 Fixed and Pegged Exchange Rates

In the 1980s and 90s, most countries fixed or pegged their currencies to the US dollar as the strength of the dollar presented some stability to their economies. However, because most of these countries had pre-existing problems with their economies, the central banks of such countries had to defend such exchange rates pegs by using their foreign exchange reserves. As the underlining economic problems made it difficult for such exchange rates to be defended, they ended up depleting their foreign exchange reserves and subsequently abandoned the exchange rate regime and devalued their currency. It is no strange occurrence that this period (the 1980s and 90s) was particularly dominated by currency crises as most developing countries maintained either a fixed or a pegged exchange rate. Examples will be the currency crises of Mexico, Argentina, Russia, Brazil, etc.

5.5 Lack of Capital Controls Over The In and Outflow of Foreign Direct Investments

In general, an increase in the influx of Foreign Direct Investment (FDI) into a country is a positive signal indicating economic growth and also serves as an indication of continuous economic growth. However, underlining faults in the economic fundamentals can undermine the efficiency and effectiveness of such resources. Instances like those discussed in Sections 5.1 and 5.2 can potentially result in a capital flight from a country. Provided that there is a huge proportion of FDI in that country and there are no controls over the movement of capital in and out of a country, it will be nearly impossible for the government to fend off such a capital flight. The ultimate result will be a currency crisis and an imminent devaluation of the currency.

Historical examples of this instance will be the events that unfolded in the Russian; Mexican and East Asian Crises where after an initial influx flight of FDI, deteriorating economic conditions and political instability caused a withdrawal of such capital resources.

5.6 Hyperinflation

Inflation erodes the real value of a currency. With persistently high inflation rates, confidence in a currency as a legal tender is lost. The currency becomes worthless as it losses its real value and purchasing strength. Currency crises resulting from hyperinflation are typical of economic crises. Examples of hyperinflation-currency crises are the German paper mark, the Zimbabwean dollar, the Venezuelan bolivar, the Ecuadorian sucre, and the Lebanese pound.

6. THE OUTCOMES AND COSTS OF CURRENCY CRISES

Usually, most countries successfully restrict the impact of a currency crisis to the devaluation of their currency and the depletion of their foreign exchange reserves. Others however struggle to minimize the impact of a crisis and it often develops into a huge economic crisis characterized by severe output losses.

Aziz et al. (2000) in a study of 50 countries (for whom currency crises were identified from 1975-97) observed that though not all crises were alike, there were some similarities in the behavior of some macroeconomic and financial variables. In the post crises period, they generally observed the following outcomes:

i. A fall in the level of real exchange rates;
ii. A rise in the level of inflation;
iii. A rebound in export growth following an initial dip in the crisis period;
iv. An improvement in trade and current account balance as well as foreign reserves;
v. Contraction of real money growth as well as real credit growth;
vi. A decline in the growth of output; and
vii. Weakening and deterioration of fiscal balance.

Aziz et al. (2000) concluded that the impact of currency crises can be very costly, particularly in terms of loss of output. They however indicated that losses in output are more likely in crises where the currency collapses entirely than in crises where the impact is mainly shown in huge losses in reserves.

Figure-2 below shows that while the growth of output for all the currency crises studied was generally below normal during the crisis, output losses were much more severe in crises with currency crashes compared to those with a reserve crisis.

Figure 2 Output Growth During Currency Crises

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Source: Aziz et al. (2000), page 50.

In a separate study, Abdushukurov (2019) studied the effects of currency crises on economic growth and foreign direct investments using a sample of 71 emerging and developing economies. His baseline results generally confirmed that currency crises led to a significant decrease in economic growth and foreign direct investments respectively. Thus confirming that currency crises can potentially be detrimental to economic development and growth.

7. EARLY WARNING SYSTEMS AND INDICATORS OF CURRENCY CRISES

Given the potential threat of currency crises, it is important to discover them early and take the necessary precautions to minimize their impact. Many attempts have been made towards developing the perfect early warning system for predicting currency crises (Abdelsalam & Abdel-Latif, 2020). Frankel & Saravelos (2012) indicates that the modeling approaches in this field of research have been generally categorized into four broad groupings, namely:

i.The Probit and Logit Models: These models are used to test the statistical significance of various indicators in estimating the probability of a financial crisis occurring (Eichengreen et al., 1995; Frankel & Rose, 1996; and Sachs et al., 1996).
ii.The Signals Approach: In this approach, several leading indicators of a crisis are selected and studied. If the values of these indicators fall beyond a certain threshold, then it is assumed that a crisis signal has been identified (Kaminsky et al., 1998).
iii.Cross-Country Qualitative and Quantitative Analyses of the behavior of various variables that indicate the occurrence of a crisis (Edwards & Santaella, 1993).
iv.The use of modern techniques such as binary recursive trees (Ghosh & Ghosh, 2003) ; artificial neural networks and genetic algorithms (Nag & Mitra, 1999) ; and Markov Switching Models (Cerra & Saxena, 2002).

These models together with some leading indicators (such as reserves levels, the real exchange rate, GDP, and current account balances) help in identifying impending currency crises. Thus helping policymakers and investors to take the necessary measures to avoid or limit the impact of the crises.

8. MEASURES TO MITIGATE OR PREVENT A CURRENCY CRISIS

In a broad context, it can be concluded from the argument of Krugman (1979) that good economic policy and strong economic fundamentals decrease the likelihood of a speculative attack on a currency. It can also be concluded that huge stock foreign exchange reserves enable the central bank of a country to successfully defend its currency and exchange rate once such an attack is initiated. Thus any country with these two criteria can be assumed to be better positioned to handle a currency crisis. Aside from these two general measures for preventing and handling a currency crisis, the following are some specific measures to help prevent or handle a crisis:

i.Instituting capital controls to limit the in and outflows of capital from a country as well as helping to govern a country’s balance of payment.
ii.The International Monetary Fund’s (IMF) guidance and assistance concerning sound economic policy as well as bailouts to help shore up foreign exchange reserves and address structural economic issues.
iii.Promoting and facilitating economic and political stability as well as the pursuit of sound fiscal and monetary policy.
iv.Creation of a safe and sound investment environment that involves strong banking and financial systems with a guarantee of investor’s safety and void of moral hazards. This ultimately diminishes the probability of a capital flight and a speculative attack.
v.Using and maintaining the appropriate exchange rate regime might prevent the central bank from spending a significant proportion of its reserves in defending the exchange rate when it comes under attack.
vi.Countries should differentiate their economies structurally from others (particularly from those nearby) to limit the probability of currency crises spreading to them (insight from the East Asian currency crises).

9. CONCLUSION

From the analysis made above, it can be concluded that a currency crisis occurs when a currency gets devalued against a foreign currency as a result of a speculative attack on the said currency coupled with the depletion of foreign exchange reserves thus limiting the central bank’s ability to defend the currency against such an attack. These attacks are usually likely when there exist fundamental economic weaknesses as well as political instability.

The impact of a currency crisis can be costly as it results in output and reserve losses as well as low economic growth. Therefore, economic agents need to pay attention to the leading indicators of currency crises and take the appropriate measures to limit their impact and if possible to avoid them.

Works Cited

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• College: University of Siegen (Faculty 3: School of Economic Discipline)
• Grade: 2.3
• Author: James Oppong-Gyebi (Author)
• Publication Year: 2021
• Pages: 19
• Catalog Number: V1348984
• ISBN (PDF): 9783346853684
• ISBN (Book): 9783346853691
• Language: English
• Tags: Currency Crises, First generation currency crises, Second Generation Currency Crises, Third Generation Currency Crises